Constructing a Capital Budget

Introduction

This paper outlines the practice of budget in two entirely different businesses and working capital in a manufacturing company. The first part of this paper describes how budget exercised in these two companies, which are one in a static condition and another in a dynamic driven. Traditional approach of budgeting and budgetary control is still commonly used by most companies in the world despite of its limitations. In current rapidly changing environment, traditional budgeting no longer the only budgeting approach to be exercised in a company. There are some alternatives such as beyond budgeting, Zero-Based Budgeting, Activity-Based Budgeting, etc. which would be explained further in this paper. The second part of this paper describes how working capital holds major role in a company and how to improve each element in it. Working capital which generally consists of trade debtors, trade creditors, cash and stock can be improved individually to achieve optimal profit for the company.

Part A

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“A budget is a plan, expressed in financial and/or more generally quantitative terms, which extends forward for a period into the future” ((Gowthorpe, 2003) Cited from DocShare.com). The traditional budgeting typically developed from the review of past year’s budget with addition of extra value of changing factors, such as growth and inflation, from assumptions by the business. It is basically a fixed annual plan and tie managers to predetermined actions. It is based on hierarchy and centralized leadership (Stewart, 2004). It has offered many contributions over the years, but it seems unsuitable for the modern business (DocShare.com, 2009).

Serven (cited in Banham, 2000) argued, “The customary system of trying to accurately predict what will happen in 12 months and budgeting accordingly is an exercise in futility”. It is nonflexible to utilize the traditional budgeting in today business environment. “The business budget today generally used as a tool to formulate intelligent decisions on the management and growth of a business venture, enabling business to set priorities monitor progress toward both financial and non-financial goals.” (Hyperion, 1998) Most budget processes are inefficient and costly. It is complicated and it takes too long to be completed, by the time its finished the business environment has changed and the budget prepared no longer applied. According to Stewart (2004), there are ten reasons why budget cause problem, as it summarized in the next figure. Though traditional budgeting have such crucial weaknesses, but most companies still rely on it because its history and their unchallenged position in the top division of accepted management practices (Hope & Fraser, 1999).

Source: www.BusinessSculptors.com

Therefore many companies now seek to find alternatives of traditional budgeting, even some attempt to abandon it. However, some analysts estimate that as many as half the companies that attempt the overhaul become so exhausted they give up and go back to traditional approach (Banham, 2000).

Traditional Budgeting in Dynamic Business

In a business that operates in a very dynamic, rapidly changing, and innovative environment, traditional budgeting is inappropriate to exercise. Budget is a barrier for the business because the vibrant market demands flexibility, fast response, innovation, process improvement, customer focus, and shareholder value (Daum, 2001). And it is the limitation of the traditional budgeting not to be able to fulfil these demands. The dynamic driven business should keep up with the change and adaptive to recent development to achieve success.

Hence Beyond Budgeting approach introduced. Daum (2001) argued that, “The Beyond Budgeting Model is designed to overcome traditional barriers and to create a flexible, adaptable organization that gives your local managers the self-confidence and freedom to think differently, make decisions rapidly, and collaborate on innovative projects with colleagues in multifunctional teams both within your company and across its borders.” Exercising beyond budgeting may have become the turnaround for many companies of their budgeting problems.

Beyond budgeting is about a performance management system, made up of a series of interdependent and interlocking process (Verlag, 2005). The objective is to create an adaptive system to the real world that ideally develops the business plan from the environment, i.e. growth of markets, performance of competitors, etc. Then, instead of trying to meet a negotiated number in the budget, business should try to beat this performance standard (Verlag, 2005). Thus it would not make managers feel undervalued.

The process of beyond budgeting is portrayed in 12 principles of Beyond Budgeting (BBRT, 2005). The first six ‘process’ principles is concerning performance management systems that allows employees to response faster to customer needs and competitive environment. The second six ‘leadership’ principles provide a decentralization framework of responsibility to employees to facilitate them adapting quickly to potential events and improves their relative performance. Beyond budgeting can be exercised successfully by applying these principles and the business can be adaptive to the rapidly changing environment.

12 principles of Beyond Budgeting

Beyond Budgeting Process Principles

1. Targets Set aspirational goals based on continuous relative improvement not fixed targets

2. Rewards Base rewards on relative performance with hindsight not on meeting fixed targets

3. Planning Make planning an inclusive and continuous process not an annual event

4. Resources Make resources available on demand not through annual budget allocations

5. Coordination Coordinate cross company actions dynamically not though annual plans and budgets

6. Controls Base controls on KPIs, trends and relative indicators not variances against plan

Beyond Budgeting Leadership Principles

1. Governance Base governance on clear values and boundaries not on detailed rules and budgets

2. PerformanceBuild a high performance culture based on relative success not on meeting targets

3. Freedom to act Devolve decision making authority to frontline teams don’t micro-manage them

4. Accountability Create a network of small units accountable for results not centralized hierarchies

5. Customer focus Focus everyone on improving customer outcomes not on meeting internal targets

6. InformationPromote open and shared information don’t restrict it to those who ‘need to know’

The benefits of beyond budgeting is it will examine targets, strategies, action plans, forecasts and management reports. Comparisons might also be made against competitors and past-year performance. It will concentrate on the key drivers of business performance. The purpose is to be alert and take advantage of new opportunities and respond to potential threats by using an advanced information system to make decisions early. Speed of action and good decisions are the result of beyond budgeting. (Hope & Fraser, 1999)

The major change required by beyond budgeting will raise some resistance to change (Verlag, 2005). Organisations will differ in scale, culture and business context. It would be challenging to demonstrate to key stakeholders that control can still be achieved without a budget (Max, 2005). Beyond budgeting may raise issues such as doubt of loosening control, giving front-line people decision-making authority, and trusting people to act in the best interest of the business that is not easy change to contemplate (Hope & Fraser, 1999). However if these issues can be handled, the business may gain success in long term.

For example, the companies that have successfully practised beyond budgeting and abandoned the traditional budgeting system are Volvo (one of Europe’s most profitable car manufacturers), IKEA (the world’s largest furniture manufacturer and retailer), etc. (Hope & Fraser, 1999). Many organizations that have gone beyond budgeting found that their performance has improved once the budgeting process was abandoned in favour of more relative and adaptive means of planning, evaluating performance and control (Stewart, 2004).

Although beyond budgeting is the most updated method, but not all companies can adapt to it. Thus the other alternative for the dynamic driven business is Activity-Based Budgeting (ABB). It focuses on generating a budget explicitly from activities and resources (Hansen, Otley, et all., 2003). It creates an operationally feasible budget before generating a financial budget.

Advantages of ABB approach is it allows better product, process, or activity costing and decision making, and better resource allocation to support organizational priorities. It identifies capacity issues and makes adjustment earlier in the budgeting process than under traditional budgeting which does not track resource consumption patterns. It enriches managers ability to respond to contingencies and also improves performance measurement, evaluation, and decision making (Hansen, Otley, et all., 2003). ABB can be a proper alternative for the dynamic company since it will provide more accurate analysis to quickly forecast the next budget compared to the traditional budgeting.

However, ABB is not without problems. According to Barret (2003), ABB can be difficult to understand about the rules relating outputs to resources and costs. Consequently business managers tend to be doubtful of the approach. Although ABB directly relates increase in the volume of an output with increases in certain activities, it does not help in linking activities with resources. Thus any application of one of these alternatives, whether it is beyond budgeting or ABB, must be considered thoroughly subject to the business current condition.

Traditional Budgeting in Static Business

In a business that operates in a very stable and static market place, where there is slight change in either products or demand every year, traditional budgeting still can be appropriate (Daum, 2001). Static business would not need to take a risk to change their invariable budgetary plan as it would cost higher and consume more time than usual. However if this condition continuously persisted, the business will never develop more than its current position. It could lead to boredom for the employees who seek for challenge. As it is argued by Hope & Fraser (1999), “Budgets are well known for reinforcing the command and control culture, constraining freedom and autonomy, and stifling the very challenges that excite prospective managers”.

As an alternative to the static business, Zero-Based Budgeting (ZBB) is introduced. ZBB refers to proposals by Pyhrr (1973); Cheek (1977) et al. to modify the traditional budgeting process in organizations in which budgeting is an incremental process in relation to the prior year’s actual expenditures. The proposed ZBB process requires each manager to justify the budget request approximating the organizational functions were starting from “ground zero”. It entails clarifying the goals of an organizational unit as well as identifying the functions and projects it proposes to perform in order to achieve its goals. These activities are then ranked in order of importance (Flamholtz, 1983). Basically it is a systematic logical approach to allocate limited resources where they will be best used.

Benefits of ZBB are cost saving, improving services, increase self-discipline in developing budget, reduce the entitlement mentality with respect to cost increases and make budget discussions more meaningful during review sessions (LaFaive, 2003). On the contrary ZBB also can cause problems for example, may increase the time and expense of preparing budget, may be too radical a solution for the task at hand, and can make matters worse if not conducted accordingly. Moreover a substantial commitment must be made by all sectors involved to ensure that the change is followed through (LaFaive, 2003). ZBB is recommended for the static businesses in order to improve performance. It can be useful for shaking up a process that may have grown stale and counterproductive over time (LaFaive, 2003).

Variance analysis is still the most common tools to calculate the mismatch between the planned budget and the actual performance. Based on the survey by Sulaiman, Ahmad & Alwi (2005), the common practice among local Japanese (about 71%) and local Malaysian companies (about 64%) is to investigate variances only when the variance exceeds a certain percentage. This is a typical characteristic of traditional budgeting. However it is inadequate to be used in today modern business. Thus Ramsey (1999) introduced diagnostic variance analysis, where budget variances are analysed in terms of the activity-based components that make up the variance, and evaluated in light of overall business performance. As a result of this analysis, the underlying cause of the variance is revealed, providing the necessary business insight to support strategic decisions.

In conclusion, traditional approach cannot be abandoned completely. Budgeting is still very important in the company and need serious attention in the organization in spite of its complication (France, 2006). Zero-Based Budgeting and Activity-Based Budgeting are only improvement of traditional approach. In a dynamic driven business that evolve in rapidly changing environment like today modern business ambience, beyond budgeting can be the suitable alternative with proper handling in the organization. As for the static business, ZZB can assist the breakthrough in the organization so that the business will develop more and achieve success in the future.

Part B

Working capital management is important for XYZ Limited as a medium sized manufacturing business. XYZ Limited has most of their assets in the form of current assets and also current liabilities for their one of main external finances (Teruel & Solano, 2007). Working capital components of XYZ are cash, debtors, stocks of raw materials, work in progress and finished goods and creditors. Each of these components can be improved as it will be discussed together with its implication to others.

Working capital is the amount available in liquid that invested to build the business. In general, a company with surplus working capital will be more successful since they can expand and improve their operations (WebFinance Inc., 1999). Meanwhile companies with negative working capital may find difficulties to grow the business due to lack of funds.

To improve working capital, XYZ Limited can choose between the relative benefits of two basic types of strategies for working capital management; to minimize working capital investment or to adopt working capital policies designed to increase sales. However, the management of XYZ has to evaluate the trade-off between expected profitability and risk before deciding the optimal level of investment in current assets (Teruel & Solano, 2007). Profitability and risk have positive relationship. When company make decision that involve high risk, the expected profitability company will also increased. So does when company make decision that involve risk reduction, potential profitability of the company decreased as well.

Minimizing working capital investment would increase company’s profitability by cutting the proportion of its total assets in the form of net current assets. However, if the inventory levels are reduced sigificantly, the firm risks losing increases in sales (Wang,2002). Moreover a significant cutback for trade credit granted may trigger sales decline from customers requiring credit.

On the other hand, investing heavily in working capital may also result in higher profitability. Specifically maintaining high inventory levels cut down the cost of possible disturbance in the production process and loss of business due to the scarcity of products, reduces supply costs, and protects against price fluctuations, etc. (Teruel & Solano, 2007) In addition, granting trade credit promote the company’s sales in various ways. Trade credit can perform as an effective price reduction, enhance customers order to acquire goods at times of low demand, allows customers to check that the goods they receive is as agreed (quantity and quality) and to ensure that the services contracted are carried out, and helps company to intensify long-term relationships with their customers. However, these benefits have to offset the reduction in profitability due to the increase of investment in current assets. (Smith, 1987; Ng et al., 1999)

Basically if the company can obtain cash to move faster around the working capital cycle as it shown in figure 1 (e.g. by collecting payment due from debtors faster) or reduce the amount of cash tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need less to fund working capital. (http://tutor2u.net/business/images/working_capital_cycle.gif) As a consequence, the company could reduce the cost of bank interest or it will have additional money available to support supplementary sales growth or investment. Likewise, if the company can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit; it will effectively create extra finance to help fund future sales. (PlanWare, 2009)

The first component of XYZ working capital is cash. The cash conversion cycle was a key factor in working capital management (Gitman, 1974). It is a reflection of decisions about amount to invest in the customer and inventory accounts, and quantity of credit to accept from suppliers which represents the average number of days between the date when the company must start paying its suppliers and the date when it begins to collect payments from its customers (Teruel & Solano, 2007). The only way to improve this component is to shorten the cash conversion cycle which lead to better operating performance based on research by Wang (2002).

The second element is debtors. The objective is to obtain payment from debtors as fast as possible improving cash flow and minimising the risk of bad debts and not being paid at all (Cartwright, 2008). All staff in the company that dealing with the debtors should clearly understand the payment terms offered and ensure that debtors comprehend it as well. A cash discount system can be considered to encourage sales invoice to be paid faster. New debtors should go through a strict credit check to avoid incapibility to fulfill the payment. However, the company should not be too agressive to pursue the debtors because it may lead to antagonized debtors and loss of customers. (Boisjoly, 2009)

The third component is stock or inventory, which divided to raw materials, work-in-progress and finished goods. Managing inventory is about timing and organizing performance. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc. The key is to know how fast the overall stock is moving or how long each item of stock need to be kept before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. (PlanWare, 2009)

Meanwhile the work-in-progress is the stocks of unfinished goods. Work-in-progress can be sold out to customers as they will use it in their own production process or kept for XYZ’s production line. Keeping stocks of unfinished goods can be a useful way to protect production if there are problems down the line with other suppliers. As for the finished goods, the company may consider to stock up the finished goods when the demand is certain, goods are produced in batches and the company completing a large order. (Boisjoly, 2009)

The quantity of overall stocks the business keep will affect the cash conversion cycle, thus there are several factors the company should consider to determined the quantity to keep. There are the realibility of supply and availability of alternative sources; the production and delivery terms (whether it is in batches or singles); demand; the stability of price; and the availibility of discount if the company purchase in bulk. (Boisjoly, 2009) These are the factors the company need to consider because the longer material kept in inventory before they moved to production process, the higher cost it will charge to the company. If XYZ can shift inventory faster, then company can cut unnecessary costs and allocate the available cash to other process. (PlanWare, 2009)

In order to determine the quantity to keep in the business, nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular day, arrive at the factory early that morning. (Boisjoly, 2009) This helps to minimize manufacturing costs as JIT stocks take up minor space, minimize stock-holding and virtually eliminate the risks of obsolete stock. Company are able to conserve substantial cash because JIT manufacturers hold stock for a very short time. (PlanWare, 2009) It is the most common method to be used in certain industries if the business is in fast-moving environment. This method might suitable for XYZ if the company produce products with rapid development, where the stock is expensive to buy and store, and the goods are fragile or restocking goods is fast and effortless.

The last factor is creditors. The idea is to extend the time allowed for payment of expenses the business incurs (Cartwright, 2008). If company get better credit in terms of duration or amount from suppliers, then they are able to increase the cash resources. However, slow payment may signal inefficiency of the company. Therefore it is important to look after the creditors. Working capital often assumed to be well improved by squeezing the suppliers. However, this approach might impair sales and damage relations. Thus trade credit is offered as alternative to solve this issue. However it would depend on the industries involved. Some industries may need to improve their working capital by trade credit; some may not, because there are risks of competitive pressure, price discrimination and transaction pulling. Furthermore trade credit should not be done aggressively since it might damage the supply chain. When supply chain disrupted, the share price will drop. Applying the right mix of trade credit strategies will improve working capital of the company. (Seifert & Seifert, 2008)

In conclusion, working capital is playing a major role in XYZ Limited as a medium manufacturing company. It is important to improve working capital to enhance the liquidity and profitability of the company with the existence of risk. The key to improve working capital is to shorten the cash conversion cycle. Therefore fasten collection payment from debtors, proper inventory management and squeezing creditors can be effective to boost the cash flow. Nevertheless too aggressive persuasion of payment and extending the time of credit may decline sales, break the supply chain, and lead to antagonized customers. Hence improvement approach should be done in order.

Figure 1 The Working Capital Cycle

Taken from http://tutor2u.net/business/images/working_capital_cycle.gif

Word Count: 3,212 words

References

• Banham, Russ. (2000). Better Budget. Journal of Accountancy. Vol. 189. No. 2. Research Library

•Barret, Richard. (2003). How Incorporating Drivers Can Revolutionize Budgeting and Re-forecasting. The Journal of Bank Cost & Management Accounting. Vol.16. No. 1. ProQuest Central

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• Flamholtz, Eric G. (1983). Accounting, Budgeting and Control Systems in Their Organizational Context: Theoritical and Empirical Perspectives. Accounting, Organizations and Society Journal. Vol. 8. No. 2/3. Great Britain.

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List of references for Part B:

•Boisjoly, Russell P. (2009) The Cash Flow Implications of Managing Working Capital and Capital Investment. Journal of Business & Economic Studies. Vol. 15. No. 1.

• Cartwright, Terry. (2008). Manage Debtors and Creditors to Improve Liquidity. Icthus.Net Communication. [Internet] Available from:[30 Mar 2010]

• Dunn, Paul & Cheatham, Leo. (1993). Fundamentals of Small Business Financial Management for Start up, Survival, Growth, and Changing Economic Circumstances. Managerial Finance. Vol.19. No. 8. ProQuest Central.

• Gitman, L.J. (1974). Estimating Corporate Liquidity Requirements: A Simplified Approach. The

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• Shukla, Arun. (2009). Working Capital Management’s Role in the Turnaround Engagement. American Bankruptcy Institute Journal. Edition: June 2009. Vol. 28. No.5. Research Library.

• Seifert, Daniel & Seifert, Ralph W. (2008). Working Capital in Times of Financial Crisis: Three Trade Credit Strategies. Perspective for Managers Journal. No. 166. [Internet] Available from: [25 Mar 2010]

• Smith, J.K. (1987). Trade Credit and Informational Asymmetry. Journal of Finance. Vol. 42, pp. 863-72.

• Teruel, Pedro J. G.& Solano, Pedro M. (2007). Effects of Working Capital Management on SME Profitability. International Journal of Managerial Finance. Vol. 3. No. 2. Emerald Group Publishing Limited.

• Wang, Y.J. (2002). Liquidity Management, Operating Performance, and Coroporate Value: Evidence from Japan and Taiwan. Journal of Multinational Financial Management. Vol. 12.

• WebFinance Inc. (1999). Definition of Working Capital. WebFinance Inc. [Internet] Available from: [25 Mar 2010]

• WebFinance Inc. (1999). Definition of Working Capital. WebFinance Inc. [Internet] Available from: [25 Mar 2010]

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