Budgets HL Only
Cost and profit centres, constructing budgets, calculating variances, and using budgets in decision-making.
All content on this page is Higher Level only.
- Distinguish between cost centres and profit centres, and explain how they can be organised
- Compare historical (incremental) budgeting with zero-based budgeting
- Construct a budget and calculate variances, identifying each as favourable or adverse
- Evaluate the role of budgets and variance analysis in business decision-making
Cost Centres and Profit Centres
Roles and Benefits
| Cost Centre | Profit Centre | |
|---|---|---|
| Purpose | Control and monitor costs | Measure performance and profitability of a unit |
| Benefit | Identifies where money is spent; supports cost-cutting | Creates accountability; enables comparison across divisions |
| Limitation | Cost allocation can be arbitrary for shared resources | Can create internal competition; ignores interdependencies |
Types of Cost and Profit Centre
Businesses organise cost and profit centres in different ways depending on their structure:
| Basis | How it works | Example |
|---|---|---|
| By function | Each functional department (Marketing, Finance, HR, Operations) is its own cost centre | A manufacturing firm tracks costs separately for its Marketing, Finance, and HR departments |
| By product / division | Each product line or brand operates as a separate profit centre | Adidas tracks Adidas Originals, Adidas Performance, and Reebok as separate profit centres |
| By geography | Each regional operation is a separate profit centre | Samsung and Apple report North America, Europe, and Asia-Pacific as distinct profit centres |
A profit centre is not just a cost centre that also has revenue — it requires that both revenues and costs are tracked to it, so a meaningful profit figure can be calculated. Cost centres only track costs.
Budgets
A budget is a financial plan expressed in monetary terms, covering a future period. It sets targets for revenue and/or expenditure and provides a benchmark against which actual performance can be measured.
Types of Budget
- Revenue budget: Forecasts expected sales income
- Expenditure (cost) budget: Sets limits on spending
- Profit budget: Combines revenue and expenditure budgets
How Budgets Are Set: Historical vs Zero-Based
| Historical (Incremental) Budgeting | Zero-Based Budgeting (ZBB) | |
|---|---|---|
| Method | Last year's budget is used as the starting point; adjustments made for inflation or known changes | Every budget period starts from zero; every cost must be justified from scratch |
| Advantages | Quick, simple, and familiar; minimises disruption; managers can predict their budget easily | Forces managers to justify all spending; eliminates wasteful legacy costs; encourages efficiency |
| Disadvantages | Perpetuates past inefficiencies ("budget padding"); fails to challenge unnecessary expenditure | Time-consuming and costly to implement; can demotivate managers who must re-justify everything |
| Best used when | Operations are stable and cost structures are well understood | Costs have grown unchecked; significant restructuring is underway; tight cost control is needed |
Zero-based budgeting sounds ideal in theory but is rarely used for all departments simultaneously due to the time and cost involved. Most organisations use ZBB selectively — for departments suspected of inefficiency — while applying historical budgeting elsewhere.
The Importance of Budgets
- Planning: Forces managers to think ahead and allocate resources
- Control: Provides a benchmark to compare actual vs planned performance
- Motivation: Gives departments ownership of financial targets
- Coordination: Aligns different departments towards common goals
- Decision-making: Highlights where resources are needed or where to cut
Constructing a Budget
A simple profit budget:
| Q1 Budget | Q2 Budget | Q3 Budget | Q4 Budget | Annual | |
|---|---|---|---|---|---|
| Revenue | $80,000 | $95,000 | $110,000 | $90,000 | $375,000 |
| Cost of goods sold | $32,000 | $38,000 | $44,000 | $36,000 | $150,000 |
| Operating expenses | $20,000 | $20,000 | $22,000 | $20,000 | $82,000 |
| Budgeted Profit | $28,000 | $37,000 | $44,000 | $34,000 | $143,000 |
Variances
A variance is the difference between a budgeted figure and the actual figure. Variance analysis is the process of investigating why actual results differ from the budget.
Favourable vs Adverse Variances
| Type | Revenue | Costs | Meaning |
|---|---|---|---|
| Favourable (F) | Actual > Budget | Actual < Budget | Better than expected — positive for profit |
| Adverse (A) | Actual < Budget | Actual > Budget | Worse than expected — negative for profit |
For revenue: higher actual than budget = favourable. For costs: lower actual than budget = favourable. The test is always "does this help or hurt profit?"
Worked Example — Variance Analysis
| Budget | Actual | Variance | F / A | |
|---|---|---|---|---|
| Revenue | $100,000 | $92,000 | −$8,000 | Adverse |
| COGS | $40,000 | $38,000 | −$2,000 | Favourable |
| Operating costs | $25,000 | $29,000 | +$4,000 | Adverse |
| Profit | $35,000 | $25,000 | −$10,000 | Adverse |
Overall profit variance is adverse by $10,000. The revenue shortfall ($8k adverse) and overspend on operating costs ($4k adverse) were only partially offset by cost savings on COGS ($2k favourable).
Causes of Variances
| Variance | Possible causes |
|---|---|
| Adverse revenue | Lower sales volume than expected, price reductions, competitor pressure, poor forecasting |
| Favourable revenue | Higher demand than forecast, successful marketing, new customers |
| Adverse cost | Raw material price increases, wage rises, inefficiencies, poor cost forecasting |
| Favourable cost | Bulk discounts, efficiency improvements, lower-than-expected input prices |
The Importance of Variances in Decision-Making
Variance analysis enables managers to:
- Identify problems early — an adverse variance signals that action is needed before it worsens
- Reward performance — favourable variances can be linked to bonuses or commendations
- Update future budgets — repeated variances suggest the budget was unrealistic
- Allocate resources — move resources away from underperforming areas
Budgets and variance analysis are only useful if the budget was realistic. A budget set too high or too low creates meaningless variances. "Budget padding" (deliberately setting easy targets) and unrealistic top-down targets both undermine the system.
Key Terms
- Cost centre: tracks costs only; profit centre: tracks both revenue and costs
- Centres can be organised by function (Marketing, HR), by product (Adidas divisions), or by geography (regional offices)
- Historical budgeting adjusts last year's figures; zero-based budgeting justifies every cost from scratch
- ZBB eliminates waste but is time-consuming; historical budgeting is quick but can perpetuate inefficiency
- Budgets plan expected revenue/costs and act as a control benchmark
- Variance = actual − budget; favourable improves profit, adverse reduces it
- Adverse revenue variance: actual < budget; adverse cost variance: actual > budget
- Variance analysis helps identify problems, reward performance, and update plans
- Budgets are only useful if they are realistic and challenging
| Budget | Actual | |
|---|---|---|
| Revenue | $150,000 | $162,000 |
| COGS | $60,000 | $65,000 |
| Operating costs | $45,000 | $42,000 |
Show answer
| Budget | Actual | Variance | F/A | |
|---|---|---|---|---|
| Revenue | $150,000 | $162,000 | +$12,000 | Favourable |
| COGS | $60,000 | $65,000 | +$5,000 | Adverse |
| Operating costs | $45,000 | $42,000 | −$3,000 | Favourable |
| Profit | $45,000 | $55,000 | +$10,000 | Favourable |
Overall profit variance = +$10,000 Favourable. The strong revenue outperformance (+$12k F) and cost savings on operating expenses (+$3k F) more than offset the COGS overspend ($5k A).
Common mistake: Applying the same rule to revenue and cost variances. For revenue: actual > budget = favourable. For costs: actual > budget = adverse (you spent more than planned). Students often mark all "actual > budget" figures as favourable — the test is always "does this help or hurt profit?"
Show answer
Any two of:
- Input price increases: If commodity prices rose unexpectedly, the actual cost per unit of raw material exceeds the budgeted price.
- Higher production volume: If output exceeded the budgeted level, more raw materials were consumed — though this would also generate a favourable revenue variance.
- Waste/inefficiency: Poor quality control or production waste increased material consumption beyond the budget.
- Inaccurate budgeting: The original cost estimate was simply too optimistic.
Common mistake: Giving only one-word causes ("inflation," "waste") without explanation. Each cause needs development: state the cause, then explain the mechanism by which it creates the adverse variance. Award 1 mark for identification + 1 mark for explanation.
Show answer
Arguments for: Profit centres create clear accountability — managers know exactly how their unit performs. They allow direct comparison across divisions (which branch is most profitable?), support reward systems, and help senior management allocate resources where returns are highest.
Arguments against: Setting up profit centres requires allocating shared costs (e.g. central IT, HR), which is inherently arbitrary and can distort results. Divisions may compete rather than cooperate. A profit centre that looks weak may still be essential to the business as a whole (e.g. a customer service team).
Conclusion: Profit centres are a valuable tool for large, diversified businesses but must be used with care — especially when shared costs are significant or when divisions are highly interdependent. Award marks for balanced argument with reference to context.
Common mistake: Treating "evaluate" as just listing pros and cons. A good evaluation reaches a reasoned conclusion: which side of the argument is stronger, and under what conditions? Without a conclusion, the response is analysis at best, not evaluation.