Budgeting System - Case Study Example

Budget planning Budgeting system Planning – action plan Aim of case study Ergodesign Ltd is a Scotland based medium sized furniture manufacturing firm that produces various range of office furniture. The company has strong market reputation but due to economic downturn, it is having spare capacity. Ergodesign is planning to make optimum use of the capacity. The case presents an alternative choice in this regard and relevant cost that will be incurred. In the development stage, the feasibility of the new product in terms of production and profitability will be assessed and alongside pertinent budgets will be prepared. The evaluation stage is focussed on establishing practicability of the project based on various evidences and recommendations will be included if necessary. Time frame for achieving the goals The goals can be significantly categorised as planning, development and evaluation. The planning process is very crucial and should be devoted moderate amount of time. The expected time frame for the planning process is approximately two weeks. The development stage require gathering of various primary information as well as secondary information for careful assessment and budget planning. A time period of three weeks can be considered thereof. Evaluation process can be conducted within a span of 10 days. Key factors and their interdependency in the case The key factors are quantity of the final product the wholesaler is willing to stock, direct and indirect material required for production, manpower for operational activities and hours required for determination of total cost. Factors that require more research Additional requirement of resources such as manpower and method of costing require more research and attention. It was determined that the company has implemented traditional as well as activity based costing for budgeting for its products. Since the new product is going for production for the first time, appropriate cost method requires significant consideration. The company is planning to make some additional investment in CNC machine and should research whether the investment is worthy. Method of research and sources to be used There are two research methods that can be implemented in research process, namely, primary research and secondary research. Primary research indicates towards first hand obtained data while secondary research is pursued by evaluating various readily available data such as company database, journals, books and other sources. The case study is a prominent secondary source in this paper and the other secondary sources that will be used in this regard are books and journals. Resources required to carry out the case study The case study analysis requires a variety of financial analytical tools and data and for this purpose, books and journals are consider appropriate. Development stage Additional research undertaken The report is a multifaceted project and requires evaluation of several minor and major aspects underlying the situation. Costing booklets and study materials were relatively useful in budget preparation and cost determination along with various lecture notes in this regard. The report is an elaborate assessment various factors such as costing, budgeting and investment. It was ascertained that literatures and articles related to investment appraisal, taxation, standard and variance costing and budget preparation will prove useful. Cost management accounting books has been assessed for determination and appropriate allocation of fixed and variable costs (indirect and direct cost). Books are useful in cost classification and relevant examples. Additionally, accounting theories are useful for variance analysis and budgetary planning. Case study analysis The case is mainly related to launch of a new variety of comfort chair by Ergodesign specifically designed for people with back problem. The case revolves around development of the new project and implementation of an efficient budgetary system. The firm is a reputed furniture producer in Central Scotland and is known for manufacturing custom made products in different range. The company is planning to make maximum utilisation of its spare resources to develop the new product. For production, purpose the firm need to make an investment of £125,000 in machinery purchase and hire two more employing in production sector. For next 1 year (12 months or 48 weeks), the company will be manufacturing 1800 chairs distributed evenly over the time span. Putting otherwise, the company will be manufacturing 150 chairs every four week. The relevant costs have been discussed in the case, based on which product cost sheet, budget, product’s projected income statement and balance sheet will be prepared. Appendices based on analysis Appendix 1: cost sheet Cost sheet, as the name suggests, is referred to a statement that present total costs that has been incurred or will be incurred with respect to a product or with respect to its associated cost pools and cost centres. Cost sheet is an important component of cost accounting as it represents total as well as unit costs associated with production process. Cost sheets are useful in cost comparison. Cost sheet of a product specifically represents all the cost associated with the product and not other external cost (Horngren 20-35). In the appendix 1, cost sheet of the new product has been prepared where cost of each raw material has been shown in terms of per unit, per batch and total batches in a year. The labour charges have been shown in terms of per hour consumed in the production process. Lastly, the overhead costs have been determined by dividing total overhead cost by total number of production hours. The profit has been determined after deducting total production cost from the net sales. Appendix 2: Functional budgets The functional budgets are indispensable for preparation of master budget. In this paper, functional budgets such as sales budget, production budget, direct labour budget and cash budget has been prepared. The production budget indicate that at the end of six months the firm will have 60 chairs extra if the budgeted sales is deducted from actual production. The cash budget suggests that the company initially will have negative cash flow but over the time, the product will be successful in generation of positive cash flow (Wildavsky 15-69). Appendix 3: Profit and loss statement The profit and loss statement, otherwise known as, income statement is a vital financial statement for a corporation. It indicates the financial performance of the enterprise for a specific period of time. The profit and loss statement has been prepared while assuming certain expenses such as salary, sales and administration, maintenance, depreciation and other utilities and corporation tax of 20 percent. The project will be earning gross profit of £52195.38 and a net profit of £17956.31 (Kaplan and Atkinson 25-86). Appendix 4: Balance sheet Besides income statement, balance sheet is another important accounting statement that is great significance to an organisation. Balance sheet preparation is of utmost importance because it represents the overall financial position of an organisation for a specific period of time. In the balance of the new product, the asset comprises both current and fixed assets. The current assets comprise cash in hand and bank, accounts receivable and inventory while the fixed asset comprises the CNC machinery. The liabilities consist of current and long term liabilities. The current liability consists of accounts payable to creditors while long term liability includes firm’s capital and net profit (Kaplan and Atkinson 25-86). Appendix 5: capital investment appraisal Capital investment appraisal or capital budgeting is referred to evaluation of long term investment proposals with respect to future uncertainties by using a variety of discounted and non-discounted techniques. In this project, discounted cash flow techniques such as net present value and internal rate of return was considered for evaluation of the firm’s investment in the machinery as it is relatively expensive as an investment. Discounted techniques were considered appropriate because they emphasise on time value of money. It was determined that the firm has positive net present value and a relatively high internal return. Therefore, it can be suggested that the investment is feasible (Bierman Jr and Smidt 64-93; Graham and Harvey 12-79). Budgetary control system A budget is defined as a financial plan for a corporation that is generally prepared well advance in time for a specific time period. Budget can be prepared in several ways where the planning can be done partly or in a composite manner. A composite budget is referred as master budget while specific budgets are classified as functional budget. Budget can be classified as fixed and flexible as well. Depending upon functional area, various kinds of budget can be prepared such as sales budget, production budget, production cost budget, purchase budget and labour cost budget (Wildavsky 15-89). The budgeting process is essential for planning and control and is often considered as a reflector of firm’s overall objective that is developed and converted into a feasible action plan. The budgeting process is not limited to preparation of budgets but its role is also to participate in planning, allocating, monitoring, reassessing and amending the various budgets as per the requirements of the management. Budget brings about consistency in a firm’s long term strategies. As a result, long term strategies and resources allocation do not change due to minor fluctuations and developments (Wildavsky 15-89). The planned long term strategies of a firm are generally qualitative in nature which needs to be measured in quantitative terms for better control and resource management. Correspondingly, it is essential for the management to categories the long term objectives in to SMART (Specific, Measurable, Attainable, Realistic and Timely) objectives. For better budgetary control, it is essential to segregate existing limiting factor (s), if any. In this regard, a limiting factor is determined by any resource that is short in supply due to its requirement in production of multiple products. When limiting factor exists, a firm is posed with the question that: how should the firm utilise the limiting resource for maximise its profit? Commonly, the most usual limiting factor is maximum sales and a firm should ensure that sales values are as accurate as possible for all other functional budgets and master budget relies heavily on the budget of the limiting factor (Wildavsky 15-89). Post preparation of all functional budgets, the master budget is drafted considering the fact that the other budgets have obtained approval from various budget holders. In case of difference of opinion, the proposed changes are evaluated and are incorporated in the master budget and it is presented to the senior management. In a number of organisation zero based budgeting is adopted so that efficiency of the budget is maintain as in this method every activities is done from beginning (Wildavsky 15-89). However in traditional budgeting process, the budget is prepared by making minor or necessary changes in the existing or previous budget. Standard costing and variance analysis is considered very useful in determination of these changes. Standard costing and variance analysis are essential aspects of cost accounting as it helps in recognising areas where a firm can minimise its cost and the areas where the firm is actually incurring more cost. In an ideal firm, standard cost is equal to the actual cost of direct material, direct labour and direct overhead. If standard cost is more than the actual cost then the variance is determined as favourable while comparatively low standard cost is evaluated as unfavourable or adverse variance (Wildavsky 15-89). Adverse cost conditions are generally adjusted by manufacturers and are reflected in budget reporting. Budget reporting is referred to formal documentation of the prepared budget for future reference and controlling. One of the major advantages of documentation is that it enforces systematic planning and control. Furthermore, documentation provides information regarding the need of increasing or decreasing the budget by managers. Appropriate budgeting process precisely involves nine planning steps. These steps are as follows: Step 1: strategic or long term planning Step 2: conversion of long term objectives to SMART objectives Step 3: identification of limiting factor (s) Step 4: cost assessment and variance analysis Step 5: preparation of limiting factor budget Step 6: preparation of various functional budgets Step 7: evaluation and combination of all the budgets for preparing master budget Step 8: evaluation of master budget and incorporation of necessary changes Step 9: presentation of the master budget to senior management Budget is essentially financial representation of a firm’s short and long term plans and correspondingly is associated with firm’s control system. Once the budget is determined, it is the prime responsibility of the managers to ensure that financial performance is continuously monitored. Several benefits of budgetary control and financial planning have been highlighted so far but to mention a few, budgetary control and extensive planning result in developing an understandable picture of the company’s position and its performance. Budgeting is primarily about monitoring and controlling and by means of budgeting, workplace stress and haphazardness is reduced as managers are clearly informed regarding resource allocation and consumption. Budgets are great source of communication and motivation as every organisational member plays an important role in the budgeting process. Planning and organising by means of budgets enables employees to have clear knowledge of organisational direction and enhances control thereof. However there are certain drawbacks of the budgeting process as budgets are highly subjective in nature and requires sufficient knowledge of the budgeting process (Wildavsky 15-89). Additional and alternative approaches The company will be purchasing the CNC machine from its own fund as the company has no intention to take up an external loan as large as that considering high interest charges. In this regard, an alternative approach could have been adopted by the firm by hiring the machine on rent agreement and later it could have considered purchasing the same depending upon performance and demand of the product in the long run. Leasing is recommended because leasing requires minimum set-up cost and zero maintenance and repairing cost. In the purchase decision, the company should not have maintained the machine for 10 long years and earn negligible residual value. Instead, the company should have sold the machine when it was having atleast some residual value. One additional approach that can be proposed in this regard is that that the company should evaluate various raw material suppliers for selection of the most inexpensive supplier as the manufacturing process requires mass scale of direct material. The firm can consider raising price of the chairs in recent future keeping in view increase in inflation and commodity price. Conclusion The complete financial analysis suggest that the project is feasible as the project will be earning profit in its first year as well as positive net present value with respect to investment in the requisite machinery. Furthermore, the project generates high internal rate of return and consequently the project should be accepted by the management of the firm. In the 6-month cash budget of the project, it was observed that the firm will be able to earn positive cash flow from the project by the end of the sixth month. The scope of profitability is relatively high for the product as the company can increase price of the product in near future and maximise its revenue. It was gathered from the case that firm has some difficulty with the budgeting process and consequently a formal budgeting process has been discussed in the paper so that relevant issues are mitigated. Recommendations The company needs to incorporate an appropriate budgetary control mechanism for the current as well as all other projects so that efficiency of the management is enhanced. In long term, the firm should take into account advertising of the product along with its existing products so that it is able to stay ahead of its competitors. The turnover forecasting has been provided by the supplier for only 3 years and the company should undertake internal projection and forecasting activity for better resource alignment. The company should also take into account scope of price rise, inflation and increase in corporation tax while forecasting on product demand and cost. It was also observed that some of the raw materials are relatively more expensive; in this context, the company can consult with other suppliers to have an inexpensive deal thereof. Evaluation stage Criteria for evaluation It was determined that the most appropriate evaluation criteria for the project will be capital budgeting techniques. The company is planning to develop a new project to make maximum utilisation of its resources. However, for this purpose the company need to invest around £125000 into new machinery. The investment amount is high and the machinery will be used for 10 years with zero scrap value. Hence, NPV and IRR techniques were considered appropriate for assessing the investment. Evidence gathering For measuring various cost accounting methods, it is important to refer to various relevant books and journals to maintain accuracy in the measurement process. No comparison with respect to market research has been pursued in the paper. However, opinion regarding product demand was developed on the basis of suppliers’ viewpoint regarding the same. Relevance of evidence The company has already pursued pilot project regarding development of the product and was successful in the same. The supporting evidences were gathered from development of various financial statements such as cost sheet, balance sheet and income statement. It was gathered that the company will be making profit in the first and other consecutive years and thereby supporting feasibility of the project. Modification The modification that can be proposed for the company is that instead of buying the machine, it should have considered hiring the same on rent. That would reduce maintenance and repairing cost for the company. The company can also source its raw materials from more than one supplier as it helps the firm to have greater choices and scope for cost reduction. Conclusion and recommendation The paper has adopted various financial tools for presenting a comprehensive analysis of the proposed project. The project was determined to be feasible from short term as well as long term perspective. However, it was also observed during the assessment that the by the end of 10th year, the machine will be completely obsolete and negative inflow will be observed. Therefore, it is recommended that the company should sell the machine before it becomes obsolete. Works Cited Bierman Jr, Harold and Seymour Smidt. The capital budgeting decision: economic analysis of investment projects. London: Routledge, 2012. Print. Graham, John and Campbell Harvey. "How do CFOs make capital budgeting and capital structure decisions?." Journal of applied corporate finance 15.1 (2002): 8-23. Print. Horngren, Charles T. Cost Accounting: A Managerial Emphasis, 13/e. New York: Pearson Education, 2012. Print. Kaplan, Robert S. and Anthony A. Atkinson. Advanced management accounting. Vol. 3. Upper Saddle River, NJ: Prentice Hall, 1998. Print. Wildavsky, Aaron B. Budgeting: a comparative theory of the budgeting process. New Jersey: Transaction Publishers, 1986. Print. Appendices Appendix 1 Appendix 2a Appendix 2b Appendix 3 Appendix 4 Appendix 5 Read More