Budgetary Planning and Control - Case Study Example

Use of Financial Accounting in Organisations Importance of Budgeting in Business Name: Instructor: Course: Institution: Date: Use of Financial Accounting in Organisations Use and Importance of Budgeting in Business Budgeting is the process of quantifying the plans of an entity in order to achieve its objectives within a certain specified period. Budget is normally used for performance evaluation, cost control and future decision making (Shields & Young, 1993). A business uses such a budget to evaluate the amount of money that is flowing into the business in a given period, and consider the best way to spend it among different categories of commitments. Incidentally, an entity normally designates a suitable amount of funds to capital expenditure, recurrent expenditure and other categories. By keeping track of where and how money is spent, a business is less likely to overspend; and hence meeting the intended financial objectives (Hopwood, 2008). Budgetary Planning and Control may is a short short-term monitoring and quantification of long-term strategic plans of the business. Strategic planning is the process of preparing strategic plans which identifies the objectives of the organisations. Long-term corporate plan is implemented by help of budgeting. Budgets may be prepared for functions, financial departments or resource items. Incidentally, some organisations refer to budgeting as a means of harmonizing the combined intelligence of the entire business into a plan of action (Collier & Ampomah, 2007). Budgeting helps the business coordinate its activities. The budgetary process requires that observable detailed budgets are developed to cover each department, function or activity in the organization. This is only possible when the effort of one function’s budget is associated to the budget of another function. Consequently, harmonization of activities, department and function is attained (Tyagi & Madhu, 2003). Budgeting is a strong communication tool for business purposes. The whole budgeting process comprises of cooperation and discussion among all levels of management. Both horizontal and vertical communication is crucial to make certain appropriate coordination of activities. The strategic decisions are communicated down to the functional area, where they are required to get implemented (McQuaig et al, 2010). Control of expenditure is only possible if budgeting plan is done, designating the specific amount that should be spent on a particular activity, function or department. Budgetary control requires the business entity to compare the actual results with the budgeted results and reporting on any variances. Budgets set a control measure, which helps to achieve the plans set within established confines of expenditure (Tyagi & Madhu, 2003). Budgets may be seen as a negotiating process in which managers’ fight with each other for limited resources. Budges set objectives, which have to be attained. Where budgetary goals are firmly set, some individuals will be positively motivated towards achieving them. This contributes positively to the entire company, as it becomes more efficient and productive (Mittendorf, 2006). Budgetary process requires the organization of a business into responsibility and budget centres with apparent lines of tasks of each manager. This reduces replication of efforts. It is also by Budgetary Planning that long-standing strategies are put into action. Planning involves identification of objectives to be achieved at a future predetermined time (Shields, 1997). Although budget appears to be so useful in business planning. South-guys partnership Ltd should be very careful to avoid its becoming counterproductive. The objectives which must be determined should be reasonable and attainable. If unattainable targets are set, the managers’ strains to achieve them-but they rather causes loss of morale and the objectives are not met. For example, the estimated future cash inflows should be reasonable and realistic, to avoid shortage of cash in the future (Tyagi & Madhu, 2003). In the modern world, budgeting is no longer the responsibility of just the finance department. The whole business benefits when the knowledge of front-line managers is acknowledged. Collaborative surroundings involve all the stakeholders at every level to contribute towards planning and budget process. The collaborative process supports innovation, communication and shared goals throughout the business. By connecting strategic targets with financial metrics, operational actions and performance yardsticks, budgeting applications and Web-based planning steer the performance and strategy indicators through the business to see to it that everyone is working in the direction of the same goals (Mittendorf, 2006). Different participants need varied views and right of entry to data. For example, while senior managers may require only summary information, front-line managers may be requiring the details. By instantaneously updating projections and other relevant data online, operational managers, sales and field personnel can communicate appropriate data back up to keep top management aware of varying circumstances on the ground. Instant model updating facilitates updating of information and can be recomputed speedily and keeps all stakeholders updated with the most current information (Luft, 1997). Budgetary conflicts The process of budgeting in South-guys partnership involves different parties, and monitoring must be carried out to ensure the objectives are met. It becomes very difficult sometimes when people supposed to confine their activities within the plans of the budgets results into antagonism and exerting of undue pressure, because the results are difficult to be met. It is particularly important that the budget is set in a manner that it can encourage implementation without causing chaos (Tyagi & Madhu, 2003). For example, a certain department may strongly oppose the plans of a budget, perhaps for not setting aside what they may consider enough shares of the resources. Other times the manager may confront the workers at the functional areas so that they can control cost expenditure to meet the budgetary requirements (Ghank & Govindarajan, 1992). The purpose of budgeting as a control tool can be very conflicting sometimes. Particularly, the employees’ salaries are part of the cost structure which the budgets control. In that respect, the employees may feel discontented of budgets, and rebel against their implementation. The matter can be made worse if the managers fail to involve them in the process of planning (McQuaig, Tracie, Nobles, & McQuaig, 2010). The employees can however be encouraged to develop a positive attitude towards budgets by explaining to them the significance of controls, and ensuring they participate in budget planning (Tyagi, 2003). Capital budgeting Capital budgeting decisions are critical to Flight high ventures plc success for a number of reasons. First, capital expenditures characteristically require large expenditure of money. Second, Flight high ventures plc must ascertain the best way to raise and pay back these funds (Droms , 1997). Third, the majority of capital budgeting decisions require a long-term pledge, and it might be very difficult to reverse the decision once made. Finally, the timing of capital budgeting decisions is very fundamental (Tyagi & Madhu, 2003). Before deciding which of the available options is to be adopted, Flight high ventures plc must give consideration to the financial markets because the cost of capital is directly linked to the present interest rate (Khan & Jain, 2003). The need for pertinent information and analysis of capital budgeting options has a series of methods which can assist Flight high ventures plc in making the best distribution of resources. Payback period method This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon ventures can payback the initial cost. An investment with shorter payback period is more viable. Option A is therefore preferable as it requires 1.5 years to pay back the initial investment, compared with 2.5 years for option B (Bragg, 2010). This method is usually an important preliminary screening stage of the viability of the venture and it may yield clues to profitability although in principle it will measure how fast a venture may payback rather than how much a venture will generate in profits and yet the main objectives of an investment is not to recoup the original cost but also to earn a profit for the owners or investors (Free, 2010). The firm’s choice of the best alternative based on payback period method can be supported by several advantages. The method is particularly simple to use and understand, since it does require complex computations. This method is Ideal under high-risk investments because it will identify which venture will payback earlier thus minimizing the risks with a venture. The two projects which the company is evaluating are mutually exclusive projects which makes this method very suitable since it will give clue as to which venture is viable if one considers the shortest PBP and the highest inflow of a venture (William , Richard, & Henry, 2004). The reliance on this method is however disadvantageous because it does not take into account time value of money and assumes that money received in the first year and in the Nth year have the same value so as to rank them together to ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now. Again, PBP method does not measure the profitability of a venture but rather measures the period of time a venture takes to pay back the cost. PBP method ignores inflows after PBP and as such, it does not accommodate the element of return to an investment (Frank & Pamela, 2009). Accounting Rate of Return ARR method will accept those projects whose ARR is higher than that set by management or bank rate and it will give highest ranking to ventures with highest ARR and vice versa. Option B is preferable with 0.12 against option A with 0.024.This method can be preferable because it is Simple to understand and use; and is readily computed from accounting data thus much easier to ascertain. It is consistent with profitability objectives as it analyses the return from entire inflows and as such it will give a clue or a hint to the profitability of venture. It however ignores time value of money and does not consider how soon the investment should recover the cost-it is owner looking rather than creditor oriented approach (Robert, 1990). Net Present Value Method Net Present Value Method discounts inflows and outflows and ascertains the net present value by deducting discounted outflows from discounted inflows to obtain net present cash inflows. For example, the present value method will involve selection of rate acceptable to the management or equal to the cost of finance and this will be used to discount inflows and outflows and net present value will be equal to the present value of inflow minus present value of outflow. If net present value is positive you invest, if NPV is negative you do not invest. Option A and B can be adopted, but option B is the best with 70.13%. · This method is very reliable because it recognizes time value of money and appreciates that a dollar now is more valuable than a dollar tomorrow and the two can only be compared if they are at their present value. It takes into account the entire inflows or returns and as such it is a realistic gauge of the profitability of a venture. This method is consistent with the value of a share in so far as a positive NPV will have the implication of increasing the value of a share. It is consistent with the objective of maximizing the welfare of an owner because a positive. NPV will increase the net worth of owners (Dayananda, 2002). The method is however difficult to use. Its calculation uses cost of finance which is a difficult concept because it considers both implicit and explicit, it ignores implicit costs. It is ideal for assessing the viability of an investment under certainty because it ignores the element of risk. It may not give good assessment of alternative projects if the projects are unequal lives (Alice, 2009). Internal Rate of Return Internal Rate of Return method is a discounted cash flow technique which uses the principle of NPV. It is defined as the rate which equates the present value of cash outflows of an investment to the initial capital. IRR will accept a venture if it’s IRR is higher than or equal to the minimum required rate of return. Both of the investments do not meet the minimum requirement which is 20%, but option A is preferable with 15.3%. The use of this method is reliable because it considers time value of money. It considers cash flows over the entire life of the project. It is compatible with the maximization of owner’s wealth because, if it is higher than the cost of finance, owners’ wealth will be maximized. Unlike the NPV method, it does not use the cost of finance to discount inflows and for this reason it will indicate a rate of return of interval to the project against which various ventures can be assessed as to their viability (Bierman & Smidt, 2006). This method is however difficult and expensive to use because it calls for trained manpower and may use computers especially where inflows are of large magnitude and extending beyond the normal limits. It may give multiple results some involving positive IRR in which case it may be difficult to use in choosing which venture is more viable. References Alice, C. 2009. Financial analysis, planning & forecasting: theory and application. London: World Scientific. Bierman, H., & Smidt, S. 2006. The capital budgeting decision: economic analysis of investment projects. London: Routledge. Bragg, M. 2010. The Ultimate Accountants' Reference: Including GAAP, IRS and SEC Regulations, Leases, and More. London: John Wiley and Sons. Collier, M., & Ampomah, A. 2007. Management Accounting - Risk and Control Strategy. Oxford: Butterworth-Heinemann. Dayananda, D. 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Droms, W. 1997. Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know. New York: Perseus Books. Frank, J., & Pamela, P. 2009. Finance: capital markets, financial management, and investment management. London: John Wiley and Sons. Free, C. 2010. 21st Century Economics: A Reference Handbook, Volume 1.London: SAGE Ghank, K., & Govindarajan, V. 1992. Strategic cost management: The value chain perspective. Journal of Management Accounting Research, 4, 179-197. Hopwood, G. 2008. Management accounting research in a changing world. Journal of Management Accounting Research, 20, 3-13. Khan & Jain. 2003. Cost Acc & Fin Mgmt Ca Pe Ii. New Delhi: Tata McGraw-Hill Education Luft, L. 1997. Long-term change in management accounting: Perspectives from historical research. Journal of Management Accounting Research, 9,163-197. McQuaig, J., Tracie, A., Nobles, J., & McQuaig, C. 2010. College Accounting, Chapters 1-24. Mason: Cengage Learning. Mittendorf, B. 2006. Capital budgeting when managers value both honesty and perquisites. Journal of Management Accounting Research, 18, 77-95. Phillinglaw, G. 1989. Managerial cost accounting: Present and future. Journal of Management Accounting Research, 1, 33-46. Robert, J. 1990. The economics of building: a practical guide for the design professional. New York: Wiley-IEEE. Shields, D., & Young, M. 1993. Antecedents and consequences of participative budgeting: Evidence on the effects of asymmetrical information. Journal of Management Accounting Research, 5, 265-280. Shields, D. 1997. Research in management accounting by North Americans in the 1990s. Journal of Management Accounting Research ,9, 3-61 Tyagi, C., & Madhu, T. 2003. Financial and Management Accounting. New Delhi: Atlantic Publishers. William, W., Richard, C., & Henry, A. 2004. Smart financial management: the essential reference for the successful small business. New York: AMACOM Div American Mgmt Assn APPENDIX I: South-guys partnership Ltd cash budget APPENDIX II Payback period year Cash flows(A) accumulated Cash flows(B) accumulated 1 726 726 424 424 2 484 1210 484 908 3 363 1573 605 1513 4 242 1815 787 2300 5 242 2057 847 3157 A B Cost = 968 1,210 Option A payback= 1 year + ({968-726}/484) 2 year + ({1210-908}/605) =1.5 years =2.5 years Accounting Rate of Return ARR= (average income/average investments)*100 Or (Average income – Average depreciation)/Initial investment Option A = 217.4-194=23.4/968 =0.024 Option B =387.4-242=145.4/1210 =0.120 Net Present Value Method (NPV) Pv(inflow) – Pv(outflows) = NPV Option A. PV inflows= 726/ (1.14) +484/(1.14^2)+363/(1.14^3)+ 242/(1.14^4)+242/(1.14^5) =636.84+372.4+245+143.3+125.7 = (1523.23-968)/968 =57.37% Option B. PV inflows= 424/ (1.14) +484/(1.14^2)+605/(1.14^3)+ 787/(1.14^4)+847/(1.14^5) =371.9+372.4+408.4+465.97+439.9 = (2058.6-1210)/1210 =70.13% Internal rate of return method: IRR= Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0. Option A PV at 14% =1523 difference=555 PV required =968 difference =132 PV AT 15%=1100 R= 14 %+( 15%-14%) *555/(555-132) =14%+1.312 =15.3% Option B. PV at14%=2058.6 difference=848.6 PV required=1210 difference=-296.4 PV at 15% =913.6 R =14 %+( 15%-14%)*848.6/ (848.6+296.4) =14%+0.74 =14.74% APPENDIX.III Budget’s role as a moderator on the relationship between strategic change and performance APPENDIX.IV Effects of Organizational Structure on the Budgeting Read More