Finance and Managment Analysis of HK Corporation - Case Study Example

HK Corporation Table of Contents Page Introduction………………………………………………………………………………………..3 Problems in HK’s Budgeting Process……………………………………………………………..3 Revisions to HK’s Budgeting Process…………………………………………………………….4 Reducing Budgets in Response to Sales Shortfalls………………………………………………..5 Impact on Employee Motivation and Behavior from HK’s Reporting System…………………...6 Benefits Of a Standard Cost System…………………………………………………………........6 Improvements to HK’s System to Increase Employee Motivation……………………………….7 Conclusions………………………………………………………………………………………..7 References…………………………………………………………………………………………8 Case Study: HK Corporation Introduction HK Corporation manufactures standard and custom plastic products. In recent years, the company has not achieved the sales and profit targets established by its annual budgeting process, nor have HK’s functional departments met their individual budgets. Disturbed by these results, HK’s managing director hired an experienced industry consultant who concluded that HK’s total and individual departmental budgets over the last four years were reasonable. This paper will identify problems in HK’s budgeting process and suggest revisions to improve that process; assess whether HK’s functional departments should cut their expense budgets when sales fall below targets; describe the motivation and behaviour of two key functional department managers that likely are being driven by HK’s standard costing and reporting system; describe the benefits that can be realized from a properly implemented standard costing system; and recommend ways for HK to improve its standard costing system to increase employee motivation. Problems in HK’s Budgeting Process HK’s budgeting process has several major problems. First, the only obvious business objectives identified in the budgeting process are sales and income. But despite being expressed mostly in financial terms, a budget should reflect a process of setting and balancing all major business objectives for the coming year, not merely the financial ones. (Drucker, 1973, p.118) Other important objectives that might be identified include HK’s market position or share, launch of new products, balance between standard and custom product sales, discontinuance of underperforming products, introduction of manufacturing improvements and so on. Next, there is little or no discussion among the management team about the budget objectives prior to preparing initial budgets. The objectives are set solely by the managing director, but even if he already knows everything necessary to set all important business objectives, the department managers may not, so they would not be prepared to construct budgets addressing the managing director’s concerns. Similarly, the department managers seemingly do not share information among themselves until a “standstill” occurs in the process. As a corollary, it appears the process does not explicitly identify and share among the management team key assumptions that should be used in preparing budgets, such as costs of key raw materials, product demand from major customers and market segments and important competitive moves. Because budgeting inherently is a forecast, the quality of the budget projections depends on assumptions regarding future developments of certain key external factors important to HK’s business performance. Each manager is almost certainly making his or her own assumptions, so without advance coordination, there may be significantly different assumptions driving conflicting budget proposals. Moreover, in the absence of specific shared assumptions, it would be much more difficult to approve a later budget adjustment if an implicit assumption is proved drastically wrong. This is likely contributing to department budgets being “set in stone.” Because HK’s budgeting process always surfaces the same problems and similar forced solutions among the functional department managers, it could be encouraging the managers to manipulate the process. That is, if certain budget adjustments are always required, a manager’s initial proposal could be specifically designed to emerge with the manager’s preferred budget after the adjustments. For many companies, problems like those noted above are often worked out in advance of budgeting in a process of strategic planning, but it appears that HK does not have this process. If HK does engage in such a process, the company’s budgeting problems suggest it is not particularly effective nor linked to HK’s budgeting process. Revisions to HK’s Budgeting Process Four key revisions to HK’s budgeting process could alleviate, if not immediately solve, most of the above problems. The first would have the managing director and the department managers work together in advance of preparing budgets to explicitly identify (a) major assumptions about HK’s external business environment in the coming year and (b) HK’s major business and financial objectives to be achieved in the budget. This work in advance of preparing budgets is a form of strategic planning, but more explicit, formal and robust than whatever strategic thinking is being done by the managing director. Second, the management team would approach budgeting as a critical part of executing HK’s strategic plan rather than merely a stand-alone exercise in hitting two financial targets. The advance strategic planning would drive formulation and balancing of key budget objectives and the budgeting process would ensure that key strategic initiatives are funded. (Kaplan, 2006) This suggested revision recognizes that linking the two processes may not be easy for HK to achieve, especially at first. According to a major U.S. provider of planning consulting and software, up to 60% of firms fail to link the two because “linking strategies to budgets is one of the most challenging of all management activities.” (Infor, 2009) Nevertheless, even weak initial linkage should help improve HK’s budgeting process. The third suggested revision is to incorporate a team review cycle of proposed budgets. The managing director and the department managers would jointly review the major elements of each department manager’s initial budget proposals and the consolidated total. After these reviews, the managing director would provide final guidance to each department manager to finalize a detailed budget. The fourth revision is to implement quarterly, high-level rolling forecasts that look at least five quarters into the future in order to “help managers to continually reassess current action plans as market and economic conditions change.” (Hope and Fraser, 2003, p.111). Another goal would be to reduce the need for HK’s detailed monthly evaluation of budget variances. Over time, these revisions should result in several improvements, including more realistic and strategically-focused budgets; better communication and teamwork among HK’s management team; and less time and effort involved in budgeting and reporting. The revisions might also facilitate adjusting budgets because of major, unexpected developments and reduce incentives to manipulate the budget process. Reducing Budgets in Response to Sales Shortfalls In HK’s current environment, the most important budget objective is profit, so whenever sales results are below budget, each department is expected to cut costs in order to still achieve the managing director’s target. If HK’s budgeting process remains unchanged and the managing director does not grant an exemption, employees will continue to be obligated to cut costs in response to sales shortfalls. In the event that an employee believes this cost cutting jeopardizes some important operation, the employee should inform his or her supervisor and ask for an exemption. However, if HK’s budgeting process is revised as suggested above, HK budgets would reflect funding and balancing of strategic objectives in addition to profit. In this case, the managing director would have the responsibility for ensuring that cutting costs to achieve the profit objective is still the best strategic decision. Impact on Employee Motivation and Behavior from HK’s Reporting System Because of their functional responsibilities, Ali and Adam are among the HK employees most likely to personally suffer when monthly reports show significant variances between budget and actual costs. Production (Ali) and purchasing (Adam) typically have relatively large cost budgets and relatively slow ability to react to unexpected operational changes, so their variances are commonly among the largest within any production-based company. Moreover both of their annual performance evaluations are logically based significantly on their variance results, so their compensation and careers are more likely to suffer when large variances occur. Based on the conversation between Ali and Adam, motivation and behaviour are major issues for them. This would be expected because motivation is partly a function of the rewards, recognition and punishments an employee receives for job performance, and neither seems to receive much reward or recognition. Similarly, behaviour is partly driven by the consequences an employee expects from a behaviour, but neither Ali nor Adam has much control over the financial consequences of their functional supervision. Nevertheless, it seems not quite accurate to ascribe these negative impacts to HK’s reporting system. More precisely, these impacts seem to primarily be the result of the problems in HK’s budgeting process and management’s ill use of the financial results conveyed by the reporting system. Benefits Of a Standard Cost System Pratt has summarized a rather complete list of the benefits to a business from developing and using a standard cost system: “Useful control information is provided by the standard:actual comparison and the resulting variances.” “The variances allow ‘management by exception’ to be practised.” “The technical analysis necessary to set standards may lead to better methods, greater efficiency and lower costs.” “Motivation and cost consciousness may be stimulated.” “Variance analysis may help to define areas of responsibility.” “The standards set are a useful aid to establishment of budgets, prices and production schedules.” “Standard costs simplify record keeping and stock valuation because standards are used throughout the system.” Pratt also summarizes problems with standard costing but says that “its advantages can outweigh the disadvantages if the business is of sufficient size to be able to use the formal management discipline of variance analysis.” (Pratt, 2009, p.10) Improvements to HK’s System to Increase Employee Motivation As noted above, realising benefits from a standard costs reporting system is not automatic. Rather, it is a function of the accuracy with which the system is designed and the management skill to appropriately apply its outputs. And as earlier discussed, it appears that the negative impact on employee motivation is due to problems in HK’s budgeting process combined with management’s ill use of the financial results conveyed by the reporting system. Therefore, improvement requires that (a) the suggested revisions to HK’s budgeting process be implemented, and (b) the entire management team and certain functional departments such as finance, production, purchasing and personnel be retrained in how to appropriately understand and apply variance analysis with in HK. Conclusions Based on the above analyses, I draw three major conclusions regarding HK Corporation and its budgeting and reporting processes. Perhaps most important, the managing director bears most responsibility for the HK’s dysfunctional budgeting process and ill use of variance reporting. Second, the entire management team shares responsibility for allowing these problems to persist for at least the last four years. Finally, the professional skills of the finance and personnel managers warrant special evaluation by the managing director or his successor. References Drucker, Peter F., 1973. Management: Tasks, Responsibilities, Practices. New York: HarperCollins Publishers, Inc. Hope, Jeremy and Fraser, Robin. February, 2003. Who Needs Budgets? Harvard Business Review. Infor. 2009. 6 Steps for Linking Corporate Strategy to the Budget. Infor Performance Mangement. [online] Available at http://go.infor.com/6steps. [Accessed 3 December 2009] Kaplan, Robert S. 2006. The Office of Strategy Management. Research & Ideas, Harvard Business School Working Knowledge. [online] Available at http://hbswk.hbs.edu/item/5269.html. [Accessed 3 December 2009] Pratt, Maurice. 2009. Standard Costing. University of Cumbria [online] Available at http://www.staff.ucsm.ac.uk/mpratt/STDCSTG2.DOC [Accessed 3 December 2009] Read More