Sales revenue / income budget
Forecasts revenue expected from sales. Managers need estimates of sales volume and selling price. It can be prepared for the whole business or for individual products, regions, brands or divisions.
Cambridge International AS & A Level Business · 9609 · AS Level
5.5 Budgets
Budgets turn business plans into financial targets. They help managers plan revenue and expenditure, allocate resources, monitor performance and investigate why actual results differ from expectations.
Exam-focusedComplete Topic 5.5Calculations + interpretationInteractive questions
What you need to know
You should understand different types of budgets, evaluate their benefits and drawbacks, compare incremental, flexible and zero budgeting, explain how budgets support management, and calculate and interpret favourable and adverse variances.
High-grade habit: a variance is not automatically evidence of good or bad management. Identify its size and direction, then explain possible causes and whether they were controllable.
Subtopics
These follow the textbook table of contents. Select one to jump directly to it.
5.5.1
The meaning and purpose of budgets
A budget is a financial plan for a future period. Businesses normally prepare a set of linked budgets for a financial year, often broken down month by month. Budget figures are forecasts, so their usefulness depends heavily on the quality of the information and assumptions used.
Production / expenditure budget
Forecasts spending required to operate, such as labour, materials, fuel and overheads. These budgets help keep spending under control and can be delegated to managers responsible for particular areas.
Profit budget
Combines forecast revenue and forecast costs to predict the profit or loss expected over the period. Changes in demand or costs can make the original figure inaccurate.
Budgeted profitBudgeted sales revenue − budgeted total costs
Actual profitActual sales revenue − actual total costs
Business-wide financial plan
Revenue budgetsSet income targets.
Expenditure budgetsLimit and direct spending.
Profit budgetShows the combined expected result.
Benefits of budgets
Control expenditureManagers can compare spending with agreed limits and act before costs become excessive.
Allocate resourcesFunds can be directed toward areas considered important, such as research, promotion or product development.
Motivate and delegateResponsibility for a budget can give employees and managers clear targets and greater responsibility.
Set performance targetsSales budgets can provide measurable targets for individuals, teams and divisions.
Compare parts of the businessActual performance against budgets can highlight areas that control costs or generate revenue effectively.
Support planningPreparing budgets forces managers to research expected sales, costs and resource requirements before acting.
Drawbacks and limitations of budgets
- Forecasts may be wrong. Unexpected changes in demand, competition, prices or the wider economy can make budgets inaccurate.
- Delegated budgets may require training. Some employees may not be confident managing financial responsibility, and training can be costly.
- Allocation can be political. Strong negotiators may obtain larger budgets even when other departments have greater needs.
- Budgets can encourage short-term decisions. Managers may cut spending simply to meet this year's target even if the decision damages long-term performance.
- Targets can distort behaviour. Managers may try to make targets easier to achieve or protect their own departments rather than the overall business.
Evaluation: the value of budgeting rises when forecasts are realistic, budgets are reviewed regularly, managers understand the reasons behind targets and the system does not encourage short-term behaviour.
Different approaches to budgeting
Incremental budgeting
The new budget starts with the previous period's figures and adjusts them by a relatively small amount.
Works best: when the environment is stable and changes are predictable.
Problems: it can carry inefficiencies forward, encourage overspending, allow managers to manipulate forecasts and make it difficult to obtain funding for new or risky projects.
Flexible budgeting
A flexible or flexed budget changes in line with the actual level of sales or production. Costs that vary with activity are recalculated, while costs that do not depend on output may remain unchanged.
Benefit: it gives a fairer picture of management performance when actual activity differs substantially from the original plan.
Zero budgeting
Expenditure budgets begin at zero. Budget holders must justify the resources they request rather than automatically receiving last year's allocation.
Benefit: it can control cost and redirect funds as priorities change. Limitations: it is time-consuming, depends on managers' ability to justify bids and is not suitable for setting sales-revenue budgets at zero.
Flexible-budget example
Suppose the original sales-revenue budget is $800,000 but actual sales are $640,000. Actual activity is therefore 80% of the original level. If a variable labour-cost budget was $200,000, a simple flexed labour budget would be:
$200,000 × 80% = $160,000. Comparing actual labour cost with $160,000 is more meaningful than comparing it with the original $200,000 when sales were 20% below plan.
How budgets are used
1Measure performance
Compare actual revenue, costs and profit with the budget and investigate major differences.
2Allocate resources
Direct finance, people and other resources toward areas expected to perform well or needing support.
3Control the business
Give responsibility to budget holders and monitor whether spending and revenue stay on plan.
4Assess projects
Forecast the financial effects of a new product, market, location or other major decision before committing resources.
5.5.2
Variances
A variance is the difference between a budgeted figure and the actual result. Variance analysis helps managers monitor whether financial plans are being achieved and decide whether corrective action is needed.
What managers analyse
- Expenditure: repeated overspending may indicate weak cost control, waste, inefficient capacity use, quality problems or unrealistic budgets.
- Sales revenue: revenue below budget may result from high prices, weak promotion, poor targeting, low product quality or stronger competition.
- Profit: profit below budget can be caused by lower-than-planned revenue, higher-than-planned expenditure, or both.
Favourable and adverse variances
Favourable variance
The difference is expected to improve profit compared with the budget.
- Actual sales revenue is higher than budget.
- Actual wage, material, fuel or overhead cost is lower than budget.
- Actual profit is higher than budget.
Adverse variance
The difference is expected to reduce profit compared with the budget.
- Actual sales revenue is lower than budget.
- Actual costs are higher than budget.
- Actual profit is lower than budget.
Fast rule: for revenue and profit, higher actual figures are normally favourable. For costs, lower actual figures are normally favourable.
Calculating and classifying variances
Sales revenue: budget $900,000; actual $845,000. Difference = $55,000 adverse because revenue is below plan.
Materials: budget $260,000; actual $245,000. Difference = $15,000 favourable because cost is below plan.
Profit: budget $150,000; actual $172,000. Difference = $22,000 favourable.
Materials: budget $260,000; actual $245,000. Difference = $15,000 favourable because cost is below plan.
Profit: budget $150,000; actual $172,000. Difference = $22,000 favourable.
Why a variance occurred matters
Variance analysis is useful only if managers investigate causes. Some causes arise inside the business; others result from changes in the external environment.
| Possible cause | Possible variance | Why |
|---|---|---|
| Unexpected economic growth | Favourable sales revenue | Demand may exceed the original forecast. |
| Strong competitor launches a new product | Adverse sales revenue | Customers may switch away from the business. |
| Input prices rise unexpectedly | Adverse expenditure | Materials, fuel or other operating costs exceed budget. |
| Imported inputs become cheaper | Favourable expenditure | The business pays less than forecast for resources. |
| Poor market research | Either direction | Revenue and related expenditure plans may have been based on inaccurate forecasts. |
| Lower-than-expected output | Favourable direct-cost variance may appear | Less production uses fewer variable resources, so the lower cost may not reflect efficient management. |
Responding to adverse variances
Sales revenue below planReview promotion, pricing, product quality, customer targeting, brand image and possible new markets.
Production costs above planReduce waste, improve labour productivity, seek lower-cost inputs or review purchasing methods.
Profit below planInvestigate both revenue and cost variances rather than assuming one side of the budget is responsible.
Repeated variancesCheck whether the original budget was realistic. Persistent differences may reflect poor forecasting rather than poor operating performance.
Favourable variances also need investigation
A favourable variance can create new problems. Sales above budget may require extra materials and labour, producing adverse cost variances. If demand rises beyond what the business can supply, customers may face delays or stock shortages. Managers therefore need to interpret budgets as a connected system rather than judging each figure in isolation.
Evaluation: budgetary data is useful for measuring financial performance, but it is not a complete measure of business success. The quality of the original budget, external changes, customer satisfaction, quality and long-term objectives may all affect the judgement.
5.5 revision checklist
Define a budget.
Explain sales revenue budgets.
Explain production/expenditure budgets.
Explain profit budgets.
Evaluate benefits of budgeting.
Evaluate drawbacks of budgeting.
Explain delegated budgets and budget holders.
Explain incremental budgeting.
Evaluate incremental budgeting.
Explain flexible budgeting.
Flex a variable-cost budget when activity changes.
Explain zero budgeting.
Evaluate zero budgeting.
Explain how budgets measure performance.
Explain how budgets allocate resources.
Explain how budgets support control and monitoring.
Define a variance.
Distinguish favourable and adverse variances.
Calculate revenue variances.
Calculate expenditure variances.
Calculate profit variances.
Explain causes of variances.
Suggest responses to adverse variances.
Explain why favourable variances still need investigation.
Evaluate budget data as a measure of performance.
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.