Budgetary Control and Working Capital Management - Essay Example

?Table of Contents Introduction 2 Traditional Approach of Budgeting 2 4P Based Budgeting 5 Conclusion 8 Working Capital Management 8 Conclusion 13 Introduction: The case study is about two different businesses (A Ltd. & B Ltd) which are contemplating on the outcomes of the implementation of traditional budgeting and budgetary control processes in their organizations. Budgeting is a way of considering resource constraints to formulate plans for development. They are prepared for a long term of about 5 years in future with annual revisions. But, to analyze the benefits of such procedures to any firm, it is very important to understand about the environment in which the firms perform their businesses. A Ltd operates in a very stable environment wherein there is hardly any variation in the different activities of the business like sales, inventory, closing stock, demand and profit. B Ltd on the other hand operates in a very dynamic environment. There are huge variations in the different activities of business continuously for which deciding a single course of action would be very difficult. Whether in stability or dynamism, zeroing on the suitable approach of forecasting and budgeting is imperative. Initiating the suitable course of budgeting helps the management to direct its employees in the desired manner. There are many types of budgeting like the traditional, performance, zero based etc. As A Ltd operates in a non-dynamic environment, traditional approach sounds to be an apt option for it. Traditional approach of budgeting: It is a procedure of forecasting contingencies and planning to overcome those situations effectively. It starts with the: Assumptions to be considered: Developing up of assumptions and plans to mitigate those circumstances- The assumptions could be mostly economic in nature. Some of the economic considerations could be in terms of inflation rate, growth rate, exchange rate, interest rate etc. For example, if there is high inflation, the demand of our product could be low (Unless our product is a necessity). This implies an inverse proportion also as in the case of high interest rate. Similarly, the demand of our product is directly proportional to growth and exchange rate of that particular region. Once these assumptions are laid out, course of action plans which should be taken to control these situations have to be well drawn out in the form of budgets. (Chandra.P, 2006) Approval of the plan: It is like succeeding in the endeavor of convincing the management to take up a particular course of action. As such, a standard path has to be outlined to prepare a successful budget report as follows: Plan Administration: Senior officials of operations along with finance executives should get involved while execution of budgets. The plan should involve all related resources like HR, Technical etc. Planning Profit: Optimum production volume and desired profit have to be ascertained by considering the unit sale price, volume, mix, and cost of production per unit, research and competitive forces of markets. Operational strategies which could be alternatively followed in place of the current plan also have to be examined and the best one has to be selected. These plans usually deal with the realities of plan execution like objective, description of plan, assignment of responsibility, costs expected, need for research and deadlines for each stage and the expected results of those efforts. Planning for contingencies: In case of any contingencies, crisis response also has to be planned to mitigate the loss. Continuous observation of warning signals has to be undertaken. Once all these rigorous efforts have been taken up, by all the functional departments namely sales, production, marketing, HR, Research, sales etc. all these budgets would be combined to form a master budget which would be approved for implementation purposes. (Shim.J.K& Siegel.J.G, 2009) Comparison of Budgets: After the budget period commences, the actual results of all the planned budgets have to be called for on a regular basis. The actuals have to be then compared with the budgeted departmental figures to find if there are any variances (favorable or unfavorable) in monetary terms. If the variances are of significant degree then the managers would be forced to check out for the discrepancies. The degree of significance is mostly dependent on the % of variance to the sales volume and profit earned. (Jain.S.P& Narang.K.L, 2006) Budgetary control: If the variances are of great significance, then immediate control measures have to be implemented to ensure that future results would not be deviating from the budgets. For example, once a hotel administration has discovered that it has paid too much for its room attendants as overtime allowance which is @150% of normal wage. Then, it made a rule to take a 6 hour prior approval for every OT from then onwards. Thus, control has to be implemented to ensure that the actuals do not deviate from the budgeted figures. In this traditional approach, there are a variety of budgets like rolling, continuous, flexible etc which are basically adopted according to the organization’s budgeting period. (Khan.M.A, Olsen.M.D & Var.T, 1993) Advantages of traditional approach: The advantages of traditional budgeting are: Many governmental entities and organizations in static environment use it. It is very simple to implement and control orientation is also simple. Depending on the details available, it offers flexibility. It is very easy to prepare. Due to its familiarity, it is acceptable. It is also consistent with responsibility and authority requirements. Disadvantages of traditional approach: There are also certain disadvantages for this: Today’s business demands are dynamic for which it fails to cater to the needs. Waste identification is not concentrated on. Incoming workload identification is not done. It does not focus on continuous improvisation. Cost drivers which are the key items responsible for increased costs are not identified. It is time consuming and is more focusing on in-puts than on output. Decision makers severely criticize on its ineffectiveness of information delivery. As it is observed that traditional approach is not advisable for dynamic environment, it is inevitable that the firm operating in such circumstances should go in for alternative type of budgeting like the 4P based budgeting comprising of paradigm, process, priority and performance based budgeting. 4P Based Budgeting In this type, all expenditures are ascertained on the basis of standard costs multiplied with the number of units produced in that segment. Paradigm: The basic difference between the traditional and 4PBB is that while the former focuses on workers, the latter focuses on the work. Also, it does not try to carry any backload of previous years like that of traditional type. The activity budgeting is developed according to the workloads projected for the related activity drivers. Process: It focuses on synchronizing workloads within business processes immaterial of departmental limitations. The greatest challenge that the departmental managers face is the synchronization process after preparing independent budgets. For instance, for the same sales forecast, the purchase and receiving manager may budget different budgets thereby leading to variances. These departmental budgets are synchronized to minimize process wastes. Priority: The organizations have limited resources and budgets requests always exceed these limits. When such situations arise, prioritized budgeting provides rank related opportunities to all important functions. The function related activities are not seriously considered if they do not yield the required importance. As such, the important activities are sure to get great importance for a profitable business. Performance: It focuses on outcomes. It concentrates on providing a sound basis on which resource allocation is done. The measurable results are communicated with its help and thus a connection between the current program and forecasted budget can be established. It involves 5 steps: Desired outcome to be identified Outcome performance measure has to be selected Setting of goals reporting of results and Consequential implementation. (Anon, 2003) In this manner the 4PBB can be implemented to focus more on the work quality while maintaining the cost incurrence. There are many advantages of this system due to which it has become quite popular and followed by many firms mostly in the competitive environment. The advantages are: There could be visible increase in efficiency as well as effectiveness by concentrating on important and critical activities The linking of budget to performance would help in improvising the operations cycle. The managers could be more accountable when budget outcomes are considered. Improvement in understanding and communication can be achieved. Issues are prioritized and in this manner, use of resources could reach the optimum levels. Mostly suitable in dynamic circumstances. Minimization of wastage could be achieved through synchronization of activities. As every activity is not short of certain weaknesses, even 4PBB also have some of them: Prioritizing of work may lead to issues of change management in the organization. It should be remembered that budgets are to be drawn only if there is some visible benefit failing which the whole process only would mean hard work without results. Increasing accountability on managers has pressurized them so badly that they are not willing to take up risk and leave some activities unattended only to prove that they are accountable. Prioritizing of works is done on a faster mode to achieve excellent results. But, in this run, usually, some important back end activities may be neglected. Thus, the firm’s comprehensive growth may be crippled. Following this type of budgeting may result in quick fix solutions which may prove to be detrimental to the organization in the long run. Nevertheless, 4PBB, being a new concept is gaining more importance these days because, of its flexibility to face any kind of markets. Thus, the company, Y ltd has to take up 4PBB case of budgeting to ensure that it stays ahead even in dynamic times. Conclusion: Every organization should implement budgeting controls and derive benefit out of that exercise to sustain in the present competition. Where the business is done in a static environment, traditional budgeting which measures controls in terms of money is suitable. In this approach, economic assumptions have to be developed in answer to which budgets have to be formulated with prior approval. The actuals have to be compared with budgeted figures and controls if necessary have to be tightened. There are many advantages and disadvantages of this approach, the main of them being that it is not suitable for dynamic situations. For such scenario, the 4PBB is very useful. It prioritizes work and synchronizes between departments to avoid wastage of time and activity. It makes the managers more accountable. Except for its reliance on quick fix solutions, it is widely accepted in today’s world. Working Capital Management: Cash Flows or liquidity is the important factor for a healthy and growing business. It is the first job of every firm to ensure that its cash reserves are comfortable so that they can be put to optimal use. Here, one point to be noted is that cash flows are not always equal to profit. There may be businesses surviving without profits (by utilizing surpluses of other businesses or periods) but not without cash flows in hand. However, in the long run, the reserves may deplete. Hence, it is important that every business should generate surplus to sustain itself in the long run. The best source for cash in an organization is its working capital. (Anon., 2009). As such, good management always ensures that there is a continual flow of cash. Cash locked in inventory and creditor balances should be released within the planned schedule. In short, working capital is a cycle between sales and other sources of funds like equity loans and the uses of such funds like debtors and inventory. The following diagrams explain the concept more clearly: Sources of funds: Cash is generated in the organization through sales, receivables and equity loans which is utilized for inventory and payables requirements. The overheads costs are also one type of uses of funds. This whole generation of cash and utilizing for further product manufacturing which again transform into sales is called the working capital cycle. It is always desirable if this cycle is less to indicate efficient working capital management. To achieve such efficiency, the firm should ensure faster money collection, reduction in inventory levels and release money tied up in receivables as early as possible. Similarly, if longer credit period facilities are arranged, they will help in easy finance for the future of the organization. The company always has to ensure enough cash reserves to satisfactorily run its day to day activities. The sources of such working capital could possibly be: cash reserves already existing, profits earned, payables received, equity loans raised, overdrafts, lines of credits or even long term loans. The last three sources are the most costly means. However, if the firm fails to raise the required working capital it can lead to a situation of overtrading wherein the customers to whom the sales have been effected may not be serviced properly. This can lead to a negative goodwill of the organization. Hence, sales to working capital ratio should always be optimum. The sales volume is decided by the marginal costing estimates and as such, the firm should ensure that the working capital is sufficient enough to meet those sales targets. If these targets are not met, the early signals of warning are depicted in any of the following discrepancies: Overdrafts/lines of credit exceeding limits Greater pressure on existing reserves Issuing payments in installments to creditors and suppliers Management more concerned with its survival rather than managing the concern Urgent short-term requests to the banks to lend small amounts. Such cashless positions in the organizations in the time of urgency may lead to distortions in its activities which could hardly be set right in the future. As such, they should be avoided. Early recovery of funds: One more way of ensuring working capital reserves is through efficient handling of receivables. Cash collections, if done faster, also mean higher liquidity in hand. This can be achieved by keeping a perfect record of all the debtors and their payment periods. Delay or part payments may lead to higher bad debts in future. As such, collections should never be neglected by following the steps given below: Right attitude should be developed for control on credit disbursement and it should be given a priority Clarity in credit practices should be established by the company The staff and other stakeholders should be very clear of these policies Dealings have to be done professionally when large and new accounts are undertaken Credit rating agencies have to be referred to for examining the debtors to whom we want to extend the credit Every customer has to be given a level of credit limit and no exceptions can be accepted Large customers have to be monitored closely Penalties or charges on overdue have to be commissioned Ageing debtors have to be monitored and fast actions need to be taken to recollect cash from them If the company’s debtor’s average age is longer than the industry estimates then, it should check reasons like weak judgments of credit, lack of proper collection methodologies, credit term enforcement laxity, erotic or sluggish issuance of invoices which may lead to customer dissatisfaction also. Management of payment of funds: Cash can be effectively managed even by carefully handling of creditors. Cash outflows occur due to purchases which can lead to liquidity problems if done unsystematically. Hence, the following points have to be checked: Whether purchase functions are tightly held with few responsible people or are they scattered between junior employees Do purchase sizes get synchronized with demand estimates Are stock-holding and cost of purchasing taken into consideration while placing orders Are all the alternatives of suppliers evaluated to arrive at the right quote and reduce carrying costs Try to deal with creditors offering policy of returns and never depend on single supplier What is the measure of increase in costs that you can pass onto your customers Can you charge a supplier for delay in job Can materials be arranged for staggered or just-in-time-type of purchases and that too with confidence A shrewd businessman always believes in buying well to ensure that he can sell his products with confidence. While early payments or purchase may trigger liquidity problems, slow payments may signal about your paying inabilities. Hence, just as you create a debtors receivable schedule, you should follow a creditor’s payment schedule to enhance your company’s viability. Management of inventory: It is an act of juggling wherein stocks in excess may mean cash lock-up while inadequate stocks may result in sales lost or delays in service. The companies have to identify the slow and fast movers of stock and accordingly plan the purchases. If there are many suppliers, it can also think of just-in-time inventory management. Planning of optimum levels of stock and its maintenance helps in avoiding cash lock-up in unnecessary inventory, and its maintenance/insurance costs. Thus efficiency in working capital management has to be achieved to ensure adequate liquidity in the organization at any given point of time. Working capital management ratios help in proving the efficiency of the management and are as such developed as given below: Ratio name Formula Parameter Desirable Stock turnover ratio: 365*Stock of average no.of days Lower ratio Cost of goods sold Debtors cycle: 365*receivables no.of days Lower ratio Sales Creditors cycle: 365*payables no.of days Higher ratio Cost of sales Working capital ratio Receivables + Inv. -payables sales % Lower ratio Sales Current ratio Current assets no.of times double Current liabilities Quick ratio Quick assets no.of times 1 to 1 Current liabilities Thus the ratios can be calculated which are then to be compared with the industry standards to understand the efficiency of the concerned organization. Accordingly, the managing director of XYZ ltd should also ask for the ratios and take actions of conditioning receivables and payables through efficient schedules. (Anon., 2010). Conclusion: It has been observed that the working capital efficiency of XYZ ltd is not evaluated on a regular basis due to which there may be possibility laxity in the organization which may lead to liquidity problems in the future. Hence, the ratios have to be derived and necessary measures have to be taken up to ensure sustainability of the firm in future. Internet References: Anonymous, 2003, The Strengths & Weaknesses of The Traditional Budgeting, Doc Share, Available at: http://www.docshare.com/doc/172509/The-strengths-and-weaknesses-of-the-tradition, Last accessed: 24/3/2011 Anonymous, 2009, Operating Cycle Homework Help & Tutoring, Tytors on Net, Available at: http://www.tutorsonnet.com/homework_help/working_capital_management/operating_cycle_assignment_help_online_tutoring.htm, Last accessed: 24/3/2011 Anonymous, 2010, Business Plan Papers: Managing Working Capital,. Planware, Available at: http://www.planware.org/workingcapital.htm#1 Last Accessed: 24/3/2011 Book References: Chandra, P 2006, Financial Planning & Forecasting, Financial Management: Theory & Practice, Tata Mc. Graw Hill Publishing Co. Ltd, New Delhi. Jain, S & Narang, K 2006, Budgetary Control, Cost Accounting: Principles & Practice, Kalyani Publishers, New Delhi. Khan, M & Olsen, D 1993, Operations Budgeting, VNR’s Encyclopedia of Hospitality and Tourism, John Wiley & Sons, U.K. Shim, J & Siegel, J 2009, Strategic Planning and Budgeting – Process, Preparation, and Control, Budgeting Basics and Beyond, John Wiley & Sons, U.K. Read More