3.9 Budgets 

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to learn how to construct budgets and calculate variances.

Cost centre is a unit of a business to which the costs can be allocated for accounting purposes. The idea behind creating cost centres is to see which parts/units of the business generate costs and how large these costs are. Cost centres may be compared with each other to see which ones are dealing with costs more effectively. Cost centre is not in any way a bad thing. Naturally, some parts of business do not make profits but they are still necessary for success. Usually, HR department, Research and Development department, Production department, call centres and etc. do not make any profits but are still essential and crucial to the business.

Profit centre is a unit of a business to which costs and profits can be allocated for accounting purposes. The idea behind creating a profit centre is to see which parts/units of the business are the most efficient at maximising profits and how large these profits are. Keep in mind that profit is revenue minus costs, so profit centres incur both costs and profits at the same time, unlike cost centres. Typical examples of profit centres could be Sales department or store/shop branches where sales are happening.

Why would a business create cost and profit centres? There is already division into departments, right? Well, the answer is really simple: business is divided into cost and profit centres in order to open a new perspective onto the business, to imagine a business as a machine that can do two things: generate profits and incur costs. From this perspective, managers can see which areas of business contribute mostly to the financial well-being of the organisation, and which areas are the most demanding in terms of costs.

Hopefully, from Unit 1 you remember that all businesses perform four functions. Even if the business is just one person, there are still four business functions: HR, finance, marketing and operations/production. Larger businesses are divided according to business functions and have several departments (not necessarily four), while smaller businesses do not have departments. Sometimes, departments and cost/profit centres overlap. For example, HR, Finance and Production departments can be cost centres and Marketing department can be a profit centre. In this case, cost/profit centres are defined by function. However, there are other ways how cost/profit centres may be determined, and it may not overlap with departmental/functional division. For example:

• by product (if it’s a car manufacturer, then different car models can determine cost/profit centres),
• by store (if it’s a pizza franchise, then different branches/restaurants can be cost/profit centres),
• by region (if it’s a multinational company, then different locations may serve as cost/profit centres),
• by office (if it’s a company with several offices in different parts of town, then different offices may serve as cost/profit centres).

So, overall, the purpose of cost and profit centres is to see how efficiently costs are minimised and profits are maximised in different business parts. Cost/profit centres don’t have to overlap with departments, although they may.

Brainteaser: imagine you are a CEO of your dream company. How would you divide your company functionally? Which departments would your company have? Now, how would you divide your company according to cost and profit centres? Would these two divisions be the same or different? Why?

The second assessment objective (see above, under the title of this part of class) is to learn to explain the role of cost and profit centres. One of the best ways to talk about the role of something is to be balanced and consider the pros and cons of it. That is exactly what we are going to do with cost and profit centres.

On the one hand, cost and profit centres are a great way to monitor efficiency by seeing how well different parts of business generate costs and profits . In addition, these centres may be used for decision-making and planning, including budgeting that we will talk about in the next part of class. Cost and profit centres are a great source of data that may be used for analysis and forecasting. In addition, they can act as a motivator for staff and keep employees focused on maximising profits and minimising costs. Overall, costs and profit centres open a new perspective onto business and allow managers to see the business as an organisation that generates costs and profits.

On the other hand, if too much emphasis is put on maximising profits and minimising costs by any means necessary, then it can be too stressful for employees. Even though costs and profits are crucial to any organisation, they are definitely not the only thing that business is about… In addition, qualitative factors are ignored (level of competition, fashion, etc.). So, for example, if two profit centres are nearly identical but one generates lower profits than the other, it might not necessarily be due to a manager’s fault, it might be because of more intensive competition or other qualitative factors. Besides, interdependence and coordination of the entire organisation are at risk. As we learnt in Unit 2, the more organisation is divided into parts, the more likely its parts are to turn into independent uncoordinated entities, which is unhealthy from the whole-organisation perspective. And lastly, sometimes, cost and profit centres are not even feasible, because sometimes indirect costs apply to the entire business (for example, rent), so it is impossible to attribute costs and profits to one part of the business only.

Think about division into cost and profit centres as of your school: your school is divided into floors, but it’s also divided into departments (science, humanities, languages, etc.). Floors and departments may overlap, or may not. Same thing with departments and profit/cost centres.

Budget is a financial plan of estimated revenues and expenditures for a future time period. It is, for some reason, quite a common misconception among my students that budgets are only the limitations for how much money organisation can spend. It it not true. Budgets can account for costs (how much you are allowed to spend in the future time period) and also for revenues (how much money you expect to get within the same future time period). Please be mindful of that.

Instead of saying “a person who is in charge of budget”, there is actually a business term for that. Budget holder is person (or group of people) who formulate budget(s) and are in charge of their achievement. Please use this vocabulary when you, for example, analyse individual implications for people who are in charge of budgets. Oops, I meant to say “budget holders”.

One more thing about budgets is that there are usually several budgets within any organisation and, usually, the larger the organisation is, the more budgets it has. The overall budget of all budgets in any organisation is called master budget. However, there might be other budgets as well. For example, different functional departments of any organisation might have marketing, staff, sales or production budgets.

Variance is a discrepancy between actual and budgeted outcomes. Variances occur all the time. It hardly ever happens that costs and revenues were exactly as budgeted. Variances may be favourable (when they are in favour of the organisation) and adverse (when they are not in favour of the organisation). You may also call adverse variances "unfavourable". Please do not call variances “positive” and “negative” because mathematically negative variances can be favourable (for example, if actual costs turned out to be lower than budgeted). So, “favourable” and “adverse” is the vocabulary that we use when we talk about variances.

It goes without saying that budget is basically a prediction (usually for a year ahead) and variances can also be calculated when past data is available (usually after the budgeted year ends).

Last thing about variances is that they can be expressed as a percentage or as a monetary value (dollars, yuan, rupiah, etc.). For example, if actual sales were $55,000 and the budgeted sales were $50,000, then the variance is favourable and it is $5,000 or 10%.

Below you may see the budget in IB format.

As you can see, it is pretty easy to construct. The most important points to remember are:

1. Stick to the IB format in Figure 1.
2. Make sure you categorise budgeted items into incomes and expenses right.
3. Make sure you mark variances as favourable and adverse depending on their impact to organisation’s finance.

The second assessment objective for this part of class is to learn to explain the importance of budgets and variances in decision-making. In order to achieve this objective, let’s see the advantages and disadvantages that budgets bring to the overall decision-making in any organisation.

On the one hand, budgets and variance analysis are a great way to control the allocation of funds within an organisation. Without budgets it would be a chaotic short-term approach, but budgets actually allow to stay within the limits. In addition, budgets improve coordination among the parts/units of any organisation. Coordination is making sure different parts of the whole work towards the same goal. So, when there is a master budget, all parts of organisation have to collaborate and be coordinated towards meeting the overall strategic goal. In addition, budget is in a way a tool for planning and any kind of planning reduces potential risks in the future. And lastly, budgets act as motivators by making staff work towards minimising costs and maximising revenues. Overall, budgeting is a necessary exercise for all the businesses that allows to stay within the forecasted limits.

On the other hand, budgeting may result in conflict between departments. Sometimes, if one department gains something, the other one loses something. Finance is limited, so all departments cannot get unlimited financing. That is why, when there is a need to increase budget for one department (let’s say, production), it may only be achieved by cutting the budget for another department (for example, human resources). Think of a budget as of a cake: if someone gets a large piece, someone else will get a smaller one because the size of the cake is limited. Secondly, when employees are under a lot of pressure and do not want to upset their managers, they might take unnecessary “shortcuts” by, for example, by using some cheaper and low-quality materials or even some illegal practices to avoid tax… In addition, when managers are asked to create a budget, they will usually deliberately make it easy to meet. For example, if your parents ask you which grade you are likely to get for IB Business Management, you are likely to say “6” even if you are certain you’ll get a 7. So, managers do the same thing to lower their superiors’ expectations and make themselves look good if they only have favourable variances. That is why, overall, in order to alleviate the drawbacks, planning the budget and budgetary control should be independent.

Make sure you can define all of these:

1. Cost centre
2. Profit centre
3. Budget
4. Budget holder
5. Master budget
6. Variance
7. Favourable variance
8. Adverse (unfavourable) variance