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Financial tools for planning and decision-making are essential in any organization. These tools provide valuable insights into an organization’s financial health and help to identify opportunities and risks. They allow managers to analyze financial data, forecast future performance, and make informed decisions that support the organization’s objectives. Financial tools also help to streamline financial processes and optimize resource allocation, ultimately leading to increased profitability and growth. From budgeting and forecasting to financial reporting and analysis, these tools are critical for organizations of all sizes and industries. By utilizing financial tools effectively, organizations can make strategic decisions that drive success and achieve long-term sustainability.
As a Management Accountant of the ‘Office Furniture Design and Manufacturing Company’ before advising on the changing of budgeting technique from Incremental to Zero-Based. It is essential to understand the advantages and limitations of both the budgeting techniques in order to come to the planning and decision making process whether the company should change its existing financial tools. Hence, it is necessary to understand the aims of budgeting as well as the advantages and limitations to advise about the requirement for change.
Planning and Decision Making
- The Budget is prepared to make an early prediction of the expenses that will be incurred in a particular activity.
- The aim of the budget is to compare the actual figure that has been recorded in the books of account with the budgeted figure at the end of the period to see if there is any discrepancy.
- It is a tool that is used for planning and decision making purposes about the future.
- The aim of the budgeting is to coordinate the different activities and help in minimizing the wastage.
Advantages and Limitations of Incremental Budgeting
The Incremental Budgeting is prepared at the beginning of each year after considering the previous year’s budget and some minor changes are made to the previous budget.
Advantages
- Incremental Budgeting is very simple to calculate, as it does not require any hard calculations.
- This budget can be prepared by anyone, as it does not require any specific training or specialized skills. Hence, any person with limited skills can be able to prepare such a budget.
- The Incremental budget is quite consistent as every year only some things are added or removed from the previous year’s budget. Hence, it shows a true picture of the company on a year-to-year basis without much variation.
- The Incremental Budget also helps in allocating funds to different activities, which helps.
Limitations
- The incremental budget suffers from the fact that as it maintains the same budget over the years, there may be a situation where some activities may not be required allocation of funds and still a certain portion of the amount may be allocated to such activity
- As the same process of the budget is followed every year, some redundancy can be seen here.
- The incremental budget cannot give a proper solution when the business goes through certain changes in its structure and hierarchical order. This means this budget lacks flexibility.
Advantages and Limitations of Zero Based Budgeting
Zero-based budgeting is a type of budget where a new budget is prepared every year without considering the previous budget. Hence, it starts from zero every year.
Advantages
- Zero-based budgeting is a better way to make decisions as here the activities, which will be required for the year, are identified in advance and thus it helps in reducing any wastage that may have taken place earlier as the activity was not at all required.
- With the help of Zero-based budgeting, it is possible to give justification for the activities that will be required and if behind the conduct of any activity proper justification cannot be given then such activity will not be part of the organization.
- Less than Zero-based budget, every cost that is to be forecasted needs to be analyzed thoroughly.
Limitations
- One needs to spend a huge amount of time conducting and completing a zero-based budget.
- The zero-based budget cannot be prepared by anyone having limited skills. It requires in-depth knowledge of the system and the person is required to go through a specialized training process to solve the problem of budget.
- The amount required to prepare this budget is quite expensive and many small firms cannot afford to conduct such a budget in their organization.
Recommendation for Planning and Decision Making
By discussing the advantages and limitations of both the budgetary system it is quite evident that the Zero-based budgeting provides the required flexibility that was lacking in the company’s existing Incremental budgeting technique. The existing incremental budget process lacks flexibility, as it does not make required changes to the budget as needed in the changing situations. While using the incremental budgeting the Manufacturing Company was suffering losses every year, as the company was blocking a certain amount to the activities, which were not needed by the firm.
As incremental budgeting is easy to conduct, the person who was preparing the budget did not require any training. Hence as a MA of the company, it is suggested to shift to the Zero Based Budgeting technique as the Zero Based Budgeting provides a more holistic approach and the person preparing the budget is more qualified to conduct such a budget. The zero-based budgeting is considered better than the incremental budgeting. Though the costs involved in zero-based budgeting are huge thus the cost factor should be considered by the company ‘Office Furniture Design and Manufacturing Company’ before switching to the Zero Based Budgeting.
What is Standard Costing and Appropriate Standard Setting for the Furniture Design and Manufacturing Company?
Standard costing is a measure where some standards are set before the actual work starts and after the actual work gets over, the actual cost is compared with the standard to see if any discrepancies are there between the two. The Standards set in the previous year are compared with the actual figure that occurred during the previous year. Hence, the different variances are calculated by using the following table for investigating the variances.
The different standards are set for the company, which is shown below:
Variables | Standard Amount (in Pound) | Actual Amount (in Pound) |
Sales Value | 100 | 90 |
Material Cost | 40 | 60 |
Labor Cost | 60 | 70 |
Variable Overhead Cost | 50 | 50 |
Fixed Overhead Cost | 60 | 70 |
Table 1: different standards
(Source: Created by the learner)
From the above table, it can be seen that there are different variances that are observed from the last year’s standard figure as compared with actual figures.
Variances to Be Investigated by the Management
There were different variances that were observed which are a concern for the company. Hence, these variances need proper analysis to see who is responsible for such variances. First is Material Cost variance, which states the differences between the actual cost and standard cost. These variances may occur because of the inefficiency of the production manager in handling the raw materials, which leads to wastage of resources and an increase in the actual cost resulting in material usage variance. There may be some uncontrollable variances like an increase in the price of raw materials, which cannot be controlled by the manager.
The second is Labor Cost Variance, which states the distinction between the actual cost incurred for labor and the standard cost, which was predicted by the standard cost method. The reason for getting such variance may be the increase in labor rate, which cannot be controlled by the manager and thus should not be considered for the analysis. However, when the labor variance occurs because of treating every employee as equal and skillful then this variance needs proper caring and analysis.
Third, is Fixed Cost Variance which may occur because of a sudden increase in the existing capacity of the business which was not considered earlier, and hence this variance needs to be analyzed to see if the variance is huge or negligible. Hence, it is recommended to take care of the fixed costs and if necessary try to reduce the cost, which will help the firm in setting proper Standards for the future.
Hence, it is advised to the firm that it should manage the raw materials with professionals who have enough experience in handling the raw materials so the wastage of raw materials will be minimized. It is necessary to hire qualified workers and those workers should be provided training to handle the work in an efficient way.
Issues in Standard Setting and Impact on Management Behavior
To set a standard that is comparable at the end of the period with the actual figure is a tough task.
There may be issues in reporting the standard in a timely manner as it requires a thorough study and then only it is possible to come up with the standards. The Standards when it deviates from the actual figure and if the result is adverse in nature then the person handling such operation is held responsible for such variances and they may feel low because of such blame. When the variances come favorable in nature then it is also a challenging situation, as the firm may not thoroughly check the variations. The management also gets affected mentally as the standard setting is not an easy task and they have to go through all the previous books of accounts and the current situation to set the correct standard.
What is Relevant and Irrelevant Cost
Relevant costs are those costs, which help, in the planning and decision making process and it considers as relevant as this cost will have to be incurred only when any decision has been taken to purchase certain assets or invest in any project.
Irrelevant Costs are those costs that are already incurred in the past and do not form a part of any decision-making process. Thus, it is called Irrelevant Cost.
Identification of five Relevant/Irrelevant Costs for the present decision
The Relevant Cost, which is part of the current decision-making, is:
Avoidable Cost
These costs are only incurred when any new project gets undertaken or any investment decision is made. Otherwise, these costs can be ignored or do not have to be incurred.
Opportunity Cost
These are the costs, which are not recorded in the books of account. These are the costs, which mean giving up the second-best opportunity one has.
Incremental Cost
These costs are those costs, which are incurred for producing any new extra unit of the existing products.
The Irrelevant Cost does not form part of the decision-making process and example of such costs is:
Fixed Cost
These are the costs, which need to be incurred periodically whether any production takes place, or not. Hence, they do not become part of the planning and decision making process related to any products.
Sunk Cost
Sunk Costs are those, which are already incurred by the company, and thus these costs cannot be charged to the consumers. Hence, they do not form part of the decision-making process.
Hence, the decision to use the storage house, as a manufacturing place will be considered by taking into consideration the fact that the cost incurred for that purpose must be relevant in nature otherwise such cost will not be part of the decision related to the transfer of such storage house.
Three Qualitative Factors that need to be taken into account
The qualitative factors also affect the planning and decision making process along with quantitative factors. These:
Moral
It is essential to consider the morale of the employee if they will be happy with the decision made by the management to switch the storage building.
Investors
It is also necessary to see if the persons who have made an investment in the company agree with such a decision taken by the management.
Customers
The views of the customers also matter a lot as they are the ones who purchase the goods of the company and if they will be able to get any benefits from such transactions also need to be considered before finalizing the decision.
The significance of acknowledging qualitative factors to make informed decisions.
It is important to consider the quantitative factors, as well as the qualitative factors, should not be ignored. The qualitative factors made a huge impact on the decisions that are taken by the management. One cannot be able to make any decision without considering the qualitative factors as they are also a huge part of the business and their contributions to the survival of the business cannot be taken for granted. Hence, opinions are also taken from these factors to make a decision, which is widely accepted.
Evaluation of NPV and Payback Technique
Payback Technique
It is a part of the Traditional Capital budgeting technique and under this process, the payback period is calculated by dividing the value of the capital invested by the annual cash flows. This means when the initial capital is recovered from the project is considered the payback period. The payback period does not give accurate results, as it does not discount the future cash flows to arrive at the present cash flows. Thus, it does not provide the exact payback period when the capital will be recovered.
NPV
NPV (Net present value) is the Modern Method of Capital Budgeting Technique, which helps, in the planning and decision making process related to different projects involving different cash flows. This method also takes into consideration the Time Value Factor means the future cash flows are discounted with an appropriate discounting factor to arrive at the present value. Then the Initial Investment is deducted from the Total present Cash value to get the Net Present Value. In case a situation arises where the project is exclusive in nature and only one of the two projects can be selected in that case if IRR and NPV come up with different decisions then the results of the NPV. These are preferred over the IRR method as under NPV a logical consideration has been made that the investments are reinvested at the Cost of Capital.
Illustrate Investment Appraisal Results Using NPV and Payback Techniques
Let the investment that will be made equal to the 1500m Pound and the payback period is calculated by using the following formula:
Calculation of Payback period | Column1 | Column2 | Column3 |
Year | Net Cash Flow (In Pound) | Cumulative Cash Flow(in Pound) | |
1 | 300 | 300 | |
2 | 400 | 700 | |
3 | 300 | 1000 | |
4 | 500 | 1500 | |
5 | 600 |
Table 2: Payback Period Calculation
(Source: Created by the learner)
From the above table, it is observed that the initial investment is recovered within 4 years.Therefore, the period of time required to recoup the investment is 4 years.
As the investment is recovered before the ending of the project, hence the project can be considered a suitable option to invest the money. However, the earlier the money is recovered the more feasible the investment is.
In the below table, NPV is calculated by discounting the future cash flows:
Column1 | Calculation of NPV | Column2 | Column3 |
Year | Net Cash Flow(In Pound) | Discounting Factor (10%) | Present Value |
1 | 300 | 0.909 | 272.7 |
2 | 400 | 0.826 | 330.4 |
3 | 300 | 0.751 | 225.3 |
4 | 500 | 0.683 | 341.5 |
5 | 600 | 0.621 | 372.6 |
Total Present Value | 1542.5 |
Table 3: Net Present Value Calculation
(Source: Created by the learner)
In the above table, the total present value is calculated by discounting the net cash flow with a 10 % discounting factor. Now the Net Present Value is calculated by deducting the Initial Investment, which is assumed£ 1500 RM from the Total Present Value. The NPV = TPV-IV=1542.5 -15= 42.5. Hence as per the NPV technique, as the value is positive it is advisable to choose the project as the project will enhance the profitability and the value of the company. In case it was negative, the project would have been rejected by the investor.
Potential Implication of the Investment
Here in both the examples, it is seen that the project would have been selected under both the techniques. As here, both the projects give the same results it is not a cause of concern for the company. However, if there were any contradictions and both were giving exact opposite results then the result of the NPV method is considered more valid as under a method the cash flows are calculated by using the discounting technique. This is valid as with the increase in the time, the value of money gets decreases in the future. Hence, it is better to use a time value technique to get accurate figures of the cash flows.
Hence, it is always better to remember that the value of NPV gives a better parameter to judge the acceptance of a project. However, if the current company is in favor of getting its investment back as early as possible then it should opt for the payback method. . Hence, the choice of selection of appropriate technique also depends on the risk appetite of the investors. Risk-averse investors generally want to get their money back with minimum loss; hence, they generally take the investment decision using the payback method.
However, there is also a technique known as discounting payback period method, which considers the discounting factor in calculating the cash flows. Hence, this Payback period is considered much better than the normal payback period. However, the most widely used in planning and decision making technique is the NPV method. As the Management Accountant of the company, it is suggested to follow the NPV technique as it gives the result considering the discounting technique to conclude selecting a project.