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ONE OF A SERIES OF GUIDES FOR FINANCIAL MANAGEMENT DEVELOPMENT FROM www.FinancialManagementDevelopment.com
This is one of a series of documents produced by David A Palmer as a guide for managers on specific financial topics to assist informed discussion. Readers should take appropriate advice before acting upon any of the issues raised.
Financial Management Development
DAP 213 Page 2 of 10
BUDGETARY CONTROL AND VARIANCE ANALYSIS
WHY COMPARE ACTUAL AND BUDGET? One of the objectives of budgeting is to provide a base against which actual performance can be measured. This is only worth doing if action will be taken as a result. In too many organisations the production of results compared to budget is seen as the end of the process. If no action is taken on the basis of management accounts then there is little point in producing them and even less point in wasting management time discussing them. PLAN MONITOR EVALUATE
By identifying progress from a preceding position we are better informed regarding the effects of our actions and have a clearer understanding of the effect of any future action we take. Knowing how much is being spent each month enables a manager to consider whether action needs to be taken to spend more or less in the future. THIS PROCESS IS ONLY WORTHWHILE IF THE BUDGET IS REALISTIC. ANALYSING VARIANCES AGAINST AN UNREALISTIC BUDGET IS POINTLESS. However, in a well run organisation the comparison between actual and budget is used as the basis for deciding the appropriate action. This paper sets out how the analysis is used to maximum effect. The process is really part of the normal control process. WHAT CAUSES BUDGET VARIANCES? There are four key reasons and it is important that good managers recognise the differences, because the action required is may be completely different in each case. The four reasons are: 1. Faulty Arithmetic in the Budget Figures 2. Errors in the Arithmetic of the Actual Results 3. Reality is Wrong 4. Differences between Budget Assumptions and Actual Outcome Each of these will be examined in turn.
© David A Palmer 2000
Financial Management Development Faulty Arithmetic in the Budget Figures
DAP 213 Page 3 of 10
It is perfectly possible to have an error in the budget. This includes errors of commission or duplication as well as pure arithmetic. One action is to make a note to ensure it does not happen again when the next budget is being done. Other action depends on the error. Assume the budget stated no overdraft would necessary and it now appears one is required because the sales forecast was used to predict cash inflows rather than the debtor payments. There are two options: Go to the bank and ask for an overdraft, or take some other action to improve cashflow to stay within the budget cash figure. The original budget numbers will need to be changed to reflect the new circumstances and future reporting should be against the revised budget (often called a reforecast or latest estimate.) Action is required but it may not be within the area where the error was made. AVOID: "There's a hole in the roof but we can't fix it because we haven't got a budget for repairs!!!"
Errors in the Arithmetic of the Actual Results It is perfectly possible for the actual results to be reported wrongly. This includes the use of the wrong category, omission of costs, double counting of income etc. One well known way of staying within budget is to throw away any invoices received from suppliers, or charge them to someone else's account code. This sort of deliberate action makes a nonsense of budgetary control and must be avoided. The corrective action once this is discovered is to prevent it happening again. Improvements in...