3.5.2 - Budgets and cash-flow forecasts

3.5.2 - Budgets and cash-flow forecasts

Budgets set financial expectations and limits, while cash-flow forecasts show when money is likely to be available. This lesson teaches how to construct and interpret both, calculate variances and explain what payment timing means for financial decisions.

Setting and using budgets

A budget is a financial plan for a future period, normally expressing expected revenue, costs or profit for a business or department.

Constructing a manufacturing budget

A manufacturer's sales plan for next month is 2,000 items at £30 each. Materials cost £12 per item and other monthly costs total £25,000.

  1. Revenue budget:
2,000×£30=£60,0002{,}000\times£30=£60{,}000
  1. Materials budget:
2,000×£12=£24,0002{,}000\times£12=£24{,}000
  1. Profit budget:
£60,000−£24,000−£25,000=£11,000£60{,}000-£24{,}000-£25{,}000=£11{,}000

The same planned volume drives both sales and materials. The period and assumptions make comparison with actual results meaningful.

Constructing a service budget

A cleaning service plans 400 appointments at £75 each in September. Variable supplies cost £25 per appointment and other costs are £12,000.

  1. Budget sales:
400×£75=£30,000400\times£75=£30{,}000
  1. Budget variable supplies:
400×£25=£10,000400\times£25=£10{,}000
  1. Budget profit:
£30,000−£10,000−£12,000=£8,000£30{,}000-£10{,}000-£12{,}000=£8{,}000

These are planned results, not cash receipts or guaranteed outcomes.

Budgets coordinate functions. Marketing's forecast affects the materials and staffing required in operations, while the finance function checks whether the spending is affordable. Setting a limit can make a manager choose between competing uses of funds. Comparing actual results with the budget also identifies areas needing investigation.

Budgeting is valuable only if the figures are credible and the process encourages useful behaviour. A manager may deliberately understate likely revenue or overstate costs to make a target easier to achieve. A rigid spending limit may block a worthwhile response to unexpected demand. Alternatively, a budget developed with departmental input can improve understanding and commitment, provided estimates are challenged rather than accepted automatically.

When output changes, part of a cost difference may be explained by producing more or fewer units. Spending £26,400 on materials instead of a £24,000 budget might be reasonable if production increased from 2,000 to 2,200 items at the same £12 rate. Compare actual output and prices before attributing the entire difference to inefficiency. A budget is a benchmark built on assumptions, not proof of what must happen.

TfL's budget presented to its Board on 26 March 2025 planned about £1.9 billion of capital investment for 2025/26 and an operating surplus to support its network. A public transport organisation still uses financial plans to coordinate services and resources; these were budget intentions rather than proof of the later actual expenditure. TfL's 2025/26 budget presentation.

Adverse and favourable variances

A variance is the difference between an actual result and its budgeted figure.

Use the convention variance=actual−budget\text{variance}=\text{actual}-\text{budget}, then describe its financial effect. A positive sign is not automatically favourable. Revenue above budget is usually favourable, while costs above budget are usually adverse, other things equal.

Monthly measureBudgetActualActual minus budgetClassification
Revenue£60,000£57,000−£3,000£3,000 adverse
Materials cost£24,000£22,000−£2,000£2,000 favourable
Other costs£25,000£26,000+£1,000£1,000 adverse
Profit£11,000£9,000−£2,000£2,000 adverse

The same manufacturer's monthly period is used throughout.

Actual profit is £57,000−£22,000−£26,000=£9,000£57{,}000-£22{,}000-£26{,}000=£9{,}000. The £2,000 saving in materials partly offsets the £3,000 revenue shortfall and £1,000 rise in other costs. Classification should describe the impact on profit, not simply the arithmetic sign.

Reading the manufacturing variances

  1. Subtract the budget from actual revenue:
£57,000−£60,000=−£3,000£57{,}000-£60{,}000=-£3{,}000

This is adverse because sales value is below the plan.
2. Apply the same subtraction to materials:

£22,000−£24,000=−£2,000£22{,}000-£24{,}000=-£2{,}000

This is favourable to current profit because spending is lower.
3. Combine the effects, including £1,000 higher other costs:

−£3,000+£2,000−£1,000=−£2,000-£3{,}000+£2{,}000-£1{,}000=-£2{,}000

The profit variance is £2,000 adverse.

A profit gain despite an adverse cost variance

A hotel budgets revenue £90,000 and costs £60,000. Actual revenue is £98,000 and costs £66,000.

  1. Budget and actual profits are:
£90,000−£60,000=£30,000£90{,}000-£60{,}000=£30{,}000 £98,000−£66,000=£32,000£98{,}000-£66{,}000=£32{,}000
  1. Revenue's £8,000 favourable variance outweighs the £6,000 adverse cost variance:
Profit variance=£32,000−£30,000=£2,000 favourable\text{Profit variance}=£32{,}000-£30{,}000=£2{,}000\text{ favourable}
  1. Higher costs alone do not establish a worse profit outcome.

Variances prompt investigation. Lower revenue could result from lower selling prices, weaker demand or a production problem that prevented sales. A favourable materials variance might reflect a negotiated discount, but it could also arise from using poorer materials or making fewer items. Saving training expenditure may improve this month's cost variance while harming future service.

Managers should consider the size, cause, controllability and likely persistence of a variance. Responding to a temporary adverse variance by cutting essential investment can worsen future results. Conversely, repeatedly missing a realistic budget may reveal a problem that requires action.

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