A budget is a quantitative or monetary plan for a period of time that aids the effective and efficient management of resources, by encouraging the effective planning, controlling, organising and controlling of resources. A budget is defined as ‘a quantified statement, for a defined period of time, which may include planned revenues expenses, assets, liabilities and cash flows'(Davies & Boczko,p733:2005).
The use of budgets in the operations of Langdale limited or any other business is very crucial to the management of its operations, since it forces managers to think ahead in areas of resource allocation and activity control. However, some writers and companies have criticised the use of the traditional system due to the following factors:
Inability to deal with rapid change
Main focus on financial information
Reliance on past trends
Inability to deal with rapid change
The traditional system of budgeting has been criticised by companies such as Volvo and Ericsson for its inability to change rapidly with the changing highly dynamic and competitive environment. This often makes budgets irrelevant to use even before the start of the budgeting period especially in economies of hyper-inflation. Hope and Fraser (1999) state that Volvo decided to stop using budgets following the huge losses it made from 1990 to 1992, and low profits in 1993. The management decided that the absence of budgets would enable the company to react promptly or in advance to the changing business environment. This diverted management time and costs pertaining to budgets, to strategy factors that helped build the company’s competitive edge over its rivals. Four years after Volvo stopped using budgets it evolved into an action oriented business. Therefore the absence of budgets encourages the use of management time and resources to enhance a businesses’ performance.
The use of budgets is criticised for being unrealistic and very unreliable, particularly where it concerns large or prospective projects. Schlesinger (2004) undertook a study in regard to the degree of reality portrayed by the 2012 UK London Olympics budget that was created 8 years in advance. He asked for the opinions of Finance Directors from various companies’, the outcome was that approximately three-quarters of the FDs contemplated that the 8 years budget was unrealistic. A renowned finance director, Paresh Samat suggests that companies are to learn from the budget that was drawn up for the rebuilding of the Wembley stadium, whereby estimated costs were approximately 30%-40% higher. Therefore it is highly recommended not to make decisions solely based on a budget.
Main focus is on the financial information
The traditional budgeting system is criticised for being financially oriented. This curb’s a lot of companies’ ability to operate effectively and efficiently. Nelly eta(2003) state that one of the world’s largest polyolefin plastic producers Borealis A/S stopped using budgets in 1995 and has since made use of the beyond budgeting principles (non-financial factors). These non-financial factors include things like brand image, work force quality, customer satisfaction and innovation etc. Critics highly recommend the use/ incorporation of non-financial and financial budgets a basis for decision making, planning and controlling of a companies’ operations. This is because they perceive the traditional budgeting system as encouraging accounting frauds, whereas beyond budgeting principles encourage transparency and good corporate governance.
The traditional budgeting system is criticised for taking up a lot of management, compared to the values it contributes to the achievement of objectives (cost-benefit). It is estimated that management spends approximately 20% of its time on the budgeting process. This tends to encourage blame culture and budgeting games e.g. budget slack. Factors like these would result in business failure.
Reliance on past data
The traditional budgeting system operates on an incremental basis, where by future forecasts are dependent on past data e.g. past inputs and outputs. This is mainly criticised for its inability to change effectively and efficiently in accordance to the changing business environment. In addition it discourages innovation and tends to build a corporate culture that is resistant to change. Collectively this results in businesses underperforming as a result of inability to evolve with the changing world.
It is important to note that despite the traditional budgeting system is widely criticised, it is still paramount to the attainment of business objectives.
Incremental Budgeting Alternatives
Langdale ltd’s main problems with incremental budgeting include the following:
Regarded as a filling exercise
Does not provide any assistance that improves the company’s operations
These problems associated with the incremental budget can be addressed by the use of either one of the following budgeting alternatives:
Zero Based Budgeting
Activity Based Budgeting
Zero Based Budgeting
Zero based budgeting is whereby budget preparations start from a zero base (zero resources and costs) and is established on the basis of justified costs.
The budget is set up on a basis that costs are taken into account as long as they have a subsistence effect and contribution in a company’s operations. This then forces management to evaluate and innovate new ways in which to attain the highest productivity levels from the maximum utilisation of resources, by determining inefficient operations.
The compilation of the budget would not be perceived as a filling task by both management and employees, unlike the incremental budget. This is because zero based budgeting encourages the participation and contribution of every employee. Consequently it provides employees with high morale and career development opportunities.
The use of zero based budgeting is criticised for being costly and time consuming. The cost justification process is perceived to be subjective. Hence the budget would be biased and would result in business performance being adversely affected. Additional by its nature of continuous change zero based budgeting installs low employee morale and job insecurity in employees. This would make the operations of a business very inefficient.
Collectively the use of a zero based budgeting system is most effective when applied to operational areas that most benefit from it e.g. discretionary operations- research and development or advertising. The continuous changing nature of zero based budgeting systems tends to encourage a business culture which identifies problems and derives solutions for them. As a result this facilitates a high level of business performance.
Activity Based Budgeting
The concept from which activity based budgeting is established on is similar to that of activity based costing. The budget is output oriented whereas activity based costing is activity (cost-driver) oriented.
The use of activity based budgeting encourages responsibility accounting. The manufacturing company (Langdale ltd) would benefit tremendously from the use of the budget, since the budgets approach is to identify relevant and irrelevant costs when making decisions. This encourages management and employees to control costs by taking corrective action before or when required to. This cost distinction improves the operating efficiency of the business.
Activity based budgeting is criticised for its arbitrary measure and allocation of costs. This is because it generally over simplifies costs and overlooks the effect external factors e.g. inflation, beyond the control scope that management has on business operations. Additional, the fact that activity based budgeting focuses on activities that drive costs makes it less efficient and effective. The budgets emphasis on cost control is done at the expense of non-financial value adding factors such as product quality and customer satisfaction.
The use of activity based budgeting improves the operations and efficiency of a business, if cost management is paramount to the operations of a business.
The company could increase its selling price by 3% to approximately £1,700 per batch. The company’s sales revenue would increase to £2,550,000 and consequently its net cash flow would increase to £176,277 from the previous £101,244. In turn it would generate the company £26,277 more than the targeted net cash flow of £150,000.
The increase in the selling price could increase the company’s net cash flow, as factors like the products demand remain the same. However this is highly unlikely according to the price elasticity of demand. A general increase in a products price is followed by a corresponding decrease in its demand, since customers can switch to substitutes or competitor brands who offer a lower price for the product. Under such circumstances the reduced demand would reduce both the company’s sales revenue and net cash flow.
Acquiring of a short-term loan
The company could get a short-term loan e.g. bank short term-loan or bank overdraft, which would meet some or all of its operational costs. This would provide the company with a significant amount of free cash flow which would in turn result in an increase in its net cash flow position.
A bank short-term loan has a couple of drawbacks which could outweigh its benefits. In this report the main focus is on its lack of flexibility the most predominant factor of all drawbacks. The interest charges that are paid on the bank loan are normally on a fixed rate basis, subject to the nominal value of the loan. In addition loans come with legally binding conditions if when breached the bank can call-up for the immediate full payment of the loan.
The use of a bank overdraft as a source of finance also has its own drawbacks with the major one being the high interest rate charges, with overdrafts ranging from £1,000-£4,999 incurring an annual interest rate +ranging from 11.9%-15.9%. Furthermore the bank can call-up for the full payment of the overdraft at any point in time. Therefore uncertainty as to when the bank will ask for a repayment is a serious problem, it could ask for repayment when the company is in its most vulnerable liquidity position. As a result net cash flows would be adversely affected.
Negotiation of payment terms
The company could negotiate its terms of payment for direct material with its supplier(s) by agreeing to settle them on a credit basis rather than cash. This would probably give the company more time and opportunities to generate greater net cash flows.
Paying for supplies on credit could result in the company losing benefits provided by the supplier e.g. cash and trade discounts. This would result in the company incurring high production costs due to the loss of economies of scale and as a result a it would earn a low net cash flow.
Issue of shares
Assuming that Landel ltd is a limited company, it could issue shares either in the form of a rights issue and/ the selling of its unissued shares. The rights issue can be made on a premium and would provide the company with much more cash compared to the issuing of shares at their nominal value. The cash received from either or both forms of issuing shares would improve the company’s net cash flow.
Issue of shares could also limit and probably reduce its net cash flow since it would have to pay dividends on those shares. Additionally the share issue could expose the company to take over.
It is highly recommended that the company analyses the benefits and costs aspect of any finance source(s) before implementation. This would ensure that it would take up the financing alternative(s) that are most beneficial to the company’s liquidity position.