Budgets and Variance Analysis

This lesson covers AQA A-Level Business topic 3.5.2 — analysing financial performance through budgets, budget setting, and variance analysis. You will learn how to construct and interpret budgets, calculate variances, and evaluate the usefulness of budgeting as a management tool.

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What Is a Budget?

Key Definition: A budget is a financial plan for the future, expressed in quantitative terms, covering a defined period. It sets targets for income (revenue) and expenditure (costs) and provides a benchmark against which actual performance can be measured.

Budgets are not the same as forecasts. A forecast is a prediction of what will happen; a budget is a target of what the business wants to happen.

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Types of Budget

Budget Type	Definition	Example
Revenue (income) budget	Forecast of expected sales revenue	Target: £500,000 revenue in Q1
Expenditure (cost) budget	Planned spending on costs	Target: keep raw material costs below £120,000
Profit budget	Revenue budget minus expenditure budget	Target: achieve £80,000 operating profit

Formula: Profit budget = Revenue budget - Expenditure budget

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The Budget-Setting Process

Budgets can be set using different approaches:

Historical Budgeting

Based on the previous year's figures, adjusted for expected changes. For example, if last year's marketing budget was £50,000 and management expects 5% inflation, the new budget might be £52,500.

• Advantage: Simple, quick, and based on real data.
• Disadvantage: Perpetuates past inefficiencies; does not encourage managers to justify spending from scratch.

Zero-Based Budgeting (ZBB)

Every budget starts from zero. Managers must justify every pound of planned expenditure from scratch, rather than simply adjusting last year's figures.

• Advantage: Eliminates wasteful or unnecessary spending; forces managers to think critically about resource allocation.
• Disadvantage: Very time-consuming; can create conflict and uncertainty; may lead to short-term thinking.

Exam Tip: AQA examiners frequently ask about the advantages and disadvantages of zero-based budgeting versus historical budgeting. Be prepared to evaluate which approach is more appropriate in different business contexts — ZBB is often used by businesses undergoing restructuring or facing financial pressure.

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Variance Analysis

Key Definition: Variance is the difference between a budgeted figure and the actual figure achieved. Variance analysis is the process of calculating, interpreting, and acting upon these differences.

Types of Variance

Variance Type	Definition	Impact on Profit
Favourable variance	Actual performance is better than budgeted	Positive — improves profit
Adverse variance	Actual performance is worse than budgeted	Negative — reduces profit

For revenue:

• Actual revenue > Budgeted revenue = Favourable
• Actual revenue < Budgeted revenue = Adverse

For costs:

• Actual costs < Budgeted costs = Favourable (spending less than planned)
• Actual costs > Budgeted costs = Adverse (spending more than planned)

Worked Example: Variance Analysis

A bakery sets the following quarterly budget: