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Simply budget is a systematic way for the utilization of material and human resources of an organization. Budgeting is a formal statement of the financial resources allocating for carrying out specific activities in a specific period of time. Budget evaluates from the entire value of an organization, and then it gets material in form of planning. Budget reflects the estimated overall future performance of an organization in a specific time period. So, a budget is a financial plan which extends forward for a period into the future. It is prepared in advance and is derived from the long term strategy of the organization.
The purpose of budgeting is to serve the needs of management in respect ofthe judgments and decisions it is required to make and to provide a basis for themanagement functions of planning and control (weetman, 2010).
Budget paves the way of mangers to make future decisions and drive the business to its desired destination. Budget helps managers in following ways:
It is a way of communication with all the business unit of an organization.
Its brings about improvement and efficiency of the business activity.
It serves as a benchmark of total controlling system.
It functions as a way for evaluating the performance of employees.
It helps mangers to co-ordinate the activity among the working groups and motivating them.
It can reduce wastage and bring cost efficiency.
What is budgetary control?
Budgetary control is strategic tools by which actual results are compared with budgets or pre settled standard and any if differences are identified the responsibility of managers to take necessary action in performance and if the performance is reasonable but standard is faulty then revise the original budgets. So, budgetary control is the use of this comprehensive system of budgeting to help management in carrying out its managerial functions as planning, coordination and control. Budgetary control enables mangers to monitor organizational function.
This system involves:
Division of business units into different sections known as a budget center.
Preparation of separate budgets for each "budget centre".
Co-ordination of all functional budgets presenting overall organizational objectives of the forthcoming budget period.
Comparison of real or actual performance against budgets.
Reporting any difference of actual performance with standard to provide basis for future course of action.
Budgeting in static business
The static businesses operate in a very stable and static market place, where there is little change in either products or demand year on year. In traditional market where demand is static, Organizations usually follow traditional budgeting system. It is prepared by reviewing previous year's actual expenditure and allocation of assets and addition or deduction towards extra business activities and investing activities or reduced business activities planned and also by effecting changes towards changing factors, such as inflation, growth etc if needed. It is basically a system to tie managers to predetermined actions in order to achieve the planned budget. It is usually based on organizational hierarchy and centralized leadership.
Example of static business can be small and medium business or industries of necessity products which demand is static. So producers enjoy the facility of non elastic price of their markets products. They need to give little attention towards research and development area of that product or features. Rather they are more concentrated on cost minimization that gives them a strategic position in the market. Therefore, these types of organizations are trended to adopt traditional approach to budgeting and budgetary control.
Benefits of the traditional budgetary system to static business are:
It is comparable as income of budget year can be matched against budget years expenses to know whether operations will result in profit and how much profit.
It assures business a consistent rate of profit so managers can be assured of budgeting in development area.
Actual performance can be compared with budgeted standard to know variances so that corrective actions can be taken promptly.
Budget based reports facilitate assessment of costs of products or service provided and accomplishments of the business entity.
This system has some demerits too. This budgetary process is cost inefficient. It takes a long time to complete planning and by the time of its completion, it becomes no longer applicable as meanwhile business environment has changed. Moreover it lacks the opportunity to innovate. It fails to motivate employees who want change and who want to take risk. So it hinders the rapid development of a business organization. But, the market is very much matured now a day. If a firm wants to survive it must compete and retain certain portion of the market share. So it is recommendable to the static business to adopt alternative budgeting policy to gain the maximum profit from market. Such a policy is Zero-Based Budgeting (ZBB). ZBB comes as a proposals by Pyhrr (1973) and Cheek (1977) to modify the traditional budgeting process in business organizations in which budgeting is an incremental or revision process in relation to the prior year's actual expenditures. The zero base budgeting is not based on the revision or incremental approach and previous figures are not adopted as the base.
An important characteristic of ZBB is that it tries to help business to answer the question, "If we are starting our business from zero, on what activities would we allocate our money and to what activities would we give prime priority?" It involves clarifying the goals of an organizational unit and identifying the important functions and projects it intends to perform in order to achieve best result. These planed activities are then ranked in order of importance. Basically it is a systematic and logical approach to allocate limited resources where the recourses will be best in use. Benefits of this budgeting system are cost efficiency, improved quality, and increase self-reliant in fabricating budget and make budget discussions more effective and easy to compare during review sessions (LaFaive, 2003).
The obvious problem of this zero-base budgeting process is the huge amount of managerial time needed to execute the plan but if it can be used effectively it can accelerate growth of the firm.
Budgeting in Dynamic Business
Business operates in a very rapidly changing, dynamic and innovative environment, traditional budgeting is inappropriate to exercise. Budget becomes a barrier for the business because the ever changing market, demands flexibility, fast response of rival parties, innovation in every section of business unit, process improvement, increasing customer focus, and shareholder value. It is the limitation of the traditional budgeting not to be able to fulfill these demands. The dynamic driven business firm should cope up with those change and adaptive to recent development to achieve success.
In this situation, Beyond Budgeting approach introduced. Daum (2001) argued that, "The Beyond Budgeting Model ( BBM) is designed to overcome barriers of traditional budgeting and to create a change responsive and adaptable organization that gives managers self-confidence and freedom to think differently, make decisions rapidly and collaborate on innovative projects with piers in multifunctional teams both within the company and across its borders.
This system is about a performance apprisal management system which includes a series of interdependent and consecutive process (Verlag, 2005). The rational is to create an adaptive system to the competitive world that successfully develops the business plan from the environment and instead of trying to meet a desired number in the budget, management should try to beat the performance standard (Verlag, 2005).
The process of Beyond budgeting(BB) is consist of 12 principles (BBRT, 2005). The first six 'process' principles is related with performance management systems that allows employees to response faster to customer needs and competitive environment and the second six 'leadership' principles provide a decentralization framework of responsibility to employees to facilitate business to adapt with potential events and improves their relative performance more quickly. Beyond budgeting can be exercised successfully by applying these principles and the business can be adaptive to the rapidly changing environment. Beyond budgeting framework consisting 12 `principles.
Principles of Beyond Budgeting Process
Principles concerning performance management:
1. Targets Set: Challenging and inspirational goals. Employees feel motivated and valued.
2. Rewards Base: Rewards on relative performance rather ten meeting fixed targets. Employees compete for best and their attempt can be attached to the objective of the organization.
3. Planning: Planning is continuous process not a yearly event. Plan can be changed in course of any need.
4. Resources: Make resources available on demand rather annual budget allocations. Resources can be used to capture market's best return in niche.
5. Coordination: Coordinate among business units dynamically not though annual plans and budgets.
6. Controls: Base controls on business trends and relative indicators not variances against plan
Principles concerning leadership:
1. Governance locus: Governance on clear values and opportunities not on rigid rules and budgets.
2. Performance Build: High performance culture based on relative success rather then meeting targets.
3. Delegation of authority: Freedom to act and delegating decision making authority to frontline teams those results in specialization.
4. Accountability: Creating such a network of small units where members are accountable for results to working team not to centralized hierarchies.
5. Customer focus: Everyone focus on value creation and improving customer relation not on meeting internal targets.
6. Open communication network: Information is open to all and shared in high extend. Don't restrict it to only those who 'need to know'.
The benefits of beyond budgeting are, BB will inspect targets, operational strategies, action plans, forecasting and management reports. It is also easy to compare with rivals and past-year performance. It emphasizes on the important features of business activity. The purpose is to be responsive and take advantage of new opportunities and respond to potential threats by using an advanced information system to make decisions early and be a pioneer. Thus, speed of action and good decisions are the result of beyond budgeting (Hope & Fraser, 1999).
The main problem of beyond budgeting is that it can raise some resistance to change (Verlag, 2005). Organizations can be different in scale, custom and business context. It would be tough to demonstrate to key influencer that control can still be achieved without a budget (Max, 2005). Beyond budgeting may raise issues such as possibility of loosening control, delegation of decision making authority to bottom line managers and believing employees to act in the best interest of the business that is really challenging to contemplate. However if these problem can be solved, firm may gain success in long term and gain economic interest of innovation.
Though beyond budgeting (BB) is the most updated and sophisticated method, all firmss cannot adapt it. Thus the other alternative for the dynamic driven business is Activity-Based Budgeting (ABB). It aims to generate a budget from activities and resources of the business firm.
Benefits of ABB approach
It facilitates improved product, cost designing and decision making. ABB approach also assures better resource allocation to support organizational goal achievement. In this system management identifies the core capacity issues of the firm and adjusts them earlier in budgeting process. It is a modified system of traditional and Beyond budgeting system. It promotes managers ability to respond to changing situation and also improves performance measurement, performance appraisal and decision making.
ABB can be an appropriate alternative for the firms operated in dynamic environment as it will supply more exact analysis to forecast quickly and helps to generate the next budget.
Anyway, ABB is not without problems. As per Barret (2003), it is not easy to understand about the rules relating outcomes to resources and related costs.
In time of controlling and decision making one of these alternatives, beyond budgeting or ABB, management must be considered current business position and market niche prudently . Managers must make tradeoff between those budgetary control systems.
In a highly competitive market demand is fluctuate regularly. So to survive in market business must be responsive towards the changing pattern of technology. In the era of "Cutting edged" technology business cannot survive maintaining traditional budgetary control system as it hinders innovation. Market leaders of this day believe a business can thrive only when innovation occurs from the root level of the firm. So if you can not differentiate your product competitors will certainly grebe your market share. In conclusion it can be said business operating in dynamic market need alternative budgeting control system but business in static market can also search for differentiation to thrive.
Improvement of working Capital Cycle of XYZ ltd
XYZ Limited is a medium sized manufacturing business which makes and sells products to a range of industrial customers who use XYZ's products in their own products. So this firm operates its business activity in Business market. These types of firm need to manage it working capital cycle efficiently.
Working capital typically means the firm's holding of current or short-term assets such as cash, receivables, inventory and raw materials. In other word, Working capital is the cash needed to pay for the day to day operations of any business. Working capital is needed to pay suppliers, pay employees, allow customers to buy in credit. So working capital management decision is considered to be one of the most important considerations in whole financial framework. On the other hand working capital refers to the fund held in current asset or the portion of current assets which is not funded by current liabilities.
The goal of working capital management is to manage the firm's current assets and liabilities in such a way that a favorable ratio of working capital is maintained to fulfill the organizational objectives. The interaction between current assets and current liabilities is the main theme of the theory of working capital management. So, Working capital is the amount of long-term finance the business has to provide in order to keep current assets working for the business (Weetman, 2010).
Working capital cycle
The working capital cycle of a business is the sequence of transactions and events, involving current assets and current liabilities, through which the business makes a profit (Weetman, 2010).
Working capital cycle in the manufacturing firm consists of the following events, which continues throughout the life of business. Conversion of cash into raw materials Conversion of raw materials into work in progress Conversion of working progress into finished goods Conversion of finished goods into accounts receivable through sales and Conversion of account receivable into cash (OR finished good into cash in the case cash sales)
The whole process is shown in chart:
Inventories and raw materials
Acquire inventories and raw me retrials for further production.
Conversion of raw materials and work in progress into finished goods.
Purchase raw materials in cash
Pay suppliers who have allowed time to pay
Collection of cash
Sell goods to customers in credit or cash.
Figure: the working capital cycle of XYZ ltd.
Improvement of working capital cycle
Every part of the working capital cycle can improve the overall business condition of XYZ ltd. Every part of the cycle is closely related. Simply, Working capital structure of that firm is
WC= Cash + Raw material or inventories + Work in progress + Finished goods + trade receivable-trade payables.
Cash or cash equivalent assists is the most important liquid resource of a firm. Mangers must try to maintain a reasonable portion of cash. Excessive cash can increase opportunity cost of the business as that amount could be invested and accelerate return on investment, thus it could strengthen the equity base of the firm. On the other hand low cash in hand can increase the threat of temporary insolvency which can threat the good will of the firm in market.
Raw materials and work in progress is unprocessed finished goods. Those inventories also acquired either by cash or trade finance. In both case it either decrease current assets or increase current liabilities. Experts suggest ordering raw materials in such a way that the firm can make the best use in terms of time and cost. Economic Order Quantity can be a tool to be efficient in that case.
Once finished good is produced, it is easy for a firm to convert it into cash and cash equivalent. As XYZ is a B2B producer and its main customers are industrial parties, the price of the product is les elastic. Producer and customers must be co-operative in business trisections. Usually in industrial market both producer and customers is highly dependent. So, XYZ has a favorable bargaining power among its customers. So trade receivables can be converted into cash easily but excessive pressure to customers can result industrial switching as customers may search for other options or substitute products.
On the other hand XYZ ltd. collects its raw materials from its suppliers. The firm pays back or purchase through cash. As in industrial marker XYZ usually has fewer suppliers. So the firm tries to maintain a goods relation with its supplier. Late payment can be resulted in high explicit and implicit cost that decreases its future possible earnings.
So, all the element of working capital cycle is closely interrelated. Managers must take decision in term of cost and benefits of each option. Firm can fulfill its working capital requirement by either loan financing or equity financing. Sometimes short term is more favorable for business like XYZ as raising fund from stock seems more costly for running day to day business activity. In this situation it is recommended that managers must determine the relative portion of fund to invest in working capital requirement(Kieso&Weygandt, 2012).