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Sandeep Vilas Shirsekar

Batch 13 B Roll No 93

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Budgeting

* INTRODUCTION* TYPES* METHODS

Capital Budgeting

Working Capital Management

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INTRODUCTION:

For effective running of a business, management must know:

• where it intends to go i.e. organizational objectives

• how it intends to accomplish its objective i.e. plans

• whether individual plans fit in the overall organizational objective. i.e. coordination

• whether operations conform to the plan of operations relating to that period i.e. control

“Budgetary control is the device that a company uses for all these purposes.”

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WHAT IS A BUDGET?

“ A plan expressed in money. It is prepared and approved prior to the budget period and may show income, expenditure and the capital to be employed. May be drawn up showing incremental effects on former budgeted or actual figures, or be compiled by Zero-based budgeting.”

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WHAT IS BUDGETARY CONTROL?

Budgetary control is the use of the comprehensive system of budgeting to aid management in carrying out its functions like planning, coordination and control.

This system involves:

Division of organization on functional basis into different sections known as a budget centre.

Preparation of separate budgets for each “budget centre”.

Consolidation of all functional budgets to present overall organizational objectives during the forthcoming budget period.

Comparison of actual level of performance against budgets.

Reporting the variances with proper analysis to provide basis for future course of action.

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CLASSIFICATION OF BUDGETS

ACCORDING TO ACCORDING TO ACCORDING TO TIME FUNCTION FLEXIBILITY

1. Long term budget 1. Sales budget 1. Fixed budget2. Short term budget 2. Production budget 2. Flexible

budget3. Current budget 3. Cost of Production budget4. Rolling budget 4. Purchase budget 5. Personnel budget 6. R & D budget 7. Capital Expenditure budget 8. Cash budget 9. Master budget

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1. SALES BUDGET:

Sales budget is the most important budget based on which all the other budgets are built up. This budget is a forecast of quantities and values of sales to be achieved in a budget period.

2. PRODUCTION BUDGET:

Production budget involves planning the level of production which in turn involves the answer to the following questions:

a. What is to be produced?

b. When is it to be produced?

c. How is it to be produced?

d. Where is it to be produced?

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3. COST OF PRODUCTION BUDGET:

This budget is an estimate of cost of output planned for a budget period and may be classified into –

• Material Cost Budget

• Labour Cost Budget

• Overhead Cost Budget

4. PURCHASE BUDGET:

This budget provides information about the materials to be acquired from the market during the budget period.

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5. PERSONNEL BUDGET:

This budget gives an estimate of the requirements of direct labour essential to meet the production target.

This budget may be classified into –

a. Labour requirement budget

b. Labour recruitment budget

6. RESEARCH AND DEVELOPMENT BUDGET:

This budget provides an estimate of expenditure to be incurred on R & D during the budget period.

A R&D budget is prepared taking into consideration the research projects in hand and new R & D projects to be taken up.

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7. CAPITAL EXPENDITURE BUDGET:

This is an important budget providing for acquisition of assets necessitated by the following factors:

a. Replacement of existing assets.

b. Purchase of additional assets to meet increased production

c. Installation of improved type of machinery to reduce costs.

8. CASH BUDGET:

This budget gives an estimate of the anticipated receipts and payments of cash during the budget period.

Cash budget makes the provision for minimum cash balance to be maintained at all times.

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9. MASTER BUDGET:

CIMA defines this budget as “ The summary budget incorporating its component functional budget and which is finally approved, adopted and employed”.

Thus master budget is a summary of all functional budgets in capsule form available in one report.

10. FIXED BUDGET:

This is defined as a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained.

This budget will, therefore, be useful only when the actual level of activity corresponds to the budgeted level of activity.

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11. FLEXIBLE BUDGET:

CIMA defines this budget as one “ which, by recognising the difference in behaviour between fixed and variable costs in relation to fluctuations in output, turnover or other variable factors such as number of employees, is designed to change appropriately with such fluctuations”.

12. PERFORMANCE BUDGETING:

These days budgets are established in such a way so that each item of expenditure is related to specific responsibility centre and is closely linked with the performance of that standard.

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13. ZERO BASE BUDGETING:

The zero base budgeting is not based on the incremental approach and previous figures are not adopted as the base.

Zero is taken as the base and a budget is developed on the basis of likely activities for the future period.

A unique feature of ZBB is that it tries to help management answer the question, “Suppose we are to start our business from scratch, on what activities would we spent out money and to what activities would we give the highest priority?”

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14. RESPONSIBILITY ACCOUNTING:

Responsibility accounting fixes responsibility for cost control purposes by establishing responsibility centres namely –

a. Cost centre

b. Profit centre

c. Investment centre

Principles of responsibility accounting are as follows:

1. Fixation of targets for each responsibility centre

2. Actual performance is compared with the target

3. The variances therein are analyzed so as to fix the responsibility of centres.

4. Taking corrective action.

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CONCLUSION:

Ψ Preparation of budgets is the first step in the budgetary control system.

Ψ Implementation of budgets is the second phase.

Ψ But preparation and implementation of budgets alone will not achieve much unless a comparison is made regularly between the actual performance and the budgeted performance.

Ψ Continuous and proper reporting makes this possible.

Ψ To ensure the success of budgetary control system, proper follow up action has to be taken immediately for the reports submitted.

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CAPITAL BUDGETING

Capital budgeting is a decision situation where large funds are committed (invested) in the initial stages of the project and the returns are expected over a long period of time. These decisions are related to allocation of investible funds to different long-term assets.

Capital budgeting is a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc.

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BASIC FEATURES OF CAPITAL BUDGETING

Capital budgeting decisions have long-term implications.

These decisions involve substantial commitment of funds.

These decisions are irreversible and require analysis of minute details.

These decisions determine and affect the future growth of the firm.

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CAPITAL BUDGETING

DECISION INVOLVES

THREE STEPS

1. Estimation of costs and benefits of a proposal or of each alternative.

2. Estimation of the required rate of return, i.e., the cost of capital

3. Selection and applying the decision criterion.

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1. ESTIMATION OF CASH FLOWS

The costs and benefits for a capital budgeting decision situation are measured in terms of cash flows.

An important point is that all cash flows are considered on after tax basis. The rule is that all financial decisions are subservient to tax laws.

The cash flow from the project are compared with the cost of acquiring the project.

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The cash flows may be grouped into relevant and irrelevant cash flows as follows:

Relevant cash flows Irrelevant cash flows

• Cost of new project Sunk cost• Scrap value of old / new plant Allocated overheads• Trade-in-value of old plant Financial cash flows• Cost reduction / savings• Effect on tax liability• Incremental repairs• Working capital flows• Revenue from new proposal• Tax benefit of incremental

depreciation

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Calculation of different cash flows may be summarized as follows:

INITIAL CASH OUTFLOW:

Cost of new plant

+ Installation expenses

+ Other Capital expenditure

+ Additional working capital

– Tax benefit on account of capital loss on sale of old

plant (if any)

– Salvage value of old plant + Tax liability on account of

capital gain on sale of old plant (if any).

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SUBSEQUENT ANNUAL INFLOWS:

Profit after tax

+ Depreciation

+ Financial charge ( 1-t)

– Repairs (if any)

– Capital Expenditure (if any).

TERMINAL CASH FLOW:

Annual cash inflow

+ Working capital released

+ Scrap value of the plant (if any).

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2. DECISION CRITERIA

TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or

Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index

Return 3. Internal Rate of Return

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TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

I . PAYBACK PERIOD:

# The payback period is defined as “the number of years required for the proposal’s cumulative cash inflows to be equal to its cash outflows.”

# The payback period is the length of time required to recover the initial cost of the project.

# The payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds.

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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF RETURN

(ARR)

# The ARR may be defined as “the annualized net income earned on the average funds invested in a project.”

# The annual returns of a project are expressed as a percentage of the net investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100

Average Investment in the Project

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DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at different point of time are not having same economic worth.

I. NET PRESENT VALUE (NPV) METHOD:

The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with the proposal. The decision rule is “ Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative”.

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II. PROFITABILITY INDEX METHOD:

This technique is a variant of the NPV technique and is also known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI =

Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject the proposal if the PI is less than 1.

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III. INTERNAL RATE OF RETURN (IRR) METHOD:

The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows.

The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return.

The time-schedule of occurrence of future cash flows is known but the rate of discount is not.

The discount rate calculated will equate the present value of cash inflows with the present value of cash outflows.

- - - - - - - - - - - - - - - - - - - - -

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CAPITAL BUDGETING PRACTICES IN INDI

Capital budgeting decisions are undertaken at the top management level and are planned in advance. The Corporates follow mostly top-down approach in this regard.

Discounted cash flow techniques are more popular now.

High growth firms use IRR more frequently whereas Payback period is more widely used by small firms.

PI technique is used more by public sector units than by private sector units.

Capital budgeting decisions are of paramount importance as they affect the profitability of a firm, and are the major determinants of its efficiency and competing power.

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WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the problems that arise in managing the current assets, current liabilities and the interrelationships between them.

GOAL:

To manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.

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CONCEPTS:

GROSS WORKING CAPITAL – The current assets which represent the proportion of investment that circulates from one form to another in the ordinary conduct of business.

NET WORKING CAPITAL – The portion of current assets financed with long term funds or current assets – current liabilities

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PURPOSE:

The NWC is necessary because the cash outflows and inflows do not coincide.

The purpose of NWC is to measure the liquidity of the firm.

DETERMINING FINANCING MIX:

Financing mix is the choice of sources of financing of current assets.

SOURCES OF ASSET FINANCE:

1. Short term sources (Current liabilities)

2. Long term sources (Share capital, long term borrowings).

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INSTRUMENTS OF SHORT TERM FINANCING

ǿ Trade Credit

ǿ Bill Discounting

ǿ Inter Corporate Deposits

ǿ Public deposits

ǿ Commercial papers

ǿ Factoring

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APPROACHES TO DETERMINE FINANCING MIX

1. Hedging approach

2. Conservative approach

3. Trade off between the above mentioned two approaches.

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HEDGING APPROACH

(MATCHING APPROACH)

This is the process of matching maturities of debt with the maturities of financial needs.

According to Hedging approach, the permanent portion of funds required should be financed with long term funds and the seasonal portion with short term funds.

Under this approach working capital = 0 since CA are not financed by long term funds (CA = CL).

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CONSERVATIVE FINANCING APPROACH:

This is a strategy by which the firm finances all funds requirement, with long term funds and uses short term funds for emergencies or unexpected outflows.

TRADE OFF BETWEEN HEDGING AND CONSERVATIVE APPROACHES:

One possible trade off could be equal to the average of the minimum and maximum monthly requirements of funds during the given period of time. This level of requirement of funds may be financed through long run sources and for any additional financing need, short term funds may be used.

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FACTORS DETERMINING AMOUNT OF WORKING CAPITAL

Purchase Payment for Sell product Receive resources resource purchase on credit cash

Inventory Receivable conversion conversion period period

Payables Cash period Conversion period

Operating cycle

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The ‘length of the operating cycle’ is the most widely used method to determine working capital need.

The longer the production cycle, the larger is the working capital need or vice versa.

Manufacturing and trading enterprises require fairly large amount of working capital to support their production and sales activity. Service enterprises like hotels, restaurants etc., need less working capital.

During boom conditions need for working capital is more.

Growth industries and firms need more working capital.

Working capital requirement are to be determined on the basis of cash cost i.e excluding depreciation.

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