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The purpose of this report is to identify the problems that may arise in motivating staff to achieve higher levels of operating efficiency and different approaches to budgeting which could be used to improve the current system.
1.1 Definition of a Budget
"A budget is a quantitative expression of a plan of action for defined period of time. It may include planned sales volumes and revenue, resource quantities, cost and expenses, assets, liabilities and cash flows". (Lucey,2006,p.415). A budget could be seen as a guide to achieve the goals of an organisation. A current survey has shown that top companies, be it financial or non- financial companies sees budget as a vital tool for co-ordination, planning and control. In order words, it helps firms to stay on track, and in that manner; the top managers will be able to see where they are and where they are heading to in terms of achieving its set target.
1.2 Problems with incremental Budgeting
Incremental Budgeting also known as conventional budgeting, "a type of budget which bases next year's budget on the current year's result plus an extra amount for estimated growth or inflation next year."(CIMA, 2005 p.301) According to (Hope and Fraser 2003), who said that the use of budgets could result into different problems and are part of a fixed performance contract (Robin H, and Jeremy F 2003).That is, budgets are seen as annual exercise since it is based on targeted costs and sales. Budgets have been criticized for its use in motivating managers. Budget should be motivating, that is it should persuade staff and managers to work extremely hard in attaining the set goals.
According to (Hope and Fraser 2003), an incremental budgeting approach makes staff and managers feel undervalued. They often feel this way because it is imposed on them, they feel underestimated and are not capable of handling situations all by themselves, thereby demotivation sets in. Managers may not want to take responsibility if anything goes wrong because they didn't compile the budget themselves. In comparison with the participative everyone is involved in the compilation of budget. This will then have effect on the behaviour of manager making them feel welcome and it improving the possibility of the organisation goals being achieved.
1.3 Keeps to the same condition or state of affairs/obstructs change: that is, the culture of the organisation is maintained, keeps to the way things have always been done based on past performances. It promotes a more laid back attitude from mangers and staffs because there is nothing to challenge them to think ahead and be creative. Incremental approach doesn't recognise the economy is changing, and that different ideas that can be developed to help organisations gain efficiency. For instance, in the 1990s, Volvo reported little profit, due to its use of traditional planning and control system. Later on, it decided to look beyond this and adopted a more strategic measure such as creating opportunities, process thinking, which helped them to cope with competition in the car market today(Hope and Fraser 2003). In comparison with Beyond Budgeting by (Hope and Fraser, 2003), more strategic measure is encouraged in order to increase organisations' efficiency.
1.4 Budget supports departmental barriers rather than promote knowledge sharing and ideas (Hope and Fraser 2003). Budgets are supposed to be bringing people together under one umbrella, in terms of communication, sharing ideas and so on, but in this case staff sees it as competition against other department, because they are given details of targeted sales for the year.
1.5Inaccurate forecasts are presented: past budget will include inaccuracy and personal judgement, because forecast is based on last year's estimation. That means if the budget estimation was wrong last year then, the same problem will be faced this year, which could result into goals not been achieved each year.
1.6 It focuses only on meeting the target and not beating it (Hope and Fraser 2003): This approach doesn't encourage creative thinking based on how the organisation can attain strategic goals. Setting target could be seen as restriction for other ideas to be acknowledged, as details of last year's performance is brought forward to this year.
On the other hand, traditional budgeting can still be useful in its own ways.
2 Alternative approaches to Budgeting
There is no ideal budgetary control, the best approach adopted by an organisation have to correlate with what type of service is provided.(Hussey,J and Hussey R,1999)Research have shown that the system of budgeting adopted by some organisations tends to either motivate or demotivate staff and managers.
2.1 Participative Budgeting
"A budgeting system in which, all budget holders are given the opportunity to participate in setting their own budgets."(Scarlett B,2009.p 238) That is, the approach allows lower level managers to have a hand in the development of the budget, focusing on what the lower level managers sees as ideal in achieving the set goals. For the effectiveness of this approach, negotiation is taken into account. There should be an agreement between the top and the lower level manager for efficiency and better allocation of resources.
2.2 Arguments for this approach are as follows:
2.3 Morale and Motivation is improved: because managers are given the opportunity to set budgets themselves, they will want to work hard to achieve the target they have set themselves. They will also be able to act in the interest of both themselves and that of the organisations thereby, achieving higher level of operating efficiency.
2.4 Specific resource requirements are included: since budget is set by lower managers based on their views, they tend to state specific resources needed to achieve the budget, because they will not want to be held accountable if anything goes wrong, hence, the cut in the use of resource.
2.5 Sharing of ideas and knowledge is promoted among different manager: in contrast to the conventional approach, this approach brings managers together from different levels to discuss what each one feels can be done to remain competitive, as the top managers are counting on them to come up with strategic ideas.
However, the disadvantage is that, an easily attainable budget may be set by managers by doing this, the organisations target might not be reached. Also, due to the budget been set by lower level managers, the target might not be achieved as they are unqualified
3 Zero-based budgeting: This approach recognises that the starting point for the budget is zero, that is cost and resources does not exist, unlike incremental approach where it is based on what happened last year and then adjusted for inflation etc. It is defined as "a method of budgeting that requires all costs to be specifically justified by the benefits expected."(Lucey 2006,p.436). It expects managers to be able to recognize and defend decision packages, if this cannot be justified, then the budget will not be accepted and financed by the top level managers. (Duncan 2002) said the use of this approach, has proven to be successful in the United States where it was developed by President Jimmy Carter. In 1979, President Carter in his speech said that the budget for that fiscal year should be prepared using Zero based approach because of its reported success of the use in the State of Georgia. This approach was adopted because of its better allocation of resources and cost reduction for effectiveness in an organisation.
3.1 Justifications for Zero based Budgeting are analysed below:
3.2 It focuses on not only the cost of an activity but also the relative benefit: because managers will have to justify the decision packages they have chosen, they develop a more questioning attitude, like what benefit will the proposal bring to the organisation and so on. The top level manager have to also look into the budget by cutting down all unwanted cost that will not add any value to the organisation's goal, thereby resources are allocated efficiently.
3.3 It involves participation of managers and employees in terms of planning and co ordination, because they prepare the proposal and then top level managers make the decision on what is needed. Also, motivation and sharing of ideas is promoted in the organisation as no one is left out thereby increasing the chances of the set goals been achieved.
3.4 Changes in the business environment are responded to: its idea of zero starting point is beneficial because each time a budget is drawn it includes new ideas. For instance, if there is a new software in the market for computers, Langdale will be aware of this and then restructure its plan, on how to improve its service to suit the changes, thereby gaining a major share of the market. This in turn, makes managers strong because they face new challenges and implementation every year.
However, the limitations of Zero based budgeting is that, putting up the proposal takes a lot of time as well as ranking the decision packages. Decisions made using this approach could be harsh in its attempt to control cost which will in turn result in the ignorance of better opportunity. Despite its limitation, it can be relevant to some extent in terms of costs in an organisation.
In conclusion, after weighing up its argument for and against, organisations should carefully look at the approach which suits the type of service they provide, for effectiveness and efficiency.
The cash flow statement above shows Craig Ltd's inability to meet its targeted net cash flow of £450,000 by £7488 (£450000- 442512)
4 Ways to improve the cash flow
There are different measures Craig Ltd could take to improve their net cash flow. These are analysed below:
4.1 Strict credit control policy in place. In order to avoid shortage of cash and liquidation, It could be of an advantage for the company to keep an eye on its credit control system. Craig Ltd has to adopt strict policy. That is, as soon customers have reached the payment date, and have not yet paid up their debt. The company can decide to stop selling goods to the customers until they settle their debt and then take further legal action.
4.2 Inventory control: there should be a proper stock control policy in place for efficiency and wastage avoidance. Craig ltd should make sure it carries out regular stock check by having it recorded on computer or counting it physically. Stock levels should be checked to avoid ordering too much stock. Also, the level of holding buffer stock for emergencies should be monitored.
However, if there is restriction placed on the amount of stock to be held, the business might not be able to meet demand for large orders, which will make customers go to other suppliers.
4.3 Reduce receivable days/give settlement discounts: in order to improve cash flow, Craig Ltd, can decide to reduce the length of time it takes receivables to pay for goods bought from them. That is, if customers are given 60 days term to pay off their debt, this can be reduced to say 30 days, because the more time they are given to pay up, the more cash tied up outside the business. Also, settlement discount can be given to debtors to encourage them to pay their debt promptly. However in practice, this is unlikely to happen because, as receivable days are reduced, customers will be forced to look for alternative way of getting credit from a substitute supplier.
4.4 Supplier negotiation/discount received: negotiation can be made with suppliers of materials to help increase credit days. By increasing the days it takes to pay suppliers more cash will be available in the cash flow, this cash can be used to run their day to day operations or it can be used to expand the business which will generate more cash flow. Also, discounts for prompt payment, given by the suppliers of materials should be taken advantage of. For instance, 20% discount is received from supplier, for materials purchased. The amount to pay will be (20% x £680,000 material for the year) is 136000 less £680,000 = £544,000. If this advantage is taken, it will mean that rather than paying for full cost of the material (£680,000) per year, a discounted cost of £544,000 is paid, thereby cash flow outflow is reduced by the discount received £136, 000.
4.5 Increase selling price: to help improve cash flow, average selling price can be increased to £720, while other factors like labour, number of unit is constant at 2500 units. The effect of the discount received of 8% and increase in selling price by 2.9% (700-720) = 20/700 x 100% is illustrated below, to show the effect on the net cash flow
Revised cash flow statement based on selling price increase and discount received on cost of materials
Note: labour and variable overheads figures are taken from the workings above.
In this case, the target of £450,000 is reached by increasing the selling price and receiving discount for bulk buying and prompt payment. According to the law of demand and supply which states that, as the price of a product rises, the demand for the product will fall as well.(Sloman John, 2007) That is, increasing the price of the product, may have a negative effect on the customers ability to buy more products they will be forced to go to another supplier.
Calculate the length of time the second unit will take if 85% and 95% learning rate is used.
From the above calculation, the 85% learning curve shows the faster learning rate. The lower the learning rate the greater the efficiency. The table above shows that, as production unit increases, labour hours per unit is affected by a decrease as well for both learning rates. If Craig ltd is looking for measures of reducing labour costs, then the 85% learning rate could be considered, because it does not only have a positive impact on labour hours and labour costs but also increases workers performance.(Atrill, P and Mclaney, E 2007)
To forecast its labour costs as production unit increases for both learning effect, at £6 per labour.
Note cumulative total time is taken from the above table.
It can be seen that the 95% learning effect is costing more than the 85% as production unit increases.