Written by Drew Coles CIMA chartered Management Accountant
Budgets are an important tool to assess business performance over a period. There several types of budgets a business can set, these include the purchasing, sales and cash budget which feed into a master budget. The budget should be closely matched with the objectives and plans set out for the next period. The main purpose of the budgets is to quantify these objectives in numerical terms. It should also be noted that the budget should be used as a guide to compare actual performance in which the business can then use feedforward and feedback control to close gaps in performance. As a budget is forecast there needs to be a certain amount flexible judgement needed when assessing performance.
It should also be noted when assessing performance that fixed costs and costs out of the control of managers should not be assessed. For instance, a fixed charge for the use a shared service centre on a business unit should not be used in assessing a manager’s performance.
There are a number of ways a budget can be set which include the following:
Zero based budgeting – when the company creates a budget from scratch for the next period. This ensures there is no slack in the budget and that unwanted costs are excluded. The downside is the amount of time required to create a new budget every period.
Incremental budgeting – The business will use the last years budget or company performance and add a percentage increment to account for inflation and trends. The downside of this method is that any unwanted spend is carried on into future periods.
To assess and measure performance key performance indicators (KPI) need to be set. To be of real use KPI’s should be compared to previous periods and from one period to the next to establish trends and highlight issues. KPI’s can measure profitability, liquidity, costs and return on investments therefore they play a vital role in performance measurement.
Profit measurement is one of the most important performance measure. The following key performance indicators can be used, Net profit margin, gross profit margin and operating profit margin. These measures allow the company to analyse trends, for instance a company may have a steady gross profit margin throughout the year, if one period falls this variance can be analysed and the cause rectified for future periods.
The business can focus its analysis on costs during the period using the following KPI, Cost of sales against revenue, operating costs against revenue and overheads against revenue. These costs will be displayed as a percentage to revenue. As above if there is an average cost percentage or a budgeted KPI actual costs can be compared and issues highlighted.
Return on investment measurement
Return on investments
Return on capital employed ROCE is a effective KPI to measure the return on investment in the business. It uses the profit generated and capital invested in the company to produce a measure displayed as a percentage.
There are several KPI's not mentioned here, to assess performance the most important aspect is to use the ones which are most beneficial to your type of business and the industry in which you operate.
Another point worth noting is they are interconnected. For instance, a drop in operating profit margin will cause a fall in ROCE and so on.