Role of Preparation of Budgets for Business - Assignment Example

A case study, plan the use of cash in a business and discuss the financial aspects of assessing managerial performance Contents Contents 2 Answer a. 3 Answer b. 9 References 14 Answer a. Activity Based Costing (ABC) is a method of costing that involves the identification of the key activities within an organization and then assigns each of these identified costs of the activities with their resources to all the goods and services of a company according to the consumption level of each of the products or services. The Activity Based Costing (ABC) is used to assign higher overheads or indirect costs to the direct costs as compared to the traditional costing methods like the absorption costing method (Collier, 2012). The main features of the Activity Based Costing (ABC) Method are summarized as follows: The ABC method is a costing technique which can be used by companies for obtaining the partial views as well as the full scope consideration of the production methods. This costing method is an extremely efficient method for identifying the high expense incurring products, activities and departments. The ABC costing process helps in the most beneficial allocation of resources on profit bearing products, departments and activities and reducing the costs associated with non-profitable products, services or activities. This method also helps an organization to control the expenses associated with the production in both the per-product levels as well as the departmental levels of operations. The Activity Based Costing (ABC) method is an extremely advanced costing method that helps to increase the profitability of an organization through the identification of the unnecessary costs that can be eliminated to lower the overall production costs of the organization. It is also useful for making budgetary and pricing decisions. The Activity Based Costing (ABC) method is being considered by the case company i.e. Berry Ltd. Berry Ltd. has been using the traditional absorption costing method as the main costing technique for the company. The company manufactures three main products and the costs and resources of each of the products are allocated through the use of the absorption costing process. Absorption costing is a managerial costing method in which the expensing of the costs of all the products manufactured in the company are allocated through the consideration of both the total overheard cost and the total direct costs associated with the manufacture of each of the products. As per the Generally Accepted Accounting Principles (GAAP), absorption costing is the preferred method of costing used by the companies for the purpose of external reporting (Clyde, Brown and Whalen 2006). The management of Berry Ltd is considering the adoption of the Activity Based Costing (ABC) method in the company in order to achieve better cost management and control in the company. According to both the Production Director and the Finance Director of Berry Ltd. the use of the Activity Based Costing (ABC) method is likely to improve the overall cost control of the company and thus, lead to increased profitability in the business. Since, lowering the operational costs is a major way of increasing the margins associated with the manufacture and subsequent sale of any product, therefore the Activity Based Costing (ABC) method can help to increase the profit margin through the allocation of resources according to the requirements of the manufacturing process and thereby saving the costs associated with the redundant allocation of resources in the operational processes of Berry Ltd. With the use of the Activity Based Costing (ABC) method, Berry Ltd. can estimate the mandatory cost elements associated with each of the products, services and activities of the organization as shown in the calculations and tables below. This will in turn help the organization to make informed decisions regarding the identification and elimination of the activities, products and services that are not profit bearing and in reducing the process of the products and services that are allocated more resources and are thus overpriced. The Activity Based Costing (ABC) method helps to reduce the overall expenditure in the operational processes of the company and thus is considered to be an effective costing technique for designing a suitable product, activities and services portfolio. This method of costing also helps in identifying and subsequently eliminating production processes and service processes that may be ineffective and also help in the allocation of processing concepts that may improve the production process by enabling the company to produce the same products or services through new production processes re-engineered to give better yields. The calculation of the total production costs for Berry Ltd. as per the Activity Based Costing method as well as the traditional method is given in the tables are calculations below. The ABC method can be used by berry Ltd. to assign the resource costs of the organization through activities related to the products and services that are provided to the customers of the company. ABC method takes into consideration both the direct costs and the overheads of the company. In contrast, the traditional absorption costing method does not attempt to trace the direct costs associated with the production as indicated below and as such is often an unrealistic representation of the real costs and allocation of resources in a production process. Berry Ltd. can use the Activity Based Costing (ABC) method as a technique for understanding the operational costs, product cost as well as the customer costs associated with the products or services. The organization can also adopt the new technique as a way of improving the saleability and profitability based on the production processes of the company. Also, this costing method can help to support the strategic corporate decisions of Berry Ltd. related to budgeting, outsourcing, pricing, measurement of production improvement, identification of weak and cost incurring areas of the production and so on. The Activity Based Costing (ABC) method is concentrated on the cost allocation to different activities in operations management as shown in the tables below. The process helps to segregate the fixed costs, variable costs and the overhead costs associated with the production of different products and services in a company. The methodology is effective for splitting up the costs with the aim of identifying the cost drivers and achieving the cost drivers through the planning process. This process is based on the fact that it is easy to trace the direct costs related to production but the allocation of indirect costs or overhead costs in a production process is much complex. The identification of the cost driver helps the costing manager to allocate to both the direct and the indirect cost appropriately to each of the production activities as well as products. The identification of the cost driver is a significant part of the Activity Based Costing (ABC) method; the cost drivers are the weighing factors that drive the actual cost of the production activity. Case: The three products (XY and Z) of Berry Ltd Product X Y Z Direct materials 25 28 22 Direct Labor (12/Hr) 30 36 24 Batch Size (Units) 500 800 400 Purchase Orders per Batch 4 5 4 Machine Hours per Unit 1.5 1.25 1.4 Total direct cost Cost Tools   Cost Drivers Machine Setup Cost 280,000 No. Of Batches Material Ordering Cost 316000 No. Of Purchase Orders Machine Running Cost 420000 No. Of Machine Hours General Facility Cost 361400 No. Of Machine Hours   1,377,400 Traditional Method Total Direct Labour hours = (20,000 x 35) + (16,000 x3) + (22,000 x 2) = 142,000hours Overhead Absorption Rate (OAR) = 1, 377400/142,000 = 9.7 per labour hour X Y Z Direct Material 25 28 22 Direct Labour 30 36 24 Absorbed Overhead (2.5 x9.7) =24.25 (3 x9.7) = 29.1 (2x9.7)=19.4 Total cost per unit 79.25 93.1 65.4 Activity Based Costing (ABC) method Total machine set up costs = (20,000/500) + (16000/800) + (22,000/400) = 40 +20 + 55 =115 = (280000/115) = 2,435 X = (2,435 x 40)/20,000 =4.87 per set up Y= (2,435 x 20)/16,000 = 3.04 Z = (2,435 x55)/22,000 =6.09 Total material ordering cost = (20,000 x4) + (16,000 x 5) + (22,000 x 4) = 248,000 Activity purchase orders per unit = (316,000/248,000) =1.27 X = 4 x1.22 =5.08 Y= 5 x 1.27 =6.35 Z =4 x 1.27 =5.08 Total machine running cost = (20,000 x 1.5) + (16,000 x 1.25) + (22,000x 1.4) = 80,800 hours Activity machine per hour = (420,000/80,800) = 5.20 per machine hour X 1.5 x 5.20 =7.8 1.25 x5.20 = 6.5 Z 1.4 x 5.20 =7.28 General facility cost per hour = (361,400/80,800) = f 4.47 per hour X =4.47 x 1.5 = 6.7 Y =4.47 x1.25 =5.59 Z = 4.47 x 1.4 =6.26 Comparison between the traditional method and ABC basing on product X Y and Z Product X Product Y Product Z Traditional ABC Traditional ABC Traditional ABC Material 25.00 25.00 28.00 28.00 22.00 22.00 Labour 30.00 30.00 36.00 36.00 24.00 24.00 Absorbed 24.25 28.1 19.4 Set up 4.87 3.04 6.09 Material r 5.08 6.35 5.08 Machine 2.8 6.5 7.28 Facility 6.7 5.5 6.26 Total 79.25 79.45 93.1 85.39 65.4 70.71 Basing on the calculations and tables above that include the differences between the traditional and ABC methods, it is clearly evident that ABC may be appropriate considering the fact that it concentrated on the cost allocation to different activities in operations management. The process will help to segregate the fixed costs, variable costs and the overhead costs associated with the production of XY and Z products and services in this company. Considering the cost of operation, ABC tends to be effective Answer b. The budgeting process is a method used by all the organizations, irrespective of their scale of operations to plan the use of financial and operational resources available within the organization. Budgeting is done with the aim of preparing a planning for uncertainties as well as future business contingencies. The preparation of budgets is done with the objective of achieving key business purposes including forecasting, planning, controlling, evaluating, monitoring and commutating the financial plans of an organization for a defined time of operation (Ryan 2004). Budgeting is a medium of forecasting the financial terms and plans of an organization, a vehicle for controlling the functions and activities of different departments of an organization, a way of monitoring the entities of the organization to achieve the pre-defined performance levels, a medium for communicating the plans and goals of the organization as set by the senior management. The budgets are also used as the tools for resolving the conflicts of interest arising between the different stakeholder groups inside and outside the organization. A budget is prepared as a quantitative representation of a business plan set for a defined time period. This may include the plans regarding the resource quantities, assets, liabilities, cost and expenses, sales volumes, sales revenues and cash flows. The budgetary process is used to express the strategic plans of departments, business units, activities, organizations and events in quantifiable terms. Planning: Planning is an essential purpose of budgeting. Budget is prepared by the financial managers of a company to plan for the future operations of any organization for a specific period of time. Since, Berry Ltd. wants to achieve higher financial profitability in the next evaluation period of the business; therefore, the purpose of planning for the business is much focused on in the budgeting process of Berry Ltd. The company should plan for the control of the operational expenses, particularly the production costs associated with the manufacturing of the three main products of the company. Also, the budget is aimed at reducing the operational costs and thereby increasing the saleability and profitability of the company from the three categories of products manufactured and sold by Berry Ltd. Berry Ltd should give adequate consideration to the planning part of the budget so that the company can manage and allocate the financial and physical resources in the most optimal manner. The planning purpose of budgeting is also aimed at the most optimal and feasible allocation of resources for the production of each of the products manufactured by the company (Dalai and Burrow 2003). The managers of Berry Ltd. can decide on the most effective methods by which the operational tasks of the company can be performed so that the ultimate aim of increasing the profitability and controlling the costs can be achieved. Control The control of the financial and operational resources of the company is a main consideration involved in the preparation of the budget of any organization. One of the main purposes of a budget is to establish suitable control over the financial processes of the company. This may include the management of the production processes including the allocation of resources and the expense incurred in each of the production departments. Evaluation The purpose of evaluation of a budget involves one or more of the following dimensions of organizational performance: Effectiveness, Efficiency, Impact, Relevance, Causality, Responsiveness and Reaction, Sustainability and Coherency and Validity of the budget design. The evaluation purpose of a budget is one of the most dominant functions of a budgeting process. This involves financial evaluation, physical evaluation and input versus output analysis. The evaluation part of a budget is aimed at improving the planning, implementation as well as the decision making processes associated with the budget. The performance of a budget should be evaluated by comparing it with the targeted outputs as defined during the preparation of a budget. Motivation A budget may be used by an organization to achieve other secondary goals like motivation and communication. A budget is often used as a vehicle to communicate the goals decided by the management to all the employees of an organization and to support the congruence of these objectives so that the available resources can be appropriately coordinated, focused and allocated in the key areas of the business. One of the main purposes of a budget is to allow an organization to create motivation amongst its employees through the encouragement of actively participating in the budget preparation process. A participative budgeting method is often the most useful one when it comes to the achievement of the motivation purpose of a budget. In a scenario where an employee is actively involved in the preparation of the budget, it is more likely that he/she will be more motivated to achieve the objectives of that budget. Also, the budgeting process can support organizations to communicate as well as achieve their goals. Secondarily, the budgeting process also allows the organization to monitor the achievements as well. In this way, the preparation of a budget acts as an important part of the overall strategic planning of an organization. The main objectives of budgeting are also applicable for the case company Berry ltd. The company should prepare the budget based on the associated costs of operations and the projected sales of goods in order to plan for the future prospects and financial management of the business. However, all the different purposes of a budgetary process may exist in a certain degree of conflict with one another. A bottom up approach for budget creation should be taken up in Berry Ltd. so as to ensure better control over the financial planning for the company. A bottom up budgeting would be more appropriate for Berry Ltd. than a top down approach for budgeting. This is because the accuracy and effectiveness of a bottom up approach of budget preparation is more than that of a top down approach of budgeting. The bottom up approach involves the identification of the core objectives of the business and then estimating the resource requirement for achieving these pre-defined objectives. This process would be appropriate for Berry Ltd. because the objective of the business is defined as improving the financial performance as well as the profitability of the business in the future. Since a bottom up approach of budgeting involves all the levels of the employees of a company, therefore, it helps to create a more consistent and feasible budget rather than the top down approach of budgeting. The top down approach is more focused on the decisions of the senior management and thus may at times be infeasible and biased. Berry Ltd. should use the bottom up approach so that a feasible, implementable and achievable budget can be prepared (Screifer and Friedlobe 2006). The preparation of budgets is critical in the management and planning process of an organization. A business has to necessarily to forecast and ensure whether the business will make profits in the future. A budget acts as a representative model of the future financial performances of a company with the consideration that specific plans and strategies of the business are taken up. The budget can be prepared by the production managers and the financial managers of Berry Ltd. to ensure that a financial and operational framework is decided in order to provide specific business objectives and the guidelines for achieving these objectives. Budgeting is necessary for Berry Ltd. so that it can identify the improvements in the controlling of operational costs after the implementation of the new costing method i.e. the Activity Based Costing (ABC) in place of the absorption costing method. While a budget can serve as an effective tool for planning and co-ordination, an organization like Berry Ltd. should also infuse the right amount of flexibility in the design of a budget to ensure that it can adapt to the evolving changes within the organization as well as in the external environment of the organization. Berry Ltd should also ensure that the conflicts among the core purposes of the budget are minimized or controlled through a suitable mapping between idealism and reality as appropriate for the budget. References Clyde, P. S, Brown, P. & Whalen, J. M. 2006. Financial Reporting, Financial Statement Analysis and Valuation. New York: McGraw Hill. Collier, P.M. 2012. Accounting for Managers: Interpreting Accounting Information for Decision making. New York: John Wiley and Sons. Dalai, L. & Burrow, J. 2003. Business Finance. New York: Engage learning. Ryan, B. 2004. Finance and Accounting for Business. Boston: Cengage Learning. Screifer, L. & Friedlobe, J. 2006. Essentials of Financial Analysis. New York: Sage. Read More