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3.9

Budgets

Unit 3 · Finance and accounts · Higher level only

This topic is higher level only. A budget is a financial plan for the future; a variance is the difference between that plan and what actually happened. This page covers cost and profit centres, how budgets are constructed, how to calculate and interpret variances, and why budgeting matters for control and decision-making.

🎯What you need to be able to do

  • HL Explain the difference between cost and profit centres and their roles.
  • HL Construct a budget.
  • HL Calculate and interpret variances.
  • HL Explain the importance of budgets and variances in decision-making.

📚The business management

Cost centres and profit centres

Cost centre
a section of a business (department, product line, location) to which costs can be allocated, but which does not directly generate revenue: HR, IT, maintenance.
Profit centre
a section for which both costs and revenues can be identified, so its profit can be calculated: each branch of a restaurant chain, each hotel, each product line.

Roles: help managers see which parts of the business perform well or badly; make managers accountable; aid decisions on pricing, investment and closure; can motivate managers who control their own centre. Problems: allocating shared overheads is arbitrary and can make a centre look unprofitable; centres may compete rather than cooperate; extra administration.

Constructing a budget

A budget is a detailed financial plan for a future period, setting targets for revenue, costs and profit. Budgets are usually based on the previous year’s figures adjusted for expected changes (incremental budgeting), sales forecasts and the business’s objectives; zero-based budgeting instead starts from zero and requires every item to be justified. Good practice: involve the managers who will be responsible, set realistic and SMART targets, and review regularly.

Variances

A variance is the difference between a budgeted figure and the actual figure.

Favourable (F)
better for profit than budgeted: actual revenue above budget, or actual costs below budget.
Adverse (A)
worse for profit: actual revenue below budget, or actual costs above budget.

Always label each variance F or A; the sign alone is ambiguous for costs.

Why budgets and variances matter

  • Planning and coordination: departments work towards consistent targets.
  • Control: variance analysis shows where performance departs from plan, so managers can investigate causes (“management by exception”).
  • Accountability and motivation: managers own their budgets.
  • Decision-making: adverse variances may lead to cost cuts, price changes or new forecasts; favourable ones to shifting resources to successful areas.
  • Limitations: based on forecasts; can become rigid when conditions change; may encourage managers to pad budgets or spend unused money; a variance shows that something changed, not why.

✏️Worked example HL

A craft brewery’s budget and actual figures for one quarter ($000): sales revenue 500 / 470; raw materials 180 / 170; wages 120 / 132; marketing 30 / 26. Calculate each variance and the profit variance, and comment.
Sales: 470 − 500 = 30 A
Materials: 180 − 170 = 10 F
Wages: 132 − 120 = 12 A
Marketing: 30 − 26 = 4 F

Budgeted profit = 500 − 180 − 120 − 30 = 170. Actual profit = 470 − 170 − 132 − 26 = 142. Profit variance = 28 A (check: −30 + 10 − 12 + 4 = −28).

A bar chart of variances in thousands of dollars: sales revenue 30 adverse, raw materials 10 favourable, wages 12 adverse, marketing 4 favourable, and profit 28 adverse. Budgeted profit was 170 and actual 142.
Sales and wages drove the adverse profit variance.

Comment: the main problem is sales 30 A. The favourable materials variance may simply reflect lower sales (less brewed), so it is not necessarily good news. Wages rose despite lower sales: overtime or a pay rise? The cut in marketing (4 F) may have contributed to lower sales. The brewery should investigate causes before acting.

Check it. The individual variances must add up to the profit variance when adverse ones are counted as negative.
Assuming favourable means good. A favourable cost variance caused by lower output, or cutting maintenance, may hide problems.

📝Practise

All HL.

1. [2 marks] Distinguish between a cost centre and a profit centre.
A cost centre is a part of the business to which only costs are allocated; a profit centre is a part for which both costs and revenues can be identified, so profit can be measured.
2. [2 marks] Define the term adverse variance.
A difference between budgeted and actual figures that is worse for profit: actual revenue below budget or actual costs above budget.
3. [3 marks] Budgeted revenue $80 000, actual $86 000; budgeted costs $60 000, actual $64 000. Calculate the variances and the profit variance.
Revenue: 6000 F. Costs: 4000 A. Profit: budget 20 000, actual 22 000: 2000 F.
4. [4 marks] Explain two possible causes of an adverse wage variance in a hotel.
(1) More overtime or extra temporary staff because occupancy was higher than forecast, or because of staff absence. (2) A pay rise or a higher minimum wage than was assumed when the budget was set. (Also: inefficiency, higher staff turnover requiring training.)
5. [4 marks] Explain one benefit and one problem of making each branch of a restaurant chain a profit centre.
Benefit: each branch manager can see their profit and is accountable for it, which motivates them and shows head office which branches perform well. Problem: head-office overheads (marketing, management) must be allocated between branches, and an arbitrary allocation can make a branch look unprofitable and lead to wrong decisions such as closure.
6. [10 marks] Discuss the importance of budgeting for a new social enterprise.

Budgets help plan limited resources, show donors, grant-givers and lenders that funds will be used responsibly, set targets for earned income, control costs, and highlight early when the mission is at risk. Variance analysis supports learning in an uncertain first year.

Limitations: little past data, so forecasts are uncertain; rigid budgets may prevent responding to opportunities; time-consuming for a small team.

Judgment: essential for credibility and survival, but should be flexible and reviewed often.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • AccountingCoach — budgeting and variance analysis.
  • CIMA — articles on zero-based and incremental budgeting.
  • Tutor2u — revision notes on budgets and variances.