Traditional Approach to Budget and Budgetary Control - Essay Example

PART I: TRADITIONAL APPROACH TO BUDGET AND BUDGETARY CONTROL Introduction Budgeting is a management control process, which is used by virtually all organizations especially in planning and performance evaluation. Despite their invaluable usefulness, budgets are criticized because of different challenges. For example, it is alleged that budgets hinder effective allocation of organizational resources and enhance narrow-minded decision making among other retrogressive game incidences. Myriad of these problems are believed to partially originate from the financial structure of the traditional control orientation and top-down authority as set in performance evaluation processes and annual budget planning (Bhimani et al., 2008). This paper will look into the suitability of the traditional approach to budget and budgetary control for a business that operates in a static and stable market environment on one hand, and a business that operates in very dynamic, rapidly changing and innovative environments, and possibly suggest a suitable budget approach for the latter environment. Business that operates in Static and stable environment In the traditional approach, the executive team is assumed to be the best positioned in translating objectives into operational initiatives, goals and objectives for all employees and business units. In a static environment, the employees need not possess authority and, hence a command and control system can operate successfully. Incremental budgeting is the kind of traditional budget that is suitable in a static environment. In this budget, the preceding-year or the actual budget is used as the base while; the additional sum is added or subtracted from the new budget. In other words, the allocation of resources is based on the preceding period (Atrill and McLaney, 1997; Bernstein and Wild, 2000). To calculate the amount of expenditure for the new period, entities use the preceding budget as the base. In a static environment, it is advisable to use this technique because it is straightforward and easy to understand. This technique is easy to understand because it does not include so many processes that are intended to take into account the changing circumstances, which is not a big problem in static marketplace where changes are very minimal or sometimes nonexistent (Vroom, 1960; Barry, 2010). Given that there are not many changes in the marketplace, it would be very advantageous to use the traditional method because it encourages use of the budgeted expenditure and avoid using what is avoidable. Furthermore, this budget also ensures that the budgeted amount is fully spent, hence making sure that a similar amount is used in the subsequent period, which again ensures that money is only used where is it is required (Pendlebury and Groves, 2010). A static market environment does not have many variables that need complex plans. Therefore, it would be recommendable to use traditional approach, which is very simple. A company that is operating in a static environment can really enjoy a lot of benefits by using this method because even staffs that are not very experienced can use it. Since this budget is based on the preceding period, and considering that it is used in a static environment, it is possible for the managers to introduce gradual changes without running into problems. Traditional approach to budgeting and control allows the managers to prepare budgets that are very stable, from one period to the subsequent period - which gives room for gradual changes. Furthermore, the managers cannot be tempted to make large adjustments because there will be no basis for doing so - the previous period is the only basis. For examples, in a static market, the cost of operating business usually change very slowly and, hence, the mangers will be able to introduce slow adjustments from time to time without causing substantial discrepancies (Ittner and Larcker, 2000). The other benefit that comes with a traditional approach to budget and budgetary control especially when practiced in a static environment is flexibility. Incremental budgeting is characterized by allocation processes, which are based on formulas. This could be more flexible, since such formulas are usually based on the previous period, and they can offer a flexible way of allocating more funds to certain periods when the expenditure patterns clearly shows that there is an increasing trend. For example, when inflation is on the rise, cost trends for the past few years are forecasted with amendments for both forecasted decline or growth and inflation in business activity. In regards to sales, the already established growth rates are used to forecast the new sales, which help in planning for new products and other important decisions. Also, when the management wants to allocate fewer resources to certain department based on some reasons such as a less profitable department, it is very easy to use formulas to base the allocation on the intended goals. In other words, the resources are allocated based on the patterns of the market. Business that operates in very dynamic, rapidly changing and innovative environments Incremental budgets are not suitable in a very dynamic environment because they are essentially unable to forecast drastic change. In fact, budget allocation and budgetary control is a very complicated subject. In light of a dynamic and highly volatile environment, the increasing inefficiencies and inequities of business systems and processes, procedures and structures for budgeting and allocation of resources, and the increasing demands for accountability by institutional stakeholders and the legislative bodies must be scrutinized closely. The traditional approach does not support such an environment, which is characteristically complex, and one that need difficult compromise regarding the actions that should be undertaken in different situations (Merchant, Van and der Stede, 2007). Tamari (1978) explains that, within a very dynamic market environment, so many things happens that it is practically not easy to project the amount of expenses for a future period using the current figures, because the environment is so volatile and subject to so many variables. For example, in the event of extreme economic conditions, use of static allocations based on the incremental budgeting could practically lead to hefty and uncorrectable errors in projections - this could sometimes lead to death of companies since the mistake is sometimes fatal. Due to the inadequacies of the traditional budgeting and budgetary controls, it is extremely difficult to rely on such budgetary approach in a dynamic market because they can hardly accommodate the volatility that characterizes such environments. A zero-based budget can be suggested for a business that operates in a very dynamic environment. This approach to budget and budgetary control entirely ignores the history when making projections, which actually suits a dynamic environment where making forecast from the past is ineffective. Zero-based budgeting requires each aspect of income and expenditure to be justified and documented. When programs are justified in each fiscal year, it becomes very easy to put into account drastic changes that take place in a very dynamic environment, something that is not possible in traditional budgeting approach. This approach recognizes the fact that it is not appropriate to justify expenditure on the previous year’s funding level because each year has its unique characteristics based on changes that take place from time to time. The management of companies that operates in a very dynamic environment would be encouraged to use this approach to budgeting and control as a way of ensuring that unnecessary spending is avoided. In a zero-based budgeting, each department is given authority to conduct their own reviews because such is carried out based on the unique characteristic of each department – this is very useful in a very dynamic environment because changes affect different departments differently and, hence, it would be important to allocate different levels of resources on different departments based on the prevailing circumstances in a particular period. . In a dynamic environment, it is very important for the managers to analyze each item of expenses and justify it so it can be possible to capture the volatile nature of the market – this is achieved through zero-based budgeting. It is also very important to seek ways of streamlining and cutting cost because sometimes the market may be performing very unfavorably and the business may fail to survive if rigid types of budgets are used. This approach requires a lot of time to be spent looking for alternatives by the department members, but such time is justifiable because it can save a business during a highly volatile environment. PART II: WORKING CAPITAL MANAGEMENT Ways of improving each part of working capital cycle for XYZ Company Cash cycle In order for XYZ to ensure success in its operations, it needs to ensure that the cash that is spent is less than the cash that is generated so that there could be excess cash balance to finance growth. This observation is in the view that those entities that spend more cash than they generate from sales find themselves in a situation whereby they cannot be able to service their debts and other expenses. Furthermore, a negative cash flow can make it difficult for a business to repay its loans, which eventually leads to bankruptcy. In view of this, the management of XYZ Company should seek ways of increasing cash flow always (Leonie, 2007). The following are some of the ways that this can be achieved Cash flow generated from operations The management of XYZ should work hard to ensure that the cash generated from sales, before considering its cost and depreciation, is increased. To achieve this objective, XYZ should pursue all the possible strategies of encouraging its customers purchase more of its products including, offering them discounts, trade credit facilities, and any other means of enticing them to purchase more. The company could also consider scaling up its products promotion to capture new markets and sell more products. Ideally, any tactics that is undertaken to boost cash flow for the company will require the existing customers to allocate more budgets on XYZ’s products, or they can enjoy low cost of operation if they are offered discounts. If they are offered trade credit facility, their cash flow could be improved. It is however important to note that offering of discounts to its customer will increase XYZ’s cost of operation, or if offering of trade credit facility is substantially increased, this could cause negative effect on the cash flow in the short-term, or even expose the business into a higher risk of defaults. Increasing Sales Increasing of sales will require the company to implement strategies that are almost similar to the ones for increasing cash flow, but here the strategy should target sales directly. In fact, operating cash flow relies on the total cash generated from sales; therefore, increasing sales is a good way of increasing cash flow. The strategies that are meant to increase sales include introduction of new products, advertisement, and hiring more employees to increase production, among many other ways. Reducing Operating Costs Reducing of operating costs helps increase the operating cash flow. This could be achieved thorough reduction of labor and production costs, or sometimes by calling off some of the workers or reducing their benefits. Whenever XYZ manages to reduce its operating costs, this benefit is most likely to trickle down to its customers in form of reduced cost of inputs. Reorganization If XYZ is not capable of boosting cash flow on its own, it can result to reorganization, a process which allows a company to reorganize itself under administration of a court of law. These procedures can enable the company to become more efficient and better placed to favorable operating cash flows. If the reorganization also results to efficiency in operation, then the customers of XYZ are likely to enjoy reduced cost of inputs and, hence increase their profit margins (Bromwich and Bhimani, 2010). Trade payables, trade receivables and inventories The company should ensure that trade receivable and payable cycles are short. This means these trade receivables should be collected quickly, the inventories should move through the company pretty swiftly, and the company should ensure that it takes maximum credit possible from the suppliers to boost its cash flow position. Unfortunately, some of the actions that the company may undertake to improve trade receivable and trade payable may adversely affect the response from the customers and the management must be careful to ensure all these issues are balanced. Even though correcting trade receivable in shorter periods is in the interest of XYZ, to correct trade receivables quickly; if the time of correction is reduced significantly, this may affect cash flows because some customers would be kept away by the short payment periods. On the side of the customers of XYZ, they would be encouraged by longer payment periods because this would also help them improve their cash flow position. In effect, this means that XYZ should pursue shorter payment periods for its trade receivables, but this should not be reduced too much to ensure customers are retained. Regarding, ensuring that the Inventories move through the company quickly, it means that XYZ must work hard to ensure its customers purchase the products quickly, which requires strategies similar to those of boosting sales. On the other hand, the company should ensure that the inventory level is neither maintained at very high levels nor too low levels. Very high level of inventory could lead to high cost of holding, while too low levels of inventory could lead to loss due to shortage of stock when the customers require them. In other word, the management should ensure that the inventory is maintained at an optimum level, where the customers can get the stock they want when they need them, and where the cost of holding stock is minimized without causing unnecessary shortage. The third aspect, where it is recommended that the company should take maximum credit possible from the suppliers, is extremely important because of several reasons. Most importantly, this ensures that the company enjoys an improved cash flow position because it is possible to take inputs from the suppliers without paying for them and only pay for them when the company itself is paid by its customers, hence avoiding holding too much cash in the inventory which clearly improves the cash flow position. The other important aspect of trade credit is that it is free from interest (Otley, 2008). In other words, when the company purchases inputs from its suppliers and promises to pay for them on credit, this action is the same as borrowing cash from that particular company and repaying it later, only that this time the trade credit does not attract any interest. It is therefore a very cheap way of obtaining credit to cater for the operations of the business. Furthermore, shorter cycles reduce the company’s dependence on costly external supplies of fiancé. This form of credit is actually very beneficial, even to the customers of XYZ; because, as discussed, it does not attract interest hence leading to reduction in the cost of producing goods making it possible to sell them at a reduced price. Selling goods at reduced prices also attracts customers to purchase more goods hence increasing sales, which in turn improves the cash flow position. When a lot of capital is tied in the working capital, it means that a lot of money is invested in the trade receivables and inventories. This perhaps means excessive interest paid or lost interest as well as lost opportunities because such money could have been invested in other ventures to generate income. We have also stressed that the company should maintain shorter cycles because longer cycle means that more capital is needed to finance it (McLaney, 2010). The company should estimate ratios such as the average collection period when estimating whether the level of accounts receivable is too high or too low. Accounts receivable ratio reflects the period that it takes for the company to receive its accounts receivables. The company should maintain an ideal period to be sure that conversion of its receivables into cash is done in a little time as possible, because that money is required in settling bills and other expenses. When account receivable ratio is very high, this means that the company may be headed for liquidity problems as a result of customers delaying or defaulting on their dues. This, in turn, will cause cash shortage and, hence the company may not be able to meet its administrative and operating expenses. The management should revise its debt collection policies to avoid experiencing liquidity problems (Hope and Fraser, 2003). The other issue that is likely to impact on the working capital is the level of trading. If XYZ happens to generate sales very fast, it is likely to create more credit sales and, hence large volumes of trade receivables. To maintain product at par with sales, the company will be forced to purchase inventories on credit hence increasing the amounts of trade payables. This widens the working capital cycles, which adversely affects the cash flow. In the vent that the company does not have adequate working capital to finance the extended working capital cycle, it can be very worrisome because this could lead to lack of sufficient cash to finance for the company to pay its expenses. Lack of sufficient finance t run the company is likely to cause overtrading especially if it is undergoing growth. In severe circumstances, overtrading can lead to insolvency, which infers that the company will have reached a position of severe cash flow shortage (Drury, 2008). The opposite of overtrading is over-capitalization. This occurs when a company hold large volumes of trade receivables, inventories, and cash balances on one hand and very few trade payables on the other hand. If XYZ find itself in such a situation, the management should keep in mind that this is an ineffective use of working capital, because the funds held up in the working capital could be invested more valuably in other opportunities. As matter of fact, manufacturing companies are usually known to hold high volumes of inventories (work in progress and finished goods), high volumes of trade receivables because their customers are usually not many, and low or medium levels of trade payables. Cleary, the area of working capital that XYZ, as a manufacturing company, need to have very good policies to avoid financial difficulties is on trade receivables. This means that the managing director of XYZ should have made sure that he has very good credit policies to govern the company’s few industrial companies. This, for example, could include encouragement of the customers to pay their dues in short periods, while at the same time minding not to use such policies to keep off the customers. This is a complicated area because customers are usually pulled by longer credit payment periods because they would also like to enjoy an interest free credit as discussed earlier, which conflicts with XYZ’s policy to shorten cash receivable correction period. References Bhimani, A,, Horngren, C., Datar, S. and Foster, G., 2008. Management and Cost Accounting. London: FT Prentice Hall. Bromwich, M, and Bhimani, A., 2010. Management Accounting: Retrospect and Prospect. London: Elsevier. Drury, C., 2008. Management and Cost Accounting. London: Cengage Learning. Hope, J, and Fraser, R., 2003. ‘Who Needs Budgets?’ Harvard Business Review, 81 (2), pp. 108–15. McLaney, E., 2010. Accounting: An Introduction. London: Pearson/FT. Merchant, K, and Van, W., der Stede., 2007. Management Control Systems. 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