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Why does budgeting so important for an organization. It is a planning and controlling means for an organisation. This tool works successfully only when it is implemented with due concern. The budget is not only a cost supervision method but also an integral part in terms of planning and control parts of an organisation. It always aims to achieve organizational goals and also motivates the human resources concerned. The way of gathering required information and then selecting an appropriate budgetary system is essential for the success of budgetary system.
The effective budgetary approach is one that a situation where the individual objectives & goals match the organizational objectives & goals. It is called goal congruence. To ensure goal congruence it is a prerequisite to ensure massive participation of supervisory level in the management process.
There are different types of budgets to cope with different practices. An organization may use a conventional budgetary system and may sometime need to switch over to another budgetary system to meet its requirements. It is not a simple task to invite change in a budget system. An organization has to face certain complexities in the form of impediments to change by the employee of the organization, changes necessary in the current support system due to change in its budgetary system.
The level of accuracy in estimating the revenues & costs in the budget period is immensely important for a successful budget. There are a number of statistical techniques which may be suitable in forecasting the future figures to be accommodated in budgets.
The principle of budgeting is to give management an idea of how a company is meeting their goals, whether or not the expenses are in line with budgeted levels, and how well controls are functioning. Suitably used, budgeting can and should increase incomes, reduce unnecessary expenditure, and plainly defines how instant steps can be taken to make bigger markets (Thomsett, 1988, p. 5). In order to attain this, management needs to construct a budgeting system, the major objectives of which are to (Viscione, 1984, p. 42):
Set acceptable targets for revenues and expenses.
Increase the probability that targets will be reached.
Provide time and opportunity to formulate and evaluate options should obstacles arise.
As budgeting process is very intricate, it comes as no astonishment that budgets are trying to fulfil several functions such as (Harper, 1995, p. 321, and Churchill, 1984, p. 162): Planning, Controlling, Co-ordinating, Instructing, Authorizing, Motivating, Performance measuring, Decision Making, Delegating, Educating, Better Management of Subordinates etc.
In the purview of this report I would like to discuss two different approaches of budgeting i.e. (i) Traditional Budgeting & (ii) Rolling Budgets & forecasts
In the traditional approach to budgeting and budgeting controls the system of developing a plan against the factors which may influence the budget of the next year. There are so many organizations that use traditional budgeting, which give them an idea to forecast for the coming year and do not require changing durinthe budget cyclele. Companies treat traditional budgeting suitable with simpler coordination of budget assumptions for different divisions. Nevertheless with the passage of time and changes happening in the business, companies raise complain that the traditional budgeting is not suiting with their requirements. The major criticism on traditional budgeting is due to:
Unsuitable measure they are either very simple or very complex
Not flexible with changing business situations
The budget is incorrectly timed either too short or too long
It is considered very political
Rolling Budgets and forecasts:
A rolling/continuous budget is such a plan that is continually updated & the time frame remains constant while the actual period covered by the budget adjusted. Practically, as each month passes, the one year continuous budget is expanded by one month, so there is always a one-year budget in place. In the rolling budget, managers have to re-think the process and make modifications each month. The outcome of this is usually a more correct, up-to-date budget accommodating the most recent information (Horngren, Foster,Datar, 2000, p. 182).
Encourages managers to think & re-think regarding planning as an ongoing process, it is not a static event.
An opportunity to give more "real time" response to quickly changing business situation.
In theory, the yearly planning process is eradicated; the projection for next year is the first rolling prediction.
Planning is not stated by the calendar, but can be generated by significant events and changes.
As rolling budgets are equipped with the near experience by taking into consideration the current period, they are rationalized with the recent changes. Rolling budgets are continually updated with the current events, this facilitates in minimizing the running variances. Rolling budgets are the most appropriate form of budget for organizations which are working in a tentative atmosphere, where future events cannot be predicted dependably.
Based on the discussion stated above it would be easy to recommend the most suitable budgetary approach under the following two scenarios.
Scenario-1: One of the businesses operates in a very stable and static market place, where there is little change in either products or demand year on year.
In this scenario we can easily predict about future business situation. Upon historical record we can incorporate necessary changes in the budgetary process. As the market scenario does not change frequently there is no necessity to incorporate rapid changes in the budgetary system.
As per above assumption we can advise the organization to follow the traditional approach to budgeting & budgetary control.
Scenario-2: One of the businesses operates in a very dynamic, rapidly changing, innovative environment, where there is rapid change in either products or demand year on year.
In this scenario we cannot easily predict about future business situation. Upon historical record we cannot incorporate necessary changes in the budgetary process. As the market scenario changes frequently there is a necessity to incorporate rapid changes in the budgetary system. To do so, the managers of the organization need to think & re-think regarding planning as an ongoing process & also need to respond quickly as changes business situation. So, the yearly planning process is eradicated. The projection for the next year is the first rolling prediction. Rolling budgets and forecasts need to be furnished every month or every quarter, instead of yearly as before, which amplified work and costs linked to budgeting.
As per above assumption we can advise the organization to follow the rolling budget & forecasts approach to budgeting & budgetary control. Through the planning process under this approach is time consuming, rolling budget must be suitable for such type of businesses.
There are many criticisms have come from experts. Budgeting theory has been very effective in analytical problems and providing adequate solutions linked to budgeting systems. Sometimes, the outcomes of budgeting analysis have been conflicting and unclear, but in general maximum recommendations have been incorporated & verified in real scenarios. What I personally have observed very few companies even today use a flexible budgetary system and make a clear difference between controllable & non-controllable expense when evaluating their executives or managers.
It can be freely mentioned that traditional budgeting is still not dead or totally obsolete as it is still has been used in the majority companies all over the world. Nevertheless, most of them are likely to realize that exactly the same budgeting model cannot be used in the 21st century. Business environment scenarios are no longer sane and budgeting systems must become more responsive to the exact need of consumers & requirements arise from the competition.
Answer to the Question no. 02
Here XYZ Limited is a medium sized manufacturing company which manufacture & sells its products to different industrial customers who use its products in their own production line. The typical working capital of a manufacturing company includes its cash, account receivables, three level stocks as raw material, work-in-progress & finished goods and account payables. Now I am advised to report on how each part of the working capital cycle could be improved and how it will critically evaluate the implications of the developments on XYZ and other dependent customers. To do so, I would like to discuss all the particulars of working capital cycles of a manufacturing company.
The working capital cycle means how efficient a company is at converting cash into products and back into cash again. We can say a company with a very efficient capital cycle confirms the competitive advantage over a company with an abysmal working capital cycle.
To give a better picture of working capital cycle let us suppose a company has a huge cash capital and it spends the cash to purchase raw materials. Then the finished food has been sold. As we are living in a credit world so we have not received cash instantly. So, monies can be overdue to buyers & sellers as trade receivables & trade payables respectively. So the working capital cycle requires combining the period of the inventory or sales level as well as cash recovery from customers.
Critical tools of working capital cycle:
Working Capital Cycle = INVDOH+ ARDOH - APDOH
INVDOH= Inventory Days on Hand= (Inventory/COGS)*365; This ratio measures how many days inventory of a company remains on hand. The lower number of days inventory shows a company possesses strong sales or the need to increase inventory levels. In contrary to this the higher number of days inventory shows the company possesses a low sales position.
ARDOH= Account Receivables Days on Hand = (Account Receivables/Credit Sales) *365; This ratio measures the number of days it takes to receive payments from customers. The lower number days receivables show a company is managing its receivables efficiently.
APDOH= Account Payables Days on Hand = (Account Payables/COGS) *365; This ratio measures the number of days it takes to pay its suppliers or vendors. The number of days to pay varies by organization and by industry. Each and every company wants to have suitable payment terms to ensure liquidity at an optimum level but does not want to incur overdue bills and fees.
The Factors Affecting the Working Capital Requirements of an Organization:
1) Character or nature of Business: The working capital requirement is related to the nature and size of the business. In organizations where the cost of raw materials will be used in the manufacturing of a product is huge in percentage of its total cost of manufacture. In this context the working capital requirements will be large. Contrary to this organization having huge investments in fixed asset need lesser amount of working capital.
2) Volume or Size of Business & range of Operations: The requirements of working capital of an organization are directly influenced by the volume of its business which may be shown in terms of a range of operations. The greater the size of a business concern, generally higher will be the requirements of working capital.
3) Policy of Production: A concern marked by pronouncing cyclicality in its sale may pursue a production policy that may reduce the variations in requirements of working capital. For example an Air conditioner manufacturer may maintain stable production throughout the year rather than strengthening the production activity at the time of the peak business season. Such decision may reduce the fluctuations in the requirements of working capital.
4) Manufacturing Process: In a manufacturing business, the working capital requirements increase in proportion to the length of the manufacturing process. The longer the process time of manufacturing, the larger is the requirement of working capital.
5) Variations in Supply: In the seasonal industries the raw materials are not available throughout the year. Those industries had to buy raw materials in bulk at the time of pick season to make sure an uninterrupted flow and production process than during the entire year.
6) Credit Availability: If any firm awarded credit on flexible terms it will require less working capital as it can always pay to creditors later and vice-versa
7) Inventory: In the business like sugar industry, one requires to store a huge amount of raw materials and finished products because of its sensuality. The businesses are not able to sell whole finished goods, and so more working capital to be required.
8) Working Capital Cycle: In a manufacturing company, the working capital cycle begins with the purchase of raw material and stops with the realization of cash from the sales proceeds. The working capital requirements determine how quickly the working capital cycle completes one cycle i.e., longer the period of the working capital cycle greater is the requirements of working capital.
9) Stock Turnover rate: The amount of working capital and the speed with which sales are performed is inversely related. A firm having a higher rate of inventory turnover will require lower amounts of working capital comparing to a firm having a lower rate of turnover.
10) Business growth rate: The requirements of working capital of a company increase with the growth and development of its business activities.
How working capital cycle affects an organization:
Now I will try to make understand how working capital requirement varies with changes of different particulars of balance sheet & income statements.
Let us consider the following information collected from three Years financial statements of XYZ Limited.
Land & Building
Machinery & Eqp.
Due from Officers
Current Portion of LTD
Long Term Liabilities
Long Term Debt
Deferred Income Tax
Total Long Term Liabilities
Total Stockholders' Equity
Total liabilities & Net Worth
Moving & Other Expenses
Total Operating Expenses
Net Operation Profit
Income Tax Expenses (Credit)
From the information mentioned above we can calculate the following ratios:
Working Capital Cycle
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Comments: If we analyze the above outcomes we will see that the working capital requirement in 2010 was US$3853 and working capital cycle was 172 days. But in 2011 the concern made huge development in working capital cycle i.e. it reduced ARDOH for 23 days, INVDOH for 39 days and increased APDOH for 17 days and as such it reduced its working capital cycle for 79 days and this development directly reduced its working capital requirements i.e US$2658 in 2011. Again it fails to maintain working capital cycle that level in 2012 and so its working capital requirements also increased up to US$3865.