Budgeting Process - Case Study Example

Budgeting Table of contents Introduction 3 Budgeting 4 Components of a Master Budget 5 Budgeting Process & its Impact on the Company’s Operational Efficiencies 7 Critical Analysis of Budgeting Technique Followed in the Organisation 8 Case Study Analysis: BAM Construct UK Ltd 9 Conclusion 10 Reference 12 Introduction Success of a company depends on several factors like the efficiency with which the company manages its marketing strategies, the way it handles its human resource, the core competency possessed by the company in terms of technology and its ability to manage its cash through appropriate financial decision. Any problem arising in any of these vital functions can lead to severe consequences and the company can even lose its existence. As described by Pinson “the principle reason for business failure is the lack of an adequate business plan” (Pinson, 2008, p.xi) As described by many authors “cash flow is the life blood of every business” (Williamson, 1999, p.57). The firms thereby need to take great care while handling the cash flow. For effective management of cash flow, the management should have a predetermined volume and time schedule of cash inflow as well as cash outflow. Therefore it is the responsibility of the finance department to analyse all the cash inflow as well cash outflow beforehand. Budgeting is one of the most commonly used techniques that assist the company to understand the nature of cash flow and to take preventive actions as and when required. For effective financial management the company needs to develop, execute and control its budget in the best possible way. In the below given session an in-depth analysis has been conducted to understand the manner in which the budgeting technique can be effectively used for financial management. Budgeting As described by an Anglo-Saxon “a budget may be considered to be a set of financial statements resulting from a particular scenario- generally the most likely or hoped for scenario” (Hinka, 2007, p.4). At first the top level manager set the corporate goal that needs to be achieved in future and this gets communicated to the different departments in the form of target. In each functional department, the respective managers set the budget that presents the level of activity to be conducted and the amount of cash required. Later on these budgets are submitted to the administrative department for final approval. Often the administrative department ask the respective departments to make the requisite changes. Once the budgets of the entire functional department are approved by the administrative department it goes to the finance department where the master budget is formulated. The finance department also develops a cash budget to determine cash inflow and outflow at different point of time. Figure – 1 (Source: Drury, 2008, p.352) Components of a Master Budget The master budget can be segregated into operational budget and finance budget. Each of the budgets is discussed below: Figure – 2 (Source: Shim & Siegel, 2005, p.156) 1. Sales budget: The marketing department of the company is responsible for formulating the sales budget of the company. At first the marketing personals are asked to submit their sales forecast for the coming year and then the marketing manager finalises the total sales budget for the year taking into account the sales forecast by the sales persons and the historical data. While developing the sales budget the forecasted units are multiplied with the respective sales price. The sales budget depends on sales unit forecast as well as the pricing strategy of the company (Oliver, 2000, p.72-73). 2. Production budget: This budget identifies the number of units that must be produced to meet the sales requirement. The unit to be produced is determined by the unit to be sold plus the unit needs to be kept in stock less opening stock maintained by the company. The production budget looks after the requirements of direct material, direct labour and manufacturing overheads. (Bragg, 2009, p.210-211). 3. Selling and administrative budge: Often the company incurs cost while selling the products in the market. Hence a budget needs to be developed for identifying the selling and administrative costs (Drury, 2005, p.281). 4. Cash budget: Once all the budgets are formulated, the management can derive the flow of cash in terms of time frame and volume. Thereby a cash budget is developed. This budget takes into account all the capital expenditure and budgeted balance sheet. It has three main components- cash receipt, cash disbursement and financing (Kimmel, et al., 2008, p.1019). Figure – 3 (Source: Kimmel, et al., 2008, p.1011) Budgeting Process & its Impact on the Company’s Operational Efficiencies Different companies prefer different techniques while developing the budget. Some companies rely heavily on the historical cost incurred in last few years whereas others prefer to develop a budget on zero based technique. However each of the technique has its own advantages and disadvantages. Fixed budget: This is also called static budget because it utilises the historical data for formulating the budget. Such budgeting is more suitable when the company wants to forecast its sales and other costs related to production with utmost accuracy. This is only possible when the economic conditions as well as market conditions are stable and all other factors like demand of the product or service and inflation can be predicted accurately (Shim & Siegel, 2005, p.100) Flexible budget: This is basically used when the external environment is uncertain and it is not possible to determine the nature of demand in the market or the rise in the costs of material and labour. This budget provides flexibility to the management to modify it as per the change in the external environment (Shim & Siegel, 2005, p.100). Zero based budgets: While developing this type of budgeting the management needs to develop it from the very scratch every year. For each and every cost component, the management needs to provide an explanation. This makes it very time consuming but it is more authentic since it does not rely much on the historical data. Critical Analysis of Budgeting Technique Followed in the Organisation Budgeting is a traditional practice used by the management to achieve the corporate strategy. Budgets are generally prepared on annual basis as this helps the company to plan its production and selling activities accordingly. This also assists the finance department to arrange cash beforehand so that the cost of capital does not exceed its limit. However many companies are trying to do away with the practice of developing a traditional budget. Many companies believe that the traditional process of budgeting is highly time consuming and the valuable time of the managers gets wasted in developing such annual budgets. General observations have found that the budget loses its validity after a few months as it fails to access the changes taking place in the market. The company thereafter has to introduce new policies and to take decisions which might not be in accordance with the prescribed budget. The budget of the company starts with the development of the sales budget. To start with, the sales manager asks the sales personals to provide their sales forecast for the coming year. The sales forecast mainly depends on the data provided by these sales persons, hence the possibility of data manipulation is also high. In an attempt to impress the manager, sales people often exaggerate the forecasted sales figures. On the flip side, the sales people in order to earn incentives often understate the sales figure to the manager to prove that they performed better as compared to other sales persons. Such manipulated information distorts the entire master budget and victimises the cash budget. Hence it can be concluded that although a budget assist the company to plan its operations and finance beforehand, it also leads to the wastage of time and cost. Case Study Analysis: BAM Construct UK Ltd It has been observed in the context of BAM Construct UK Ltd. that during the process of formulating a financial budget the company has made provisions for security to cover the bank loans. While extending this facility to the members of the Royal BAM Group, its board of directors have meticulously factored in the inherent risks that are associated with such securities. It has been observed that “liquidity risk and cash flow risk is actively managed through the preparation and monitoring of medium term plans, budgets and quarterly forecasts” (BAM Construct UK Ltd., 2008). The aspects of this construction giant that help mitigate the fluctuations in terms of interest rates as well as risks related to the cash flow are the healthy cash balances present in BAM’s coffer. Moreover the fact that “compliance with loan covenants associated with the non-recourse finance obtained for BAM Properties’ developments is monitored regularly” (BAM Construct UK Ltd., 2008), makes the corporate experience of the company a smooth ride. The management considers the element of price risk “at a group level as part of the review of management forecasts and at project level as part of the tender process” (BAM Construct UK Ltd., 2008), and simultaneously monitors the same on a continual basis. The factor that stands out as the most vital one in shaping the prosperity of the company is that “potential new developments are appraised using stringent financial assumptions with regard to forecast tenant demand, rental values and expected yields, as well as assessments of construction inflation” (BAM Construct UK Ltd., 2008). Conclusion To make the budget more effective, the management should motivate the sales persons to provide appropriate information. The sales manger should also verify the data with the historical one. The budget should be flexible enough to accommodate the changes taking place in the market. Flexible budgets assist the manager to introduce the required changes as and when required. Many companies opt for developing a zero based budget each and every year but care should be taken to ensure that it does not become too time consuming. A budget often loses its validity because of the changing nature of demand and rates prevalent in the market. The management should make it a point to revive the budget after each quarter or if possible each month. Such revision will enhance the utility of the budget and it can be used for executing the business decisions. With the help of advanced technology and extensive use of computer the management can easily revive the budget. The employees should thus be trained to use the technology in developing the budget. This will not only increase the reliability but will also make the budgeting process much faster. To execute an efficient budget all the departments should co-ordinate with each other and maintain a high level of transparency. Reference BAM Construct UK Ltd. 2008. Report and Accounts 2008. [Pdf]. Available at: http://www.bam.co.uk/brochure/BAMConstructUK_R&A_2008.pdf [Accessed on May 5, 2010]. Bragg, S.M. Controllership: The Work of the Managerial Accountant. 8th ed. John Wiley and Sons. Drury, C. 2005. Management accounting for business. 3rd ed. Cengage Learning EMEA. Kimmel, P. D., Weygandt, J. J. & Kieso, D. E. 2008. Accounting. 3rd ed. John Wiley and Sons. Hinka, K, R. 2007. Budgeting: Approaches and Shortcomings. GRIN Verlag. Oliver. L. 2000. The cost management toolbox: a managers guide to controlling costs and boosting profits. AMACOM Div American Mgmt Assn. Pinson, L. 2008. Anatomy of a business plan: the step-by-step guide to building your business and securing your companys future. 7th ed. aka associates. Scarlett, R. C. & Scarlett. B. 2007. Cima Management Accounting-Performance Evaluation. 4th ed. Butterworth-Heinemann. Shim, J. K. & Siegel, J. G. 2005. Budgeting basics and beyond. 2nd ed. John Wiley and Sons. Williamson, I. 1999. Start your own business, be your own boss!: your roadmap to independence. Productive Publications. Bibliography Shim, J. K. & Siegel, J. G. 2005. Budgeting basics and beyond. 2nd ed. John Wiley and Sons. Read More