Budgeting as a form of management control - Essay Example

Understanding Management Accounting and Financial Management January 17, Part A Production Solutions Ltd Cash Budget October November December January February ? ? ? ? ? Inflows: Receipts from debtors 300,000 300,000 300,000 405,000 Total Inflow 300,000 300,000 300,000 0 405,000 Outflows: Fixed Costs 90,000 90,000 90,000 90,000 90,000 Payments to Creditors 60000 60000 90,000 90,000 90,000 Payments for other variable elements 120,000 120,000 193,500 193,500 193,500 270,000 270,000 373,500 373,500 373,500 Net Inflow (Outflow) 30000 30000 (73500) (373500) 31500 Cash bal b/f 70000 100000 130000 56500 (317000) Cash bal c/f 100000 130000 56500 (317000) (285500) To: The Board of Directors – Production Solutions Ltd From: Consultant Subject: Budgeting as a Form of Management Control Date: January 7, 2011 Report Budgeting is a very useful tool in businesses. The benefits to be gained from budgeting are numerous and are available to all companies inclusive of Production Solutions Ltd. It ensures the achievement of the organisation’s objectives (BPP 1998) by forcing managers to carry out an assessment of what may happen in the future and set detailed plans for achieving the targeted results for the functional departments in the organisation. It also takes into consideration the problems that are likely to be encountered. Budgeting communicates ideas and plans (BPP 1998) so as to ensure that each employee that is affected by the plan is aware of his or her role in helping the organisation to achieve its goals. Communication can either be two-way or one-way. Two-way communication allows for dialogue until an understanding exists of what exactly needs to be done. One way communication takes place when management gives instructions or orders to subordinates to perform a task. Budgeting can also coordinate activities among the various departments at Production Solutions Ltd to ensure that there is full integration of the efforts to achieve the goals that have been set. In this respect the sales expected will be communicated in the sales forecast and the production department will base its production plans on the sales forecasted. The purchasing department will plan its purchases based on the amount of buffer stock it needs to maintain at all times and in conjunction with the production plan. Budgeting can provide a framework for responsibility accounting (BPP 1998) by making the different functional departments or budget centres at Production Solutions Ltd responsible for achieving their plans for the operations under their control. Budgeting can also establish a system of control by way of managers comparing the actual results with the plan (BPP 1998). Any deviation from the plan needs to be investigated and appropriate actions taken to close the gap between the results and the plan. Additionally, budgeting can be used to motivate employees to improve their performance by offering them rewards if they meet their targets. BPP 1992 suggests that two levels of attainment should be set so as to challenge employees. “A minimum expectations budget and a desired standards budget which provides some sort of challenge to employees”. The appraisal system lets them know how badly or how well they are doing and what they can do to improve performance if they are performing below standard. The cash budget will indicate cash surplus and cash requirements. Therefore, management can make decisions on how to address the shortfall where this exist. The cash budget for the Company suggests that it may not be a good idea to carry out the plans noted as it could place the company in a worse position than it is in currently. The increased sales and the resultant changes in the credit terms will affect the profits and the cash flow position respectively. Attention should be placed on preparing a master budget which will link or integrate the various functions in the organisation. A master budget is an essential management tool that communicates management’s plan throughout the organisation, allocates resources, and coordinates activities. It is a summary of a company’s plan. It sets specific targets for sales, production, material purchasing, distribution, and financing activities. It normally ends with a cash budget, a budgeted income statement, and a budgeted balance sheet. It represents a comprehensive expression of management’s plan for the future of the organisation and how these plans are to be accomplished (Encyclopedia of Small Business, 2007) and (Horngren et al 2000). Ways in which potential uses of budgeting may conflict with each other Budgets are used to measure performance. If the variances are positive employees are rewarded. Since budgets are used as a basis for rewards it sometimes result in managers playing games by including hedges in their budgets so that they will not appear to overspend. Fraser and Bunce (1997) indicate that the use of the budget can be “damaging to company performance and need to be addressed.” The goals of the divisional heads when preparing the budget are not necessarily the same as that of the organisation. In order to resolve this conflict instead of setting internal targets, companies should benchmark their performances with other companies in the industry. If the company performs well in comparison to others everyone benefits. Targets should be set according to the competition and rolling forecasts should be based on what is happening in the environment (Hope and Fraser 2000). Resources are scarce and so conflict results as each department seeks to obtain a bigger share of the budgeted amount. Thompson (2003) in his research finds this to be a common practice and states that the divisional heads are quick to criticise the expenses of the other departments “while vigorously defending their numbers.” He states that “this is a horrendous conflict of interest, but the ones executing the budget must obviously be responsible for creating it.” The managers in charge are more focused on getting their expenditure approved rather than on the interrelatedness of the budget centres. It is important that divisional heads realise that “members of an organisation are highly interdependent when they develop and use a budget. Top management use budgets to specify the objectives and plans for the organisation as a whole, allocate limited resources, and anticipate its revenues (Etherington and Tjosvold 1998). Fraser and Bunce (1997) also commented on this aspect of conflict and suggest that in order for these conflicts to be resolved there has to be some negotiation and compromise. Since this is a situation which requires cooperation in order to effectively integrate the budgets of the various divisions it is seen as a constructive conflict because of the interdependence of the divisions. Research done by Tjosvold and Poon (1998) revealed that “cooperative and open-minded interactions contribute to problem solving and morale.” Budgeting is being used to “influence negotiating and bargaining around resource procurement and deployment, rather than to apply bureaucratically neutral decision rules to optimize organizational functioning” (Luft 2003). The Company should consider Ezzamel (1994) suggestion to offer incrementally higher shares of scarce internal resources to those divisions which reduce the organization's dependence on the external environment. References BPP (1992). Cost and Management Accounting 11. 5th ed. London: BPP Publishing BPP (1998). Managerial Finance. 6th ed. London: BPP Publishing Etherington, L & Tjosvold, D (1998). Managing budget conflicts: Contribution of goal interdependence and interaction. Revue Canadienne des Sciences de l'Administration. USA: John Wiley & Sons, Inc. Retrieved from HighBeam Research: http://www.highbeam.com/doc/1P3-32379165.html. Last accessed 15th Jan 2011 Ezzamel, M (1994) "Organizational change and accounting: understanding the budgeting system in its organizational context." Organization Studies. Sage Publications, Inc. 1994. Retrieved from: http://www.highbeam.com. Last accessed 14th Jan. 2011 Hope, J & Fraser, R (2000). Beyond Budgeting. Strategic Finance. 10 (1), p30-35 Horngren, C.T., Foster, G & Datar, S. M (2000). Cost Accounting: A Managerial Emphasis. 10th ed. New Jersey: Prentice Hall Fraser, R & Bunce, P (1997). "Beyond budgeting .... (some companies abandon budgets)." Management Accounting (British). Chartered Institute of Management Accountants (CIMA). Retrieved from: http://www.highbeam.com/doc/1G1-19108932.html. Last accessed 14th Jan 2011 Luft, J. L (2003). Budgeting research: three theoretical perspectives and criteria for selective integration. Journal of Management Accounting Research. Retrieved from: http://www.allbusiness.com/accounting/744333-1.html. Last accessed on 14 January 2011 Thompson, J. R (2003). "Budgetting: confront the myths, build a true plan; the budgeting process contains many myths and sacred cows. Now is the time to move beyond them and use budgeting techniques that really work.(Management)." Solutions - for People, Processes and Paper. USA:Paper Industry Management Association. Retrieved from: http://www.highbeam.com/doc/1G1-108648890.html. Last accessed 15th Jan 2011 Tjosvold, D & Poon, M (1998). Dealing with Scarce Resources: Open-Minded Interaction for Resolving Budget Conflicts. Group and Organisation Management 23(3).USA: SAGE. Retrieved from: http://www.deepdyve.com/lp/sage/dealing-with-scarce-resources-open-minded-interaction-for-resolving-Qoqz5qOyBf. Last accessed 14 Jan 2011. Appendix Calculations Relating to Figures in the Budget Fixed Costs to be included in the budget: Total Fixed Cost 120,000 Less Depreciation (non-cash expenditure) 30,000 90,000 Current Position ? Sales 300,000 Received in the month following Creditors for raw material: 20% of Sales(?300,000) 60,000 Paid in the following month Contribution 40% of Sales (?300,000) 120,000 Other Variable Production Costs 40% of Sales 120,000 Paid in the same month 300,000 Possible Future Position Sales (300,000 x .9 x 1.5) 405,000 Received two month following month of sale Creditors for raw material: 60,000 x 1.5 90,000 Paid in the following Month Contribution 30% of Sales 121,500 Other Variable Production Cost (405,000 - 121,500 - 90,000) 193,500 Paid in the same month 405,000 Part B To: The Board of Directors From: Consultant Subject: Evaluation of Alternative Investment Options Date: January 17, 2011 Report When making decisions relating to capital expenditure a number of options or alternatives normally present themselves and should be considered. The role of management is to analyse each option to determine which method would result in more profits and therefore yield more benefits for the company. There are a number of techniques available to MegaFarm PLC in order to determine which project is more feasible. These techniques include payback period, accounting rate of return (ARR), net present values (NPV) and internal rate of return (IRR). The two investment options available to MegaFarm PLC will be assessed based on these techniques. Payback Period The payback period indicates the length of time that the project takes to recover the initial investment (Brigham et al 1999). This method is biased towards short term projects. “Investments with longer payback periods are often more risky than those with shorter payback periods. This is because the shorter the payback period, the lower the risk that market conditions can render the initial investments obsolete/useless” (Benzinga.com). This technique is one of the preliminary techniques used to decide whether a project is feasible. It does not take into consideration inflation and the time value of money nor can it facilitate decision making in relation to projects with the same payback period. Additionally, it does not take into account the fact that the cash flows are variable (BPP 1998). Furthermore, the choice of cut off period is not justifiable. It is arbitrarily chosen. Information in Appendix 1 shows how Payback is calculated. Using the payback technique and based on risk factors Option A would be chosen over and above Option B. Accounting Rate of Return (ARR) The accounting rate of return is “an unsophisticated technique of project appraisal (Gitman 1997). It shows the return on capital employed (ROCE) or the return on investment (ROI). Several formulae are used in its calculation. The most popular formula is dividing the estimated average profits over the life of the project by the estimated average investment and multiplying the results by 100 to get a percentage (BPP 1998). Other formulae used divide the estimated total profits by the estimated initial investment or the estimated average profits by the estimated initial investment. This method has a number of drawbacks in that it does not take into consideration the timing of the cash flows. Additionally, it focuses on accounting profits rather than cash flows and ignores the size of the investment (BPP 1998). The calculation of ARR for the two options identified is shown in the appendix. Option A has a 45% rate of return while Option B has a 64% rate of return. Appendix 2 shows the calculations for these two options. Net Present Value The net present value takes into account the time value of money as it discounts the cash flows over the period. An NPV of zero means that the cash flow from the project would not be sufficient to repay the initial investment and provide the required rate of return on the project. A negative NPV suggests that the project cannot generate sufficient funds to repay the initial investment and therefore should not be undertaken. (BPP 1998) A positive NPV suggests that the project can repay the initial investment as well as allow some returns to shareholders (Brigham et al 1999). A positive NPV therefore means that a project can be undertaken. Based on the results of the calculations in Appendix 3 Option B has a higher NPV than Option A and should therefore be chosen over and above it. Internal Rate of Return (IRR) “The internal rate of return (IRR) is a widely used tool for evaluating deterministic cash flow streams … When used appropriately, it can be a valuable aid in project acceptance and selection” (Hazen, 2003). The IRR is defined as that discount rate which equates the present value of a project’s expected cash flows to the present value of the projected cost (Brigham et al 1999, p433). That is, where NPV is equal to zero. It is calculated using the following formula: NPV = CF0 + ((CF1/(1 + IRR)1)1 + ((CF2/(1 + IRR)2) + (CF3/(1 + IRR)3) + (CF4/(1 + IRR)4) + (CF5/(1 + IRR)5) = 0. The present value tables may also be used in a trial and error fashion. The information in the appendix suggests that Option A has a higher IRR which lies somewhere between 42 and 43% than option B’s IRR which lies between 36 and 37%. Based on the results of the IRR calculation Option A is a better option. Appendix 4 shows these calculations. Comparison of the NPV and IRR As noted from the calculations in the appendices the results in terms of acceptance are not consistent. It therefore means that we will decide which of the two discounted cash flow methods (DCF) methods to use. That is we will choose between the NPV and the IRR. In order to do that we will see what others have to say about these methods. The most common problem cited with the use of IRR is “the possibility of multiple conflicting internal rates, or no internal rate at all…Contrary to current consensus, multiple or nonexistent internal rates are not contradictory, meaningless or invalid as rates of return.” (Hazen 2003). The NPV has been favoured among academicians as a criterion for evaluating alternative projects. A frequently cited reason for its preference is the “reinvestment” opportunities as implied by the net present value criterion are more realistic then that implied by the IRR (Beaves 1993). I would recommend Option B over Option A because it gives a more favourable NPV. The IRR is quite favourable in both cases and even though Option A has a higher IRR, Option B is still very high. Even though Option B requires a higher outlay it would help in achieving better economies of scale from which MegaFarms will obtain further benefits. Furthermore, the NPV is more favoured as a decision making took over the IRR. References BPP (1992). Financial Strategy. 5th ed. London: BPP Publishing BPP (1998). Managerial Finance. 6th ed. London: BPP Publishing Gitman, L. J (1997). Principles of Managerial Finance. 8th ed. USA: Addison Wesley Brigham, E. F., Gapenski, L. C & Ehrhardt, M. C (1999). Financial Management: Theory and Practice. 9th ed. USA: The Dryden Press Beaves, R. G (1993) "The case for a generalized net present value formula." Engineering Economist. Institute of Industrial Engineers, Inc. (IIE). 1993. Retrieved January 15, 2011 from HighBeam Research: http://www.highbeam.com/doc/1G1-14175839.html. Last accessed 15th Jan 2011 Benzinga.com. (2010) Quicker Paybacks. Accretive Capital LLC dba Benzinga.com. HighBeam Retrieved from: http://www.highbeam.com. Last accessed on 15th Jan 2011. Hazen, G. B (2003). A new perspective on multiple internal rates of return. Engineering Economist. Institute of Industrial Engineers, Inc. (IIE). Retrieved form: http://www.highbeam.com/doc/1P3-322982301.html. Last accessed 15th Jan 2011. Appendix 1 Payback Period     Option A   Option B Year Inflow/ (Outflow) (?) Cummulative (YTD) (?)   Year Inflow/ (Outflow) (?) Cummulative (YTD) (?) 0 (880) (880)   0 (1100) (1100) 1 660 (220)   1 385 (715) 2 440 220   2 440 (275) 3 330 550   3 550 275 4 220 770   4 715 990 5 220 990   5 770 1760 Payback Period: Option A Within 2 years Option B Within 3 years Option A Pays back the capital invested earlier than Option B Appendix 2 Accounting Rate of Return (ARR) Option A ? Total profits after depreciation for five years 990 Average annual profit after depreaciation 198 Original cost of investment 880 Average net book value (NBV) over five years [(888 + 0) ? 2] 440 Formula for calculating ARR ARR = [(198 ? 440) * 100)] 45% Option B Total profits after five years 1760 Average annual profit after depreaciation 352 Original cost of investment 1100 Average net book value (NBV) over five years [(1100 + 0) ? 2] 550 Formula for calculating ARR ARR = [(352 ? 550) * 100)] 64% Option B has a higher ARR than Option A. Both ARRs are higher than the ROCE 20% Appendix 3 Calculation of the net present value (NPV) for both options Net Present Value   Option A Year Cash Flow (?) PV Factor (14%) PV Cash Flow (?) 0 (880) 1 (880) 1 660 0.8772 579 2 440 0.7695 339 3 330 0.675 223 4 220 0.5921 130 5 220 0.5194 114   990   505 NPV = ?505   Option B Year Cash Flow (?) PV Factor (14%) PV Cash Flow (?) 0 (1100) 1 (1100) 1 385 0.8772 338 2 440 0.7695 339 3 550 0.675 371 4 715 0.5921 423 5 770 0.5194 400   1760   771 NPV = ?771 The NPV for Option B is greater than that for project A. Both are positive Appendix 4 Calculation of the Internal Rate of Return (IRR) for both options Internal Rate of Return (IRR) Option A Year Cash Flow (?) PV Factor (42%) PV Cash Flow (?) 0 (880) 1 (880) 1 660 0.7042 465 2 440 0.4959 218 3 330 0.3492 115 4 220 0.2459 54 5 220 0.1732 38   990.00   10.41 Year Cash Flow (?) PV Factor (43%) PV Cash Flow (?) 0 (880) 1 (880) 1 660 0.6993 462 2 440 0.489 215 3 330 0.3419 113 4 220 0.2391 53 5 220 0.1672 37   990.00   (1.09) The IRR for Option A lies between 42 and 43%. Option B Year Cash Flow (?) PV Factor (36%) PV Cash Flow (?) 0 (1100) 1 (1100) 1 385 0.7353 283 2 440 0.5407 238 3 550 0.3975 219 4 715 0.2925 209 5 770 0.2149 165   1760   14 Year Cash Flow (?) PV Factor (37%) PV Cash Flow (?) 0 (1100) 1 (1100) 1 385 0.7299 281 2 440 0.5328 234 3 550 0.3889 214 4 715 0.2839 203 5 770 0.2072 160   1760   (8) The IRR for Option B lies between 36 and 37% Read More