Financial Management and Performance Analysis - Essay Example

? Financial Management and Performance Analysis Budget gives the management an opportunity to plan, monitor and evaluate its activities towards achievement of a specific goal. Budgeting is a means through which management communicates its goals and sets strategies to achieve those goals. Since the budget is just an estimate of what management wishes to achieve within a specific period, the organization does not always attain the targets specified in the budget (Sherman, 2011, p. 76). The organization usually fails to achieve this target because there is no certainty of future occurrences. Managers should focus on what should be done in order to avoid variance in the future rather than concentrating on actions to correct variances in the budget. Management determines the performance of the organization by conducting budget control or variance analysis (Ramji & Geoffrey, 2002, p. 21). These approaches support management by exception by the fact that it identifies critical areas of organization performance which does not follow the management expectations. Although budget is very essential in the organization, the success of the organization is determined by the effort of the management to in making decisions that will ensure the attainment of the organization’s goals. A. Behavioural issues in budgetary reporting system When actual performance of the business differs from the planned or budgeted activities this is referred to as variance. Variance may be favourable if it shows gain or beneficial position such as an increase in actual income or profits or a decrease in actual expenditure than the standard cost (Sherman, 2011, p. 87). On the other hand, variance may be termed unfavourable if the actual cost exceeds standard cost, or if actual profit/income falls below the budgeted income/profit. It is the cause and consequences of variance that matters, and whether the variance is favourable or unfavourable (Hampton, 2009, p. 57). The management should work to establish the cause of variances and assess the impact of the variance in the organization because not all adverse variances are detrimental to the business and not all favourable variances are beneficial to the organization. Material variance refers to the differences between the actual materials used in producing actual outputs and materials that were expected to be used during the planning process (Weiss, 2006, p. 102). Material variance may occur for various reasons. For example, the difference may be due to the actual purchase price of the materials being less or more than the expected price in which case the purchasing department may be held liable. On the other hand, this variance may be due to less or more materials being used during the manufacturing process, and in this case, the production department will be held responsible. Labour variance is the difference between the actual cost of labour and the budgeted expenditure. The actual expenditure is usually greater or is less than the budgeted expenditure due to various factors. For example, the actual rate does not correspond to the budgeted cost because it is either below or higher than the expected rate (Hampton, 2009, p. 71). In addition, the actual idle time of the workers is more or less than the budgeted time while the actual productivity of the workers differs from the budgeted efficiency. These factors influence the actual cost of labour resulting to significant differences in cost of labour from the planned cost of labour. In the case study, the estimated output was ninety five thousands units while the actual output was ninety thousands units. This created a variance of five thousand units in the organizations output. This decline in units produced could imply inefficiency of workers or machines. It could also mean that the target was too high for the organization to meet (Weiss, 2006, p. 108). The management should put effort to increase the production capacity of the organization by either increasing the efficiency of workers or production tools. In order for the management to increase the production efficiency of the workers, they should put in place measures that will motivate workers to meet the target of the organization. However, the management should be aware that increase in units produced will result to increase in cost of production hence may increase inefficiency of production (Sherman, 2011, p. 134). The estimated machine hours was twenty-eight thousand five hundred while the actual machine hours were twenty-seven thousand two hundred hence resulting to a variance of one thousand three hundred hours. This machine hour variance is mainly as a result of production units below the estimated units. Furthermore, decrease in machine hour is favourable because will reduce the cost of production which in turn will increase the profitability of the organization. The organization’s budgeted sales was nine fifty thousand pounds whereas the actual sales was nine twenty two thousand two hundred and fifty pounds. There was a sales variance of twenty seven thousand five hundred pounds. Decrease in sales below the target could have been caused by inefficient marketing or low selling price of the product than the estimated price. In this regard, the management should focus on factors that will increase demand of the product such as intensifying the marketing campaign. Another option the management can take to increase sales is by exploring new regions to create new market for the products (Weiss, 2006, p. 119). During variance analysis managers should focus on causes of decline in forecast sales and set up strategies that will ensure an increase in sales. From the case study, the estimated direct labour cost was one fifty two thousand pounds while the actual cost of direct labour was one fifty three thousand pounds. This resulted to a direct labour variance of one thousand pounds (Ramji & Geoffrey, 2002, p. 24). Although the organization was not able to manufacture the budgeted products the cost of labour exceeded the budgeted labour. This means if the business manufactured the estimated produce the cost of labour would be so high compared to the budgeted cost hence reducing the estimated income. There is a possibility that the organization is operating with excess labour force hence rendering some of the workers redundant (Weiss, 2006, p. 127). The most possible course of action would be to reduce the number of workers in order to minimize the cost of direct labour. However, reducing the number of workers may cause legal issues with labour organizations. So the other option to introduce piece rate system of payment in which the workers will earn pay according to the work done. This will reduce the high cost of labour due to redundancy and resting time hence harmonizing the cost of labour with the budgeted work. Production overheads refer to factory expenses that are incurred during the production process. It is apportioned to the units of outputs produced in order to reflect the actual cost of products. In the case of Charles Ltd, the overhead cost was apportioned based on the machine hours. Although the management had estimated fixed overheads of one hundred and twenty five thousands and four hundred pounds, the actual overhead was one hundred and fifteen thousands and three hundred pounds (Weiss, 2006, p. 151). This decline in actual overheads was as a result of reduced output that was below the estimated value B. Changes that should be made to the reporting system. The main purpose of preparing production budget is to guide the management in setting goals of the organization, setting up strategies to achieve the organizational goals and communicating the intentions of the management to the departments and all the employees (Hampton, 2009, p. 97). The production budget is just an estimate of how the organization intends to spend its resources towards achieving its goals. Although the actual activities must not correspond to the planned activities, budget plays a significant role of guiding the management in the production activities. After implementation of the budget, the management should make a review of what they were able to achieve and compare with what they purposed to achieve and find out what worked well and what need to be changed. Therefore, budget assists the management in making future plans. In Charles ltd, it appears that although the actual output was below the actual output, the actual cost of direct labour was very high compared budgeted cost. The management should find a way of reducing the cost of labour and increase efficiency in order to meet the target (Weiss, 2006, p. 165). This implies that the organization should hire less expensive labour and train them to work towards the organizations goals. The management should take action to improve the performance of its activities and business profitability. Therefore, the course of action should be to increase output, increase sales and reduce the cost of operations. The management should work to increase the efficiency of workers by motivating the workers and structuring activities to increase efficiency. The management should design effective communication channels to enable the workers understand the organizational goals and work towards achieving them (Weiss, 2006, p. 172). The management should put in a place other measures to regulate the cost of running the business in order to increase business profitability. Such actions may include efficiency in the use of raw materials in order to minimize wastage. The management should strive to reduce the overhead cost in order to increase business income. One of the ways in which the business can reduce fixed overhead is by increasing the units of outputs. Since the fixed overheads are shared among the total outputs (Hampton, 2009, p. 112). Therefore, as the units of outputs increases the value of fixed overheads decreases hence increasing business income. However, the management should be very careful because as output increases, the variable overheads increase proportionately. C. Revised Budget Report for the Quarter Ended August The main essence of making a budget is to establish a guideline of what the organization intends to achieve within a specified time and resource limit. It is not unusual for the actual outcome to differ from the budget estimate, but once the organization has set up a budget the management should make proper follow up to achieve the goal (Ramji & Geoffrey, 2002, p. 27). In cases where the actual performance deviates from the budgeted activities the management should conduct variance analysis to establish the cause of deviation and take appropriate measures to improve the performance of the organization in the future. There is no point in trying to focus on the failures and blaming those who contributed to failure because this will discourage the workers and may reduce their efficiency. The right approach to consider the cause and consequences of failure and then utilize strategies to achieve the organizations target. In the case of Charles Ltd, the goal was to produce 95,000 units using 28,500 machine hours. Another goal was to make sales of ?950,000 by using raw material worthy ?133,000, direct labor of ?133,000, variable production overheads of ?152,000 and a fixed production overhead of ?125,400. Since all the estimated values failed to correspond with the actual values, the management should focus on reducing cost as much as possible and increasing the output and sales to the desired level. Revised Budget (based on the actual outcome of the first three months) Actual Planning Budget Variance Units produced 95,000 95,000 0 Machine hours 28,711 28,500 (211) ? ? ? Sales 950,000 950,000 0 Raw materials 137,750 133,000 (4,750) Direct labour 161,500 152,000 (10,500) Variable production overheads 100,902 100,750 (152) Fixed production overheads 120,810 125,400 4,590 Gross Profit 429,038 438,850 (9,812) If the management of Charles Ltd has to maintain the initial target of sales and total output, then they have to make several changes. This will require them to increase resources such as man hours, machine hours and raw materials. By increasing the total output to 95,000 units will require an increase in machine hours to 28,711. This will exceed the initial budget of 28,500 hours by 211hours if all other factors are held constant. Similarly, to achieve a sales target of ?950,000 will require an increase in direct labour to ?161,000 which exceeds the target of ?152,000. This will result to a direct labour variance of ?10,500. The management should find a way of upsetting this variance if they have to achieve that target. One of the means of upsetting this cost is by motivating the workers in order to increase their working efficiency. Alternatively, the management can introduce a different method of paying the workers such as piece rate whereby the amount of work available is subdivided into equal portions, and then those portions are given price value whose total does not exceed the organization's budget (Massood, 2012, p.14). This will result to completion of the estimated work within the budget price. Another significant change that will take place is the increase in raw materials. The budget value of raw materials was ?133,000. However, if the production is increased in accordance to the revised budget it appears that the raw materials will increase to a value of ?137,000 hence creating a variance of ?4,750. The management should focus on means to reduce the wastage of materials in order to ensure the cost remains as low as possible. This will go hand in hand with the efficient staff that can be able to utilize the resources efficiently. If the management decides to increase the output the overhead cost will also go up. However, this is quite favourable since it does not exceed the budget estimate. Irrespective of the level of output the organization will incur cost that is higher than the budget value (Massood, 2012, p. 19). Furthermore, it will be advantageous for the organization if they increase the value of output because this will result to decrease in fixed overheads because this cost is shared among the units produced. However, in this case the overhead cost is shared among the machine hours hence the fixed overheads increase as The profitability of the business activities is another guiding principle in decision making in regard to the financial management. Although there are two main goals of organization which profit maximization and sales maximization, the key factor in financial management is cost reduction and profit revenue maximization (Ramji & Geoffrey, 2002, p. 29). If we assume the management of Charles Ltd intends to increase organizations income, then the management has to consider the impact that increase in output and sales will have on organization’s income. According to the budget value the estimated gross profit is ?438,850 while from the revised budget, the gross profit is likely to go down to ?429,038. Should this be the case, the actual gross profit of the revised budget will result to a variance of ?9,812. However, this is not usually the case since not all costs varies proportionately. In addition, the management will put in place measures that will ensure the expenditure decreases while the profit increases. From the revised budget, the management has several decisions to make. First, they have to reduce the cost of direct labour in order to increase the income (Ramji & Geoffrey, 2002, p. 23). The management has to ensure the raw materials and other resources are utilized efficiently in order to achieve the budgeted activities. It is upon the management to decide the best course of action to take in order to achieve organizations goal in case the budgeted activities deviate from the actual activities. Bibliography Hampton, J. 2009. Fundamentals of Enterprise Risk Management. American Management Association, New York. Pp. 53-124 Massood, Y. 2012. Comprehensive Variance Analysis Based on Ex Post Optimal Budget. Academy of Accounting and Financial Studies Journal, Vol. 16(I). Pp. 6-21 Ramji, B & Geoffrey, S.B. 2002. Integrating Profit Variance Analysis and Capacity Costing to Provide Better Managerial Information. Issues in Accounting Education journal, Vol. 17(2). Pp.18-29 Sherman, E, H. 2011. Finance and Accounting for Nonfinancial Managers. 3rd ed. American Management Association, New York. Pp. 64-203 Weiss, D. 2006. Analysis of Variance and Functional Measurement. Oxford University Press, New York. Pp. 32-176 Read More