How Traditional Budgets Can Be Effectively Used Accounting Essay

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The first part of the paper discusses about Traditional Budgeting and how now-a-days traditional budgeting is not suitable for modern business. The essay will provide a short introduction about traditional budgeting, how it can be effectively used, and limitations of traditional budgeting, alternatives of traditional budgeting.

A budget is a business plan for the short term generally for one year (Atrill & McLaney, 2007, p304). It is generally shown in financial terms and it is formulated to fulfill strategic goals. Budgeting is quite important as it helps in operational planning, evaluation of performance, communication of goals, formulation of strategies, and control of cost which assists the organization to attain its overall goals. But it is not fit for modern business. The terminology "modern business" implies a business which is working in a global economy and practices all the modern tools to survive in a highly competitive environment. In the present scenario of information technology, it is not possible for a business to compete internationally without continuous innovation, updated information and controlled activity. In the subject of management accounting, budgeting is considered as a vast and significant concept. There are different ways of budgeting. The essay will concentrate on traditional budgeting and its operation in modern business.

Traditional Budgeting

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Strategic Planning Process in a company involves budgeting. It lists down the objectives of business, targets and decides the activities needed to accomplish these goals. It is prepared on the basis of last year data, decisions, uncertain estimates and forecast. It is generally called as the planning of one year which list down the targets for the business and at closing of period; such targets are compared with actual results. The variances obtained are reported to the budgeting team which in turn uses them as a significant piece of data for current year budgeting. Traditional budgeting results in boundaries for operations of business and sets targets for its employees, which motivates employees to work more and earn reward for achievement.

How traditional budgets can be effectively used?

Budget can be called as the exhaustive numerical strategy for the purchase and usage of financial and other sources over a fixed future time period. The action requiring preparation of budget is called as budgeting. Budgetary Control can be called as the use of budgets for controlling the activities of organization. Budgetary control system is considered as one of the important instrument for planning and control. The success of the organization is dependent on how effective planning is. Process of budgeting involves comparison between budgeted figures and actual figure. Most of the time, comparison between fixed budgeted figures and actual budget is made without flexing it. Therefore, this results in a problem with employee of the company. It appears that the concentration is on the dollar amount not on the volume of the goods manufactured. For example, the manufacturing target of the company is 2,000 units with fixed cost of $20,000 and variable cost of $60,000. It implies that the total budgeted cost is $80,000. Now, it will be compared with the actual figures without observing the volume. Presuming that the actual cost spent is $90,000 and the volume is 2500 units. If $90,000 is compared with $80,000, it appears that the expense is more by $10,000, which is incorrect. Since the actual cost should have been spent for 2,500 units is $20,000 fixed and $75,000 for variable, therefore the flexible budget for actual volume should be $95,000. After comparing it with $90,000, which shows that $5,000 is the savings and there does not exist overspending of $10,000. It implies that overspending cannot be considered as negative thing.

The company should focus on comparing the actual figures with the flexible budget not the static budget. The work to be completed in future shall also be taken into account. The estimates shall be reviewed regularly and revised if needed, if the estimate is for lower work to be done the budget will be lesser in amount, but if the work is in accordance to the capacity of the company then the budget will be rational, which will not generate problem for departmental head to work more when their budgets have been achieved, if they would have been made on impractical estimate.

The standard cost system can also be used by the companies for the purpose of control, they fix standard for every activity and then that standard rate is multiplied with actual activity carried on to make comparison with actual dollar cost. For example, the standard cost to manufacture one unit is $20 per unit and the company manufactures 5,000 units, the standard cost estimated for actual production is $100,000, then the comparison shall be made with actual cost incurred, it the actual cost spent is $90,000, it implies the company has saved $10,000 and if it is $105,000, it represents extra spending of $5,000.

Limitations of Traditional Budgeting

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Traditional Budgeting is always demotivated for the high cost involved and the longer duration taken for its preparation. These two disadvantages are always considered by the modern business firms which need a long working of financial managers and spend high cost on the company. In addition to this, there are various other aspect on which budgeting is demotivated. Budgeting is considered as significant instrument for a business and suffers from various disadvantages like it is able to meet up only the lowest targets, consumes more resources than needed, competes against other divisions, departments, business units, money is spent only on the items mentioned in the budget, gives inaccurate forecasts, designed with the intention of meeting the budget, not beating it and it ignores the risk element as well.

Budgeting is criticized by the modern business on various grounds like time consuming, quite expensive, restricts flexibility in working, its main concentration is on target and is generally misaligned with strategy, it concentrates more on cost in spite of creating value, it gives rise to gaming between superiors and subordinates, rarely updated and is prepared on unrealistic assumptions and guesswork which make it unfit for modern business.

Traditional Budgeting & Alternatives

In the present scenario, there is scarcity of resources, therefore, it is required that allocation of resources shall be done after giving priorities to various options available. But very few organizations are able to perform well in this regard. The traditional approach to budgeting is leading to silo decisions under which resources are allocated on a project by project basis. The individual decisions that are being taken exclude any clear evaluation of various alternatives available, generally resulting in missed opportunity for the business concerned. However, by implementing principles of decision analysis, it is possible to form a portfolio of different options that really do not make the best use of the available resources.

Budgeting is usually an exercise in balancing costs, benefit and risks. It includes urging a wide community of stakeholders to take up to these decisions. In the entire process, different stakeholders with different objectives will fight for scarce resources. Example of this can be the government of United Kingdom spending round, in which different spending divisions slug it out for a slice of the treasury's pie.

Allocations of resources that can be considered as optimal to individual organizational units are rarely collectively optimal and those who are not satisfied with the result can become unenthusiastic and sturdy to its usage. The main crux of decision making including budgeting is that when show with wide variety of opportunities, decision makers do not have sufficient knowledge of each alternative to be able to take informed decisions. Another problem associated with this issue is that benefits related with these opportunities are generally featured by different objectives which themselves often conflict with each other.

Conclusion

It can be concluded that budgeting is a significant instrument for business organization which assist in planning for operations, evaluation of performance, communication of goals, formulation of strategy and fixation of targets which act as a basis for working of organization and organizational control. Even after its significance it has become an issue of concern to change or abandon traditional budgeting from modern business. It is due to some of the disadvantages of budgeting which makes it rigid for flexible modern business. Traditional budgeting does not provide updated information, flexibility in operations and limits large amount of expenditure on innovation and in addition it is quite time consuming, expensive which requires engagement of a company for 12 months and thus limiting the flexibility as well.

It is believed by some of the economists and business managers that budgeting is a significant instrument which cannot be removed completely from a business. There are few other techniques like rolling forecast budgeting, zero based budgeting, process based budgeting, activity based budgeting, performance based budgeting which can be used for solving the problems of business organization.

Working Capital

Working Capital measures the liquidity in the operation of the business of the entity. Working capital is calculated by subtracting Current liabilities owed by the entity from the Current Assets owned by the entity. If current assets are more than current liabilities then it shows that company has high liquidity whereas if current asserts are less than current liabilities then it represents that company has working capital deficiency. Working capital calculations are used as an important measure of evaluating the operating and financial risks in the business of the entity. It is helps in improving the operations, expansion of business, and payment of short term bills. Negative working capital or inadequate working capital makes the business bankrupt.

Factors affecting Working Capital

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There are various factors affecting the composition of Working Capital are listed as follows:-

Availability of raw material Used and nature of finished goods

Investment on purchases and storage is more for the Industry which requires seasonally materials with limited availability and raw materials. Hence the requirement of working capital increases due to the huge Inventory of raw material. Seasonal finished goods require more of working capital, whereas finished goods with short shelf life require lower percentage of current assets to be invested in the inventory.

Type of Industry to which Entity Belongs :

A manufacturing concern requires money to be invested in work in progress and inventory that is the reason why manufacturing concern requires more working capital than an entity, whereas in service industry current assets are represented by cash at bank and accounts receivable. The inventory requirement of finished goods also affects the working capital. In trading organization, the working capital depends on the inventory of finished goods. In trading organizations due to inventory of finished goods the working capital requirement is huge.

3. Competitiveness

More working capital is required for the industries which have high market competition; reason to this is that more credit is to be given in the market which increases accounts receivable.

Stages of Growth & Expansion

Company on static stage will require less of the working capital whereas; company on a growing stage will require more working capital. Company on expansion program requires more money to be invested in working capital.

Improvement of working capital

"Cash is the lifeblood of business", this saying is true because cash flows in, out and around the business during the life of the business. To keep it flowing in the business and also to generate profits out of it is the task of managers. Cash surplus and deficit situation arises when the profits are positive and negative. So to manage the cash is the task of manager so that cash deficit situation won't arise because it will affect the lifetime validity of the business. If the receivables i.e. debtors are collected faster that means the cash is realized from the cycle.

Cash is soaked by debtors if the receivables collection is slow. If the inventory turnover is high it means the cash gets realized early whereas reverse of it means the organization consumes the cash. Cash is at the top most priority amongst others because cash is affected by trade receivables, payables, inventories, work in progress and finished goods. To enhance the cash position creditors and debtors will be managed effectively to early and too late payment of creditors and debtors are dangerous for the financial position of the organization.

Ways to improve working capital

Debtors or Receivables

Trade receivables play a major role in the organization. There is saying "If you don't manage your debtors, they will begin to manage your business" because if the receivables are not turned into cash the control in the industry will started reducing. To improve the receivables part of working capital following needs to be done:

Aging schedule and debtor balances needs to be monitored so that the debtors won't stay unrealized for the longer period.

Before giving the credit, credit worthiness is to be checked so that the idea of realization of cash will be made.

Apart from cash system, importance should be given to credit and debit card system because it will let the debtors realized soon and organization won't have to wait much long for the cash from debtors.

Charge penalties on the overdue amount.

A limit is to be set for each customer i.e. up till this amount they can take out the goods on credit beyond this either they have to mortgage their property or has to make payment via debit or credit card.

Fixing the limit does not mean it is fixed for the life of the business. In case of tough times it can be changed according to the financial conditions.

Average collection period must be reduced by active debtor management.

Creditors or Trade Payable

Creditors plays vital role in the effective cash management and should be accomplished carefully so as to enhance the cash position. Purchasing means cash outflows and an over-zealous purchasing function can create liquidity problems. To improve the payables part of working capital following needs to be done:

Cost to carry the stock should be well known.

Goods or materials will be purchased from the well-financed organizations so that they won't demand cash before the credit time.

Activity ratio needs to be improved so that the collection period will be reduced and payable period will be increased

Instead of financing from short term debt, long term debt will be used so that the burden of payment will be postponed to future and effective time will be given in growing the organization instead of payment pressure.

Inventories

Excessive and insufficient inventories both cane make the organization bankrupt that is why it is rightly said that inventories management is also one of the crucial parts in an organization. Excessive stocks places heavy burden on the cash resources in terms of ordering and carrying cost, and insufficient stocks results into lost sales because of delay in service to customers, customers prefer buying it from others. To improve the inventories part of working capital following needs to be done:

Projected sales for each product are to be calculated in advance.

The time period within which the components, raw materials will be available.

The method of inventory valuation should be selected with utmost care and must be followed consistently.

Just in time is the best policy but sometimes it is considered as bad decision because of urgent requirement of delivery. In rest cases it is best because it reduces the ordering and carrying cost and also stock defectiveness while handling it from one place to another.

ABS analysis is to be done i.e. all best controls is to be applied, the inventories which are of high value needs more care because mishandling will result into huge losses to organization. It does not mean low value inventory don't need any control. Control is required for each type of inventory but high value requires maximum care.

Working Capital can be improved by

Earning profits

Issuing preferred stock or common stock for cash

Selling long term assets for cash

Replacing short term debt with long term debt

Settling short term debts for less than stated amount

Collecting more of the accounts receivables than was anticipated and then reducing the balance required in the current asset account Allowance for Doubtful Accounts.

Increase in net profit by reduction in expenses and increasing sales

By Reducing costly products and services, which customers resist investing into.

By improving the relationship with customers

By managing inventory properly.

Conclusion

Working Capital is considered as the blood of the organization because efficiency of its operations is dependent on it. Working Capital is required for day to day operations of the business and thus it shall be effectively managed. Any mismanagement of working capital will lead to the inefficiency in operations and huge losses for the company. Thus, effective plans for the management of working capital shall be formulated for the business after consulting with top management and finance experts.