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A budget is an integral part of a business that employs systematic analysis and interpretation of financial forecasts in terms of products, markets and application of resources. As per The Chartered Institute of Management Accountants of England and Wales, a budget is a financial and/or quantitative statement created prior to the period when it would be implemented, for the purpose of attaining a given objective. It may include income, expenditure and employment of capital (Warren, Reeve and Duchac, 2011).
A budget is prepared in advance, generally for a year, and is set up by taking into consideration the past experiences and simultaneously, the macro & micro economic factors which might change in due course of time. The management of any company strives to maintain the actual functioning of a company in line with the estimated budget.
The Chartered Institute of Management Accountants of England and Wales has defined the term budgetary control as the designing of budget documents related to the responsibilities of policy executives, along with a constant tallying of the actual results with the budgeted ones, for either living up to the policy objectives or for creating a platform for adopting corrective measures.
It involves preparation of budgets, continuous comparison of actual expenses with the budgets for achievement of targets and revision of budgets in case of changed macro and micro factors (Mowen, Hansen and Heitger, 2011).
Budgetary Control and Responsibility Centres
A responsibility centre is defined as a functional unit of a business headed by a manager and is responsible for all its activities and performances.
Types of responsibility centres:
Investment Centres (Needles, Powers and Crosson, 2010)
The Traditional Approach to Budgeting and Budgetary Control
It uses the incremental approach i.e. it designs the current year's budget keeping in mind the one from the previous years and increases the expenses as per assumptions made in the new financial year.
It involves the approval of budget before the commencement of the new financial year.
With the commencement of the new budget, comparison reports with the actual performances are taken into account and action is taken up to nullify anomalies
The traditional budget involves the expenses and incomes, after subtracting the expenses from the incomes the spending levels are adjusted and are followed for the rest of the year.
The traditional model is a lengthy and time consuming process.
It focuses on what managers tend to spend rather than what they actually require to fulfil their needs (Macintosh and Quattrone, 2010).
The external environment of Business A is a placid and stable in nature, with very little changes in either products or demands year over year.
Traditional Approach for Business A
Since business A is working in a very stable and static market place, the budget can easily be made via keeping last year's budget in mind and adding up a little for deviations due to macroeconomic changes. Therefore, despite the small quantum of disadvantages that it might usher in, the Traditional approach would be the best suited for firm A.
Benefits of Traditional Approach on Business A
A traditional budget is kind of a static budget and would be suited for Business A since it works in what could be easily stated to be a static environment.
No specific projections need to be made. For instance, a department of Business A had spent $10,000 in 2012 and it projected to the management that it requires a 4% approx. increase in its budget.
The traditional budget involves both expenses and incomes. After subtracting the expenses from the incomes the spending levels are adjusted and are followed for the rest of the year (Lee, 2012).
Disadvantages of traditional Approach for Business A
It provides equal space to all its constituents no matter how important or un-influence able they are.
It focuses on what managers tend to spend rather than what they actually require to fulfil their needs. It also lacks flexibility.
The traditional approach is authoritative in nature and in grounded with command and control. It communicates that only the top management is the most competent to translate the firms objectives into goals, plans whereas the employees do not have that skill set.
Business B operates in a very dynamic, rapidly changing & innovative environment and hence, the traditional approach would not be suitable for its business success.
Disadvantages of Traditional Approach for Business B
The traditional approach is based on past experiences which is not suitable for Business B which operates in a dynamic and a rapidly changing environment. It does not take into consideration the macro and micro economic factors like changes in taxation, inflation, etc.
The goals are set up by top executives and may be unrealistic in nature. For instance, a company might set up a goal for increasing the revenues by 10 percent or reducing the costs by 7 percent. But, in order to achieve this target the top management has to take recommendations from the line managers who actually have the responsibility of achieving those targets (Hansen, Mowen and Guan, 2009).
The traditional approach uses the inputs only from the top management and the employees ranking below the managerial level are not incorporated into the process. These left-out employees often have the insider information towards many vital aspects of the business. For instance the sales people might have the direct access to the market movements and may have ideas about the trends of the market. But, since their opinions are not included in the traditional approach, the company gets deprived of their valuable inputs.
It is a very political kind of approach because it provides equal importance to all its constituents irrespective of the extent to which they influence the business
Accurate Estimates are not possible
Business B operates in an ever-changing business environment where the macro and micro economic factors change significantly with time, year over year, hence the fixed or the traditional approach cannot be a very successful budgeting technique.
Keeping all the dynamically changing factors like inflation, taxation, changes in regulatory norms & demand of the products, market trends etc. a Flexible Approach to budgetary control is recommended for Business B.
A flexible Budget is also called the Variable or Sliding Scale Budget. For planning, it takes into account both the fixed and variable factors into account and changes along with the variations in the level of activity (Abdel-Kader, 2011).
Advantages of using a flexible budget for Business B
Flexible budgets cover all aspects of the business and the changing micro and macro economic factors.
Involves each level of management for planning and implementation.
It helps in analysing the matters of all the organizational departments.
Aids in Optimum allocation of resources at all levels.
It changes with the volume of activity.
Costs are classified as per their needs and the nature of variability.
It motivates managers to find better and cost effectives methods.
It improves staff motivation because it provides more initiative and responsibility across all departments irrespective of their hierarchy in the management.
It prevents incremental budgeting which is simply based on previous year's figures.
It promotes co-ordination.
Set standards for performance (Warren, Reeve and Duchac, 2011).
Traditional Budget v/s Flexible Budget
A tool only used by the top management.
A tool that involves all members of the organisation irrespective of their position in the hierarchy.
Based on previous years.
Designed as per the needs.
Does not take into account the changing macro and micro economics factors.
Is based on the changing environment, macro and micro economic factors like inflation, taxation etc.
Does not pay importance to research and development.
Bestows required monetary allocations towards research and development.
Focuses on an authoritative approach i.e. Command and Control.
It focuses on Empowerment of all the organisational employees.
Political in nature.
Non-Political in nature.
Limited application for cost control.
Tool for cost control and its effective implementation
It does not change with the volume of activity.
It is re-moulded with changes in the volume of activity.
Rigid in nature.
Flexible in nature.
Costs are not differentiated as per their variability like fixed, variable and semi variable.
Costs are differentiated and classified as per their variabilities.
Keeping all the factors in mind, it can be stated that flexible budgeting would be better suited towards ushering in success for Business B.
Some Issues with budgeting
They act as pressure devices by the management on the staff.
They might spoil labour relations.
There might be departmental conflicts due to disputes over allocation of resources to different departments.
The employees may blame the management in case of non-fulfilment of their targets due to improper allocation of budgets.
Lengthy and Time taking procedure.
Involves a lot of time, resources at various levels.
It may sometimes result in overspending by the departments (Walker, 2009).
Q2. Improving Working Capital Cycle for XYZ Limited
Working Capital management is the fine technique of maintaining the Current Assets and the Current Liabilities of a business with utmost efficiency.
Capital management aims at ensuring that a business has sufficient cash in order to maintain its short term expenses and also, the expenses involved with production, overheads etc.
An efficient working capital management aids a business towards enhancing its profit levels (Bragg, 2008).
The key aspects of working capital for XYZ Limited are:
Inventories of Raw Materials
Work in Progress
Finished Goods &
WORKING CAPITAL CYCLE OF XYZ LTD
RAW MATERIALS, LABOUR & OVERHEADS
Source: Macintosh and Quattrone, 2010, p. 57
Working Capital = Current Assets - Current Liabilities
The following is the formula for calculating the operating cycle for XYZ Ltd.
Operating Cycle = Inventory Conversion Period + Account Receivable Period
Inventory Conversion Period = (Average Inventory)/ (Cost of goods sold/365)
Account Receivable Period = (Average Account Receivable)/ (Sales/365) (Bhimani and Bromwich, 2009)
The study, in its course, will try to recommend how each of the constituting attributes of working capital can be alleviated and in turn, the ways in which these improvements would positively affect XYZ Ltd. and its related parties.
Cash represents one of the most vitally essential parts of the working capital cycle. Cash Management involves the collection from customers and payment of cash to suppliers.
Cash management for XYZ Ltd can be improved in the following ways:
Adequate cash should be allocated to all the units of the firm like wages, trade debts, taxes, and dividends.
Any idle cash should be invested in short term money market instruments like liquid funds, short term deposits in banks and other financial institutions, shares of blue chips companies etc. which can be liquidated with the arising of any sudden requirement. It would improve the overall profitability of the firm (Needles, Powers, and Crosson, 2010).
For the purpose of improving inflows from debtors, they can be provided with a cash discount or an allowance. The cash discount might reduce the profitability of the firm but simultaneously, it would also reduce the interest costs along with improving the whole working capital cycle.
The cash received by giving a discount to the debtors can also be used to take additional discounts from the suppliers to amplify the firm's profitability.
The firm should maintain a good relationship with the bankers. This would help in fetching short term financing and achieving advantageous interest rates (Steffan, 2008).
If the company is involved in International Trade i.e. Import & Export, a Currency Manager should be appointed, who would be bestowed with the duty of managing the company's foreign exchange transactions and Hedging for Forex risk.
Implications of the improvements
With the availability of adequate cash, XYZ Ltd. would be able to make timely payments to its labours, satisfying them and thus, getting them to be more dedicated towards their work. All the taxes like sales tax, VAT, Income tax etc will also be paid on time. Salaries to the management and other personnel would be made on time, as a result motivating them to work more efficiently. This would bring about a boost in the confidence and motivation of the organizational stakeholders, hiking the credibility of XYZ Ltd (Abdel-Kader, 2011).
Adequate cash would allow XYZ Ltd. to make timely payments of dividends, keeping the shareholders happy and increasing their faith in the company. Resultantly, XYZ would attract a higher quantum of investment.
The excess cash taken out of the working capital cycle can be invested in short term investments that would yield interests, dividends etc in order to increase the profitability of XYZ Ltd.
Cash would increase the bargaining power of XYZ Ltd when negotiating with their suppliers and cash payments would help in procuring raw materials at cheaper rates. Cash purchases would also increase the market-credibility of the firm.
The negative impact of the above strategy can be the reduction in sales due to an emphasis on cash sales. Cash discount given to debtors for early recovery of receivables might also result in decreased profitability of the firm (Mowen, Hansen and Heitger, 2011).
Trade receivables are another important aspect of the working capital cycle and the entire business, too.
The following techniques can be used to improve the trade receivables for XYZ Ltd.
Providing a cash discount to the debtors for realization of fast cash. This cash can be employed towards various uses like availing cash discounts from suppliers, or can be invested for getting returns, thus increasing the profitability of the firm (Adler, 2013).
The cash discount policy should be strict and clearly communicated to the debtors.
The finance manager should determine that what are the risks associated with each of the debtors.
The company should have a strict credit policy in order to reduce interest costs, defaults or bad debts, involved with administrative and collection costs.
A strict credit policy would result in reduction of sales. Nonetheless, an optimum balance between the two should be maintained in order to run a successful business.
The amount of business given by a customer and his credibility of timely payments in the past would be the determinant of the credit period allocated to a customer (Jiambalvo, 2009).
The trade receivables can also be financed by techniques like 'factoring', which involves a third party charging a small fee based on the value of the transaction and makes immediate payment to the firm and, in turn, collects the payment from the customer within the stipulated time. This helps in improving the working capital cycle and creates a win-win situation for all.
Implications of the improvements
A stricter policy by XYZ Ltd would reduce the default risk. It might also reduce the sales to some extent but in turn it would lower the magnitude of bad debt and default risk and improve cash management which would increase the profitability of XYZ Ltd.
In order to recover money faster from debtors, the cash discount given by XYZ Ltd to its customers would reduce the acquisition costs of its customers and hence they would remain as long term stakeholders (Hansen, Mowen and Guan, 2009).
Inventories of raw materials
Inventory constitutes a major amount of working capital therefore the investment in inventory should be properly controlled.
For inventory management techniques like JIT (Just in Time) and EOQ (Economic Order Quantity) should be used.
If the raw materials required are very volatile in nature, in terms of cost, then the investment in inventory should be minimum or as per orders in hand. Otherwise, there might be losses due to the day to day fluctuating prices of the raw materials (Chapman, Hopwood and Shields, 2011).
Implications of the improvements
XYZ Ltd would be able to decide the optimum level of inventory ordering quantity by using the techniques of Economic Order Quantity and Just in Time. This would reduce the capital costs, inventory holding cost, inventory carrying cost and transportation costs and hence would increase the firm's the profitability (Schroeder, Clark and Cathey, 2011).
Work In Progress
The work in progress or the unfinished goods involve a lot of investment for any business.
The steps that can be taken to keep work in progress under control are:
Improving the overall efficiency and production in order to minimize the time taken to convert the raw material to finished goods.
Recruit efficient and highly skilled labour
Reduce the operating costs.
Use of better and new technology can reduce production time
Implications of the improvements
The changes would result in faster conversion of raw material to finished goods and hence, reducing the total working capital cycle for XYZ Ltd. The increased efficiency would reduce operating costs for XYZ and would increase profitability
The main aspect of a business is the finished good or the product which the business actually sells to make profit.
Optimum quantity of finished goods would help to maintain appropriate stock levels and this would serve the customers fairly.
Better inventory management would cut down costs (Bhimani and Bromwich, 2009).
Implications of the improvements
The new policy would help in faster realization of payments from customers by cash sales. The increased efficiency would reduce the work in progress time and would in turn increase the profitability for the firm. This increased efficiency would also ensure time deliveries to customers.
There is an old saying that the art of 'buying well' and 'selling well' are intermeshed. Managing trade payables or creditors is just as important as any other aspect of the working capital cycle.
The following costs are involved with credit:
A product bought on credit is always priced higher than on cash and yet sometimes it's very much necessary to buy on credit. An optimal balance needs to be struck between the two forms of buying.
Reduction of goodwill for the company in cases of delayed payments. So, accounting system should be updated immediately after buying on credit (Steffan, 2008).
Automated data entry systems should be used for controlling administrative costs arising due to management of creditors.
Sometimes suppliers insist that a particular quantity should be ordered even if it's not required by the customer thus increasing inventory costs. An increased bargaining power would help in preventing such cases from happening
Implications of the improvements
The new policy of cash purchases of XYZ Ltd will increase the bargaining power of the firm and it shall be able to take cash discounts from its suppliers and hence would increase the profitability of the firm. This would also increase the goodwill for XYZ Ltd. among the business fraternity and also banks and financial institutions. It would also increase the credibility of the firm and hence it will become easier for XYZ Ltd. to take loans for further business expansions. The cash discount availed by XYZ Ltd. on its purchases can be passed on to its customers in order to bring about faster realization of cash for improve the working capital cycle (Bragg, 2008).