The budgeting process

Introduction

A budget is a financial document used to project future income and expenses. The budgeting process may be carried out by individuals or by companies to estimate whether the person/company can continue to operate with its projected income and expenses.

Given a company named Animated production Ltd which is owned by Allan Rock who produces a range of products. As a management consultant an advice should be given on how to organise an effective budgeting system to facilitate control over his company's activities. The company's current and future position is given for budget analysis. The products in the company are made in batches and are started at the beginning of the month and are completed and taken into finished goods in inventories at the end. The business has some changes in its volumes, sales prices and credit terms.

The current position of the company is, sales revenue is £0.3m a month and it contributes 40p per £1 of sales revenue. Variable raw material costs account for 20p per £1 of sales revenue which means 20% of the sales revenue which is 60000.Fixed costs is £120,000 a month of which £30000 is depreciation. Trade payables for raw materials are paid one month after the purchase. At the end of each month the business has sufficient raw material inventories to meet the following month's production and enough finished inventories to meet the next month's sales.

The possible future position of the company is production and sales volumes would be increased by 50% which means if n number of units is sold in previous year, 1.5n number of units will be sell in the future. The selling prices would be reduced by 10% and trade receivables would be allowed to pay 2 months after the sale. The contribution per £1 of sales revenue would fall to 30p. These changes would commence from 1 December this year. The business's balance at bank at 1 October is expected to be £70,000.According to the current and future position of the company a cash budget should be prepared for five months.

Background

“A Budget is a short-term business plan which is mainly expressed in financial terms” (Atrill and McLaney, 2008).
“A budget is a plan expressed in monetary terms covering a future time period which typically a year is broken down into months” (Collier, 2006).

Budgets are the short-term means of working towards the business objectives which are prepared for a one-year period. The process for preparing a monthly budget includes the monthly income, expenses which are fixed and variable and opening balance. Budgets are different to forecasts in the sense that they are based on the intention and they are defining the way to achieve predetermined business objectives. Budgets are of two types, one is periodic budget which is prepared once and then it is allowed to run its course and the other is continual or rolling budget which is continually updated every month.

Analysis

The cash budget for the months October, November, and December this year and January and February next year is
Oct Nov Dec Jan Feb
£000 £000 £000 £000 £000
Sales Revenue 300 300 300 0 405
Cost of Raw materials (60) (90) (90) (90) (90)
Fixed Costs (120) (193.5) (193.5) (193.5) (193.5)
Total Expenses 180 283.5 283.5 283.5 283.5
Profit for the month 120 16.5 16.5 -283.5 121.5
Opening Balance 70 190 206.5 223 -60.5
Closing Balance 190 206.5 223 -60.5 61

Role of Budgeting

Arnold & Turley (1996) suggest that the main objective of budgeting is to provide a quantitative, formal and authoritative statement of the organisation's plan which is expressed in money terms.

A budget is a plan of operations which identifies the resources that are needed to fulfil the goals and objectives of an organisation. Budget takes both financial and nonfinancial aspects into account. Budgeting is the process of preparing a plan, which is called a budget. Budgets are useful in motivating the managers in order to achieve their targets, budgeting is used for evaluating the managerial performance, helps in controlling the activities (Marginson & Ogden, 2005).

Budgets are generally useful in five areas. It can facilitate the process of Animated production Ltd's management control by:

• Budgets can identify the short- term problems and they tend to promote the forward thinking:

It means that budgets can easily identify the problems and if the problems are identified in the early stage the managers can find the best way of overcoming that. The best solution to a problem may be feasible only if action can be taken well in advance. In case of Animated production Ltd there is a problem with increase in the sales volume and decrease in the selling price. Although the sales volume is increased there is no increase in the profit because the selling price is reduced. So if the selling price is reduced more than 10%, in spite of getting profits the company might have some loss. In this way the short-term problems can be identified through budgets (Connelly & Tompkins, 2005).

• A budget helps in coordinating the different sections of the business:

In an organisation activities of one department are linked with the activities of other department. In this way activities of different departments are linked with sections of the business. The activities of purchasing department such as purchasing the raw materials should accord with production departments having the need for raw material. Otherwise large amounts of raw materials could be brought which leads to problems (Aziah & Scapens, 2007).

• Budgets can motivate the managers to perform better: A certain task can motivate the managers to perform better. Budgeting helps the mangers to go on with their regular activities and achieve the goals of the organisation. In case of Animated production Ltd budgets helps to recognise that increase in volume of sales of 50% with decrease in selling price of 10% does not gain more profits. It helps the managers to work on that and reduce the selling price less than 10% so that profits can be gained.

• Budgets provide a basis for control:

Budgets provide a basis to put the plans into action. The managers can spend their time in checking out why they have failed to achieve the budget or reach their expectations. In case of Animated production Ltd by giving the credit period of two months i.e. the trade receivables would be allowed to pay two months after the sale, sales revenue in the month of January became zero. So there wouldn't be a net profit for that month and in the next month for the purchase of raw materials owner should have money from his pocket. So it would be better if the credit period wouldn't be more than 2 years. In this way managers can asses themselves by checking out how well they have performed and take actions to correct themselves (Kim, 2006).

• Budgets provide a system of authorisation for managers.

All the five uses of the budget can conflict with one another. A budget is used as a system of authorisation where managers may spend to the limit of their budget. This occurs when the managers are not allowed to carry the unused funds to the next budget where the managers believe that if previous funds are used the budget for the next period will be decreased as all the funds for the present year are not spent.

Conclusion

In the business cash is an important asset and it is essential to assure that it is managed properly. Cash budgets are useful for decision making purposes. It enables the managers to see the effect on the cash balance. Failures in setting the budget will have bad consequences for the business. If the cash budget signifies the surplus balance, managers should decide whether that balance can be reinvested in the business or not. If the cash budget signifies a deficit balance, managers should decide how the deficit should be financed or how the deficit should be averted. Cash budget plays a vital role in the success of an organisation. In case of Animated production Ltd if the cash budget is properly maintained with a surplus balance it would lead good profits for the organisation.

References

Arnold, J. & Turley, S. (1996) Accounting for Management Decisions. 3rd edn. Hemel Hempstead: Prentice Hall.

Atrill, P. & McLaney, E. (2008) Accounting and Finance for Non-Specialists. 3rd edn. London: Prentice Hall Financial Times.

Aziah, A.K. & Scapens, R.W. (2007) ‘Corporatisation and accounting change: The role of accounting and accountants in a Malaysian public utility'. Management Accounting Research. 18(2) pp. 209-247.

Collier, P. M. (2006) Accounting for Managers. 2nd edn. Great Britain.

Connelly, M. & Tompkins, G.L. (2005) ‘Does Performance Matter? A Study of State Budgeting'. Review of Policy Research. 8(2) pp. 288-299.

Kim, D. (2006) ‘Capital budgeting for new projects: On the role of auditing in information acquisition'. Journal of Accounting and Economics. 41(3) pp. 257-270.

Marginson, D. & Ogden, S. (2005) ‘Managers, budgets and organisational change: unbundling some of the paradoxes'. Journal of Accounting & Organizational Change. 1(1) pp. 45-61.

Appendix

For the month of October

Sales revenue is £0.3 million a month which means sales revenue is £300,000.Fixed costs are £120,000 a month. Variable raw material costs accounts for 20p per £1 of sales revenue. So the cost of raw materials is 60000
Total expenses in the month October is cost of raw materials plus fixed costs
Total Expenses= Cost of raw materials+ Fixed costs
=60+120
= 180.
Profit for the month October is Sales revenue minus total expenses
Profit for the month= Sales Revenue- Total expenses.
= 300-180
=120(which is 40p per £1 of sales revenue).
The business's balance at bank at 1 October is expected to be £70,000.
Opening Balance is £70,000
Closing balance of the month is profit for the month plus opening balance
Closing balance= 120+70
= 190,000£

For the month of November

Sales revenue is 300

Cost of raw materials will be 90 because if the cost of raw materials would be 60 and if cost per product is constant even after increase of sales volume, then 50% increase in sales volume would increase the cost of raw materials to 50% which would be 90.

Cost of raw materials is 90

Fixed costs are 193.5 because if the sales volume and production rate will be increased by 50% in December, other expenses will also be increased. It is given that at the end of each month business has sufficient raw material inventories to meet the following month's production and enough finished inventories to meet the following month's sales. If the product is to sell in December then the raw materials are to be prepared in the month of October and the product gets ready in the month of November. So the fixed costs are affected from November.

If we assume that n units are sold in October with x price then it would be 50% increase in the sales volume and 10% decrease in the selling prices.
Number of units sold be will be 1.5n and the price would be 0.9x as there is a 10% in selling prices.
1.5*0.9*300=405

Since the contribution of sales revenue would fall to 30p which is 30%
30% of 405 is 121.5.so the profit would be 121.5 after the changes made from December 1st.

The fixed costs are
405-(90)-(x) =121.5
X= 193.5

The Total expenses for the month November is 193.5+ 90= 283.5
Profit for the month is 300-283.5=16.5
Opening balance is 190 and closing balance is
190+ 16.5(profit for the month) = 206.5

For the month December

Sales revenue is £300000, cost of raw materials is 90, and fixed costs would be 193.5 as it is mentioned above in the part for the month of November.
Total expenses= cost of raw materials + Fixed costs
= 90+193.5
= 283.5
Profit the month = Sales revenue- Total expenses
= 300-283.5
= 16.5
Opening balance is 206.5(closing balance of November)
Closing balance is 206.5 + 16.5 (Profit for the month) which is 223.

For the month of January

In this month the sales revenue would be zero because as it is mentioned in the future position of the company the trade receivables would be allowed to pay two months after the sale. So the Sales Revenue is 0
Cost of raw materials is 90 and the fixed costs are 193.5
Total expenses is 90+ 193.5= 283.5
Profit for the month = Sales revenue- Total Expenses
= 0-283.5
= -283.5

There is no profit for the month January as the credit period given is for two months i.e. the trade receivables would be allowed to pay two months after the sale.
Opening balance is 223
Closing balance is 223-283.5=-60.5
It indicates that the owner has to put the money from his pocket for the next month but not from the profits in this month as there is no profit in this month.

For the month of February

The sales revenue for the month February is 405 as the sales volume is increased by 50% and selling prices are decreased by 10%.
Sales revenue=405(300*1.5*0.9)
Cost of raw materials is 90 and the fixed costs are 193.5
Total expenses is 90+ 193.5= 283.5
Profit for the month = Sales revenue- Total Expenses
= 405-283.5
= 121.5
Opening balance is -60.5(closing balance of January)
Closing balance is 121.5(Profit for the month) -60.5 which is 61.

PART B

Introduction

Accounting is a collection of processes and systems used to record, report and interpret the business transactions. It provides an account i.e. explanation or report in financial terms. Explanation or report regarding the transactions of an organisation can be viewed.

A company named Flight high ventures plc is a producer/retailer of gliding equipment. The business would like to look into expanding their business abroad with an ambitious 20% export target in 2 years time. Company's sales turnover is growing at an impressive 10% yearly and they are looking at ways to improve their productivity even further. The company is planning to set up a new plant to cope with expansion plans. To set up a new plant company will require an initial outlay of £4m.
The R&D team of Flight high ventures plc have developed two ways of manufacturing the new product. One method requires a lower initial cash outlay and a second method requires a higher initial outlay but would help in achieving better economies of scale. The methods are however mutually exclusive and a decision will have to be taken as to which method will be more appropriate.

Based on the options A & B, Investment appraisal methods i.e. Accounting rate of return, Payback period, Net present value and Internal rate of return should be calculated to evaluate the R & D projects. A conclusion should be made on the results calculated and recommend the firm the best method of manufacturing the new product.

Background

“Accounting is defined as a system for providing financial information to those who have to make decisions and control the implementation of those decisions” (Arnold & Turley, 1996).

Accounting helps in knowing profit and financial position of the organisation and also it helps in planning for the expansion of business.

“Management accounting is concerned about providing information for management. It provides a wide range of internally used information much of also contributes to the creation of the financial accounts” (Ryan, 2004).

Uses of management accounting

• Comparison of accounts with original budgets or forecasts can be done
• Managing of resources will be better,
• Trends in the business can be identified and
• Variations in the income can be highlighted which requires attention.

“Financial Accounting is the accountability which results in the production of financial statements, primarily for those integrated parties who are external to the business” (Collier, 2006).

Through financial management and by using the investment appraisal methods a decision should be made on particular investment opportunity of company named Flight high ventures plc.

Analysis

Accounting Rate of Return (ARR)

“The ARR method takes the average accounting operating profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project” (Atrill & McLaney, 2008).

For any project to be acceptable it must have a target ARR as a minimum. The Company's recent return on capital employed (ROCE) has been 20%. ARR and ROCE ratio takes the same approach to performance management. They both relate the profit to the cost of the assets invested to generate that profit. The minimum target would be based on the rate that previous investments have achieved.

ARR has many advantages as a method of investment appraisal. Since ROCE is a widely used measure of business performance shareholders use this ratio to evaluate the management performance. In case of option A the ARR is 8.75% which is very low and does not reach the target. Whereas in case of option B the ARR is 14.87% which is nearly equal to the recent return on the capital employed. If the business is seeking through their investments to generate a percentage rate of return on investment, ARR would be more helpful. But ARR ignores the time value of money and size of the initial investment and uses profit rather than cash.

Payback Period (PP)

“Payback period is the length of time it takes for an initial investment to be repaid out of the net cash inflows from a project” (Atrill & McLaney, 2008).

Although it is simple concept to understand and easy to calculate, this technique fails to recognise the cash flows beyond the payback period. It only considers the less payback period and ignores the size of the investment and any cash flows that take place after the investment has been recovered. It ignores the size and timing of cash flows (Dobbs, 2009). Both the Accounting Rate of Return and Payback period does not consider the time value of money. The time value of the money should be recognised in investment appraisals in order to compare the investment alternatives with different cash flows over different time periods. The payback period of method A is 1 year 183 days and the payback period for method B is 2 years 183 days. We cannot consider the method A since it has less payback period. Method A has less initial investment of £968000 in the year 0 and the payback period is 1 year 183 days. After the payback period the cash flows of the Method A are declined year by year. Whereas in case of Method B it has initial investment of £1210000, more than Method A and its payback period is 2 years 183 days and the cash flows after the payback period are in increasing order year by year.

Net present value (NPV)

“Net present value is the surplus value offered by an investment opportunity when the required capital investment is deducted from the present value of its future cash flows, discounted at the firms opportunity cost of capital” (Ryan, 2004).

The NPV for Method A is 554.785 and NPV for Method B is 847.916.Using NPV method it is difficult to determine how much better Method B is than Method A because each has a different initial investment. By ranking the projects a decision can be taken on the methods. Ranking of projects with different NPVs is
Cash value added= NPV

Initial capital investment
CVA for method A is 554.785
968
= 0.5731
CVA for method B is 847.916
1210
= 0.7007
Based on the profitability index or CVA the R & D team should choose method B.
By discounting the various cash flows of every method, NPV takes account of the time value of the money.NPV takes account of all the relevant cash flows over the life of a project. NPV is the only method of appraisal in which the output the analysis has a direct bearing on the wealth of the owners of the business. If the choice has to be made between methods, the business should normally select the one with the higher or highest NPV. Method B has the highest NPV.

Internal Rate of Return (IRR)

“The internal rate of return (IRR) of a particular investment is the discount rate that, when applied to its future cash flows, will produce an NPV of precisely zero” (Ryan, 2004).

The IRR for method A is 42.92% and IRR for method B is 36.66%. If two (or more) competing projects exceed the minimum IRR, the one with the higher (or highest) IRR should be selected. Although if we accept the project with the higher percentage return which will often generate more wealth, this may not always be right because IRR completely ignores the scale of investment. There might be a future problem with the IRR method in handling the projects with unconventional cash flows (Easton & Sommers, 2007). We cannot consider method A as it has highest IRR because method A has unconventional cash flows and it has less NPV. So method B can be considered as the best one because it has conventional cash flows and scale of investment is high.

Conclusion

Method B would be the best choice for R & D team to develop the new product for Flight high ventures plc. In case of method B ARR is high whereas the payback period is more, where both the methods ignore the time value of money.NPV of method B is more when compared to method A. NPV takes account into time value of money and discount future cash flows to their present value. NPV is more reliable method of investment appraisal. A business usually selects the project with highest net present value. As the net profit of method B is increasing year by year and the sales turnover is growing at an impressive 10% yearly, it would be the best choice.

References

Arnold, J. & Turley, S. (1996) Accounting for Management Decisions. 3rd edn. Hemel Hempstead: Prentice Hall.

Atrill, P. & McLaney, E. (2008). Accounting and Finance for Non-Specialists. 3rd edn. London: Prentice Hall Financial Times.

Collier, P. M . (2006) Accounting for Managers. 2nd edn. Great Britain.

Dobbs, I.M. (2009) ‘How bad can short termism be?—A study of the consequences of high hurdle discount rates and low payback thresholds'. Management Accounting Research. 20(2) pp. 117-128.

Easton, P.D. & Sommers, G.A. (2007) ‘Effect of Analysts Optimism on Estimates of the Expected Rate of Return Implied By Earnings Forecasts'. Journal of Accounting Research. 45(5) pp. 983-1016.

Ryan, B. (2004) Finance and Accounting for Business. London.

Ward, K., Srikanthan, S. & Neal, R. (1991) Management Accounting for Financial Decisions. Oxford: Butterworth-Heinemann Ltd.

Appendix

Calculation of Accounting rate of return (ARR), Payback period (PP), Net present value (NPV), Internal rate of return (IRR) of Flight high ventures plc is shown here.

Option A:

Year 0
£000 Year 1
£000 Year 2
£000 Year 3
£000 Year 4
£000 Year 5
£000

Net Profit 532 290 169 48 48
Depreciation* 194 194 194 194 194

Net Cash flow -968 726 484 363 242 242

Option B:

Year 0
£000 Year 1
£000 Year 2
£000 Year 3
£000 Year 4
£000 Year 5
£000

Net Profit 182 242 363 545 605
Depreciation* 242 242 242 242 242

Net Cash flow -1210 424 484 605 787 847

The company's cost of capital is 14% .The Company's recent return on capital employed has been 20%. To set up a new plant company will require an initial outlay of £4m.

Accounting Rate of return (ARR)
Option A
ARR = Average annual operating profit * 100
Average investment to earn that profit
Profit before depreciation is 532+290+169+48+48
5
= 217.4
Average investment to earn that profit is 4000000+968000
2
= 2484000
ARR = 217400
2484000
= 0.0875* 100
= 8.75%
Option B
ARR = Average annual operating profit * 100
Average investment to earn that profit
Profit before depreciation is 182+242+363+545+605
5
= 387.4

Average investment to earn that profit is 4000000+1210000
2
= 2605000
ARR = 387400
2605000
= 0.1487* 100
= 14.87%

Payback period (PP)
Option A
To calculate the payback period we need to calculate the cumulative cash flow
0 1 2 3 4 5
Option A cash flow -968 726 484 363 242 242
Cum Cash flow -968 -242 242 605 847 1089

The cumulative cash flow turned positive between years 1 and 2. It will be more precise by taking the negative value at year 1(-242) and calculating the proportion change to the cash flow over that year, arrive at the number of days beyond year 1 to payback
Payback = 1 year + 242/ (242+242) * 365
= 1 year, 183 days.
Option B
To calculate the payback period we need to calculate the cumulative cash flow
0 1 2 3 4 5
Option A cash flow -1210 424 484 605 787 847
Cum Cash flow -1210 -786 -302 303 1090 1937

The cumulative cash flow turned positive between years 2 and 3. The break even falls between the 2nd and 3rd year and it will be more precise by taking the negative value at year 2(-302) and calculating the proportion change to the cash flow over that year, arrive at the number of days beyond year 1 to payback
Payback = 2 years + 302/ (302+303) * 365
= 2 years, 183 days.

Net present Value
Option A
Cost of capital is 14%
Year Cash flow 14% PVF PV
0 -968 1.000 -968
1 726 0.877 636.702
2 484 0.769 372.196
3 363 0.675 245.025
4 242 0.592 143.264
5 242 0.519 125.598

NPV = 554.785

Option B
Cost of capital is 14%
Year Cash flow 14% PVF PV
0 -1210 1.000 -1210
1 424 0.877 371.848
2 484 0.769 372.196
3 605 0.675 408.375
4 787 0.592 465.904
5 847 0.519 439.593

NPV = 847.916

Internal rate of Return (IRR)
Option A
For option A IRR would be
Trying a rate of 25%, we have
-968+726(0.800) +484(0.640) +363(0.512) +242(0.409) +242(0.327) = 286.528
This shows that 25% is two low
Trying a rate of 40%, we have
IRR= a1 + a2 +..........+ an - Io
(1+r) (1+r)(1+r) (1+r) n times
= (726/1.4) + (484/1.96) + (363/2.744) + (242/3.841) + (242/5.378)-968
= 37.799
This shows that 40% is also low
Trying a rate of 43%, we have
= (726/1.43) + (484/2.044) + (363/2.924) + (242/4.181) + (242/5.979)-968
= -1.019
The negative NPV found when applying a rate of 43% shows that the IRR must lie somewhere between 40% and 43%.This can be approximated by using the technique of linear interpolation.
IRR cab be estimated as for a 3% increase in the discount rate (from 40% to 43%), NPV falls by 38.818 (from 37.799 to -1.019).If a 3% increase leads to a fall of £38.818 in NPV, the increase necessary for a fall of £37.799 is ( 3* 37.799/38.818).The IRR would be
40 + (3 * 37.799 ) = 42.92%
38.818

Option B

For option B IRR would be
Trying a rate of 35%, we have
IRR= a1 + a2 +..........+ an - Io
(1+r) (1+r)(1+r) (1+r) n times

= 424+ 484 + 605 + 787 + 847 - 1210
1.35 1.822 2.460 3.321 4.484
= 41.519
This shows that 35% is also low
Trying a rate of 37%, we have
= (424/1.37) + (484/1.876) + (605/2.571) + (787/3.522) + (847/4.826) -1210
= -8.257
The negative NPV found when applying a rate of 37% shows that the IRR must lie somewhere between 35% and 37%.This can be approximated by using the technique of linear interpolation.
IRR cab be estimated as for a 2% increase in the discount rate (from 35% to 37%), NPV falls by 49.776 (from 41.519 to -8.257).If a 2% increase leads to a fall of £49.776 in NPV, the increase necessary for a fall of £41.519 is ( 2* 41.519/49.776).The IRR would be
35 + (2 * 41.519) = 36.66%
49.776

Investment appraisal methods like ARR, PP, NPV, IRR for option A and option B results as
ARR PP NPV IRR
Option A 8.75% 1 year, 183 days 554.785 42.92%

Option B 14.87% 2 years, 183 days 847.916 36.66%

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