The current report requires preparation of different budgets of Earth Ltd., which is a new company and it is planning for the first year of business. Different budgets include production budget, sales budget, direct material budget, direct labour budget, overhead budget, and cash budget. All these budgets are interlinked, and they allow the company to plan its production to meet its expected sales requirements. Furthermore, the report also prepares budgeted financial statements including income statement and balance sheet. The usefulness of different budgets for a business in the modern world is also discussed. The discussion highlights the importance of budgets and how they can help companies to plan their operations and evaluate the performance of different business activities and functions. Furthermore, the discussion includes new trends in the budgeting process and importance of timely and periodic information that companies need to generate. The role of budgets to plan, control, and achieve corporate objectives is also considered. The new challenges faced by companies are highlighted that affect their budgeting process. The report critically analyses the cash budget and its components. In the current report, the cash budget of Earth Ltd. is prepared based on its cash inflows and cash flows. The financial data included in the cash budget is analysed, and its weaknesses are identified. Finally, the report discusses methods of improving the cash budget.
Budgets
The data of Earth Ltd. is used for preparing different budgets including production budget, sales budget, direct material budget, direct labour budget, and overhead budget. These budgets are aggregated to prepare the company’s cash budget. Furthermore, budgeted financial statements including budgeted income statement and budgeted balance sheet are also prepared for the period considered in the analysis.
Table 1. Earth Ltd. Budgets.
Table 2. Cash Budget.
Table 3. Budgeted Income Statement.
Table 4. Budgeted Balance Sheet.
Usefulness of Budgets in the Modern World
Memo
To: Management
Earth Ltd.
From: Accountant
Subject: The role of budgets and their importance
Date: 5 April 2017
The purpose of this memo is to highlight the role of budget preparation and its usefulness. The discussion provided in this memo is based on different types of a budget that a business can prepare to help it in planning its operations efficiently.
The management of Earth Ltd. must understand that planning can be carried out in two phases including long-term planning and short-term planning. Budgeting helps businesses to estimate business outcomes depending on the factors that could affect them. Therefore, it could be stated that the budgeting process is an integral part of planning and strategy development process. If the company prepares budgets, then it can make its long-term and short-term business strategies and fulfil business requirements accordingly. The role of budgets is pivotal for successfully achieving the objectives set out by the company’s management. In the current times, the role of budgeting is not just limited to the preparation of numbers and assigning them to different business functions to achieve corporate objectives. The role of budgeting has evolved from the presentation of numbers to planning, monitoring, controlling, and improving business activities to ensure that all employees who are working at different levels within the organization understand their responsibilities. They are held accountable for their actions and decisions based on budgets prepared for them (Debarshi 2011).
The role of budgeting in planning is crucial as it gives a business direction. The company can quantify its corporate objectives and help different business functions to achieve them. The company can evaluate the current business and market conditions and incorporate its estimations about the business future to plan its activities. The next role of budgets is control within an organization. The figures provided in budgets work as benchmarks for the management to evaluate the performance of different business functions, teams, and individuals. If there are any deficiencies or weaknesses, then the management can compare budgets with actual performance and take corrective actions to ensure that the corporate objectives are met (Arora 2012).
These two functions of budgeting have been discussed for many years, and their importance has been highlighted by various authors and researchers. However, in the contemporary times, the role of budgets is far more than just planning and controlling. The use of budgets must be considered after analysing its drawbacks and addressing them. The budgeting process is an integral element of planning and managing business activities. They are prepared with greater detail that helps individuals, teams, and departments to understand what is expected of them and what they need to do to achieve corporate objectives. Furthermore, the budgeting process has evolved by increasing participation of employees working at every level of the organization. The increased involvement of employees has contributed positively to their commitment to budgets prepared by companies. The employees can relate to the corporate objectives and take individual decisions that could fulfil their personal and job requirements. Thus, it could be stated that the budgeting process engages employees and gives them more responsibilities in the contemporary corporate world.
In the current times, managers are faced with many challenges regarding the budgeting process. These challenges arise from the behavioural implications of budgets. The budgeting process can be demotivating if targets are imposed rather than negotiated. It implies that managers need to collect information from departments and employees and ensure that there are no conflicts between them over budget allocation (Debarshi 2011). Moreover, this criticism of the budgeting process has led to the changing role of budgets within organizations.
It could be noted that businesses and their management use the budgeting process as a way to facilitate and encourage communication between business units and employees to bring them closer and improve collaboration between them to achieve corporate objectives. The role of budgeting in communication is crucial as it assists in fitting different parts of an organisation together and improving their working (Holtzman, 2013). For example, if the inventory management department is informed in advanced about the material requirements of the production department through an effective communication channel, then it can plan and reorder materials from different suppliers in a timely manner. It would ensure that the production unit of the company does not face any disruption. Therefore, it is important for better coordination between departments to have an effective budgeting process and open communication.
Another role of the budgeting process that has been highlighted is its motivational role. The management of companies has understood that the autocratic way of getting work done is not applicable in the modern world. Employees demand achievable targets that they can achieve under normal conditions. They do not like to work under stress and can resist to the budgeting process if the management fails to understand their requirements and needs. Therefore, it could be stated that managers can motivate employees through effective budgeting by setting achievable targets and recognizing and rewarding their efforts when they complete their assigned tasks efficiently (Leitner 2013).
Based on the discussion provided above, it could be argued that the role of budgeting has changed from resource planning to strategic planning. The company’s management can use budgets to achieve better results. However, it is also argued that due to rapid changes in economic, market, and regulatory conditions, which are highly common in the modern world, it is difficult for the management to perform the budgeting process. The budgeting process requires significant resources, and not all businesses can arrange them to carry out the process. In such cases, businesses fail to achieve their objectives and waste a lot of resources in planning.
Therefore, it could be argued that the nature of budgeting process has changed in the current times. The companies are more inclined towards preparing short- and medium-term budgets instead of long-term budgets because they need to evolve quicker to meet the demand of customers (Holtzman, 2013). Furthermore, it is also argued that the budgeting process should not be a one-time exercise at the beginning of the year or accounting period (Epstein 2012). In fact, it should be carried out on a regular basis so that the management can evaluate the performance of departments and employees. Therefore, the emphasis of businesses is now on flexible budgeting rather than static budgeting. The flexible budgeting helps managers to change their plans quickly to deal with new threats and opportunities arising in the market.
The complex environment and changing business conditions suggest that companies in the modern world should focus on forecasting rather than traditional budgeting. The traditional budgeting is a detailed aggregation of the management’s estimations of cash flows and it represents the financial positioning of the business for a specific period. Most of the companies perform budgeting on an annual basis, and variances are calculated based on actual results achieved during the year (Leitner 2013). The comparison helps managers to improve their strategies and execute them in the following period. On the other hand, forecasting assists managers to determine the output that could be achieved depending on their actions and decisions. Forecasting considers revenue and expenses and does not focus on the financial position of the company. It is carried out on a monthly or quarterly basis that helps managers to make adjustments in the short-term. This approach is useful as companies can make changes to sub-budgets, which does not necessarily affect performance-based compensation of employees (Leitner 2013).
The use of technology for carrying out the budgeting process has improved business outcomes. It could be noted that companies use different accounting tools and software such as QuickBooks, Oracle, or SAP to perform accounting and planning functions. The companies can now prepare budgets in less time, which has helped them to be more flexible and respond to the changing economic and market conditions. Even small businesses can perform budgeting at a low cost. Therefore, it could be stated that companies can have better chances to survive or achieve higher results.
Furthermore, it is noted that large companies operate in many countries that have different sets of accounting policies and it is difficult for such companies to carry out budgeting activities. They face a diverse set of risks and challenges, which must be taken into consideration for budget planning and implementation. Therefore, there is an increasing need for developing and using computerized budgeting tools that are based on complex models.
The recent economic crises have led to the revaluation of the budgeting process followed by companies. It is argued that businesses have become more susceptible to unexpected market changes and competition. It must be understood that businesses now face risks that cannot be diversified or mitigated. Therefore, the use of budgets for planning becomes weak as these risks can change the business scenario immediately and planning of businesses could become ineffective. Therefore, when companies face such unpredictable situations, they can only make use of certain budgets.
Cash Budget Evaluation
The cash budget prepared for Earth Ltd. clearly indicates its budgeted cash received and budgeted cash paid. The first section of the cash budget indicates cash receipt from the issue of shares and sales. The next section of the cash budget includes all cash payments. It is argued that the cash budget is based on estimations made by the company’s management. It could be noted that the variable overheads of Earth Ltd. are based on the estimation of expense per unit. These overheads include various expenses, but the company used only one benchmark for all them. It is not an appropriate approach. These could vary based on different assumptions and views of the management. Therefore, the use of cash budget for planning is highly subjective. In the given case of Earth Ltd., there is no indication of minimum cash requirement that the company must maintain in every month.
One of the issues that must be considered is the exclusion of depreciation from the company’s overheads. The cash budget is prepared on a cash basis. Therefore, all non-cash items including depreciation must not be included. Although depreciation has tax implications and it should be deducted from the company’s earnings before tax, it is not deductible from the company’s cash. Cash budgets are not always useful as they may cause distortions. It is noted from the cash budget of Earth Ltd. that its net cash flow is not equal to its profit. There could be other sources of cash inflows and cash outflows that do not necessarily relate to the company’s revenue (Gilbertson & Lehman 2012). For example, the sale of capital assets is recorded in the cash budget, but it is not part of the company’s revenue. Moreover, it is also argued that low cash flow in a specific period is not always a problem. It could be because companies receive cash for their sales with delay as they give credit to their customers.
The accrual concept of accounting requires businesses to record and report revenue and related expenses in the same period. Therefore, a company may not have sufficient cash in the current period, but in the long-run, it could have more profit. Therefore, the use of cash budgets to assess the performance of the business is dependent on the managerial judgment of results. Another criticism of the cash budget prepared in this report is that it does not consider sales to be realized after the completion of the one-year period. It is indicated that the company’s sales will be made on credit, and cash will be received after two months for each month’s sales. Therefore, if the company does not receive cash for its sales made in the first year of operations, then it would face financial problems. Furthermore, it is possible to manipulate the company’s cash position by increasing or delaying collections or making pay-outs. Lastly, there are non-financial factors that could also affect the company’s decisions. Therefore, it is not advisable to solely rely on the cash budget for planning and controlling business activities.
Suggestions for Cash Budget
The cash budget can be improved by providing more details of each revenue and cost element included in the budget. The cash budgeting process can also be improved by using the sensitivity analysis, which can predict the company’s cash inflows and cash outflows based on different estimations. The sensitivity analysis results in different values of the net cash flow that the company can achieve (Leitner 2013). A common approach could be to change the expected sales of the company, which will affect its cash inflows and net flows (Gilbertson & Lehman 2012). The company can prepare budgets for changes in economic and market conditions and take the corrective course of actions to achieve its objectives.
Moreover, the cash budget determines the company’s budgeted cash position and anticipates if the company requires external debt. Therefore, the cash budget should also indicate minimum cash balance required at the end of each period. Moreover, the cash budget should be prepared after considering non-financial factors (Gilbertson & Lehman 2012). The company’s business depends on its management and members of the management team. Therefore, the cash budget should indicate changes in the cash value that could be affected if one of the management members leave the company. Additionally, Earth Ltd. has prepared budgets for the first twelve months. It could improve its cash budget by preparing it on a monthly basis. It would help the company to alter its strategies in less time and respond to the market and customers’ needs in an effective manner.
Reference List
Arora, M 2012, A textbook of cost and management accounting, 10th Edition, Vikas Publishing House, New Delhi.
Debarshi, B 2011, Management accounting. Pearson Education India, New Delhi.
Epstein, MJ 2012, Advances in management accounting, Emerald Group Publishing, New York.
Gilbertson, CB & Lehman, MW 2012, Century 21 accounting: advanced, 2012 update. Cengage Learning, Mason.
Holtzman, MP 2013, Managerial accounting for dummies. John Wiley & Sons, New Jersey.
Leitner, S 2013, Information quality and management accounting: a simulation analysis of biases in costing systems, Springer Science & Business Media, Berlin.