CEE-CENTRE EXECUTIVE EDUCATION

Financial Decisions in
Business
Managing Finance
Rashida Yvonne Campbell
Table of Contents
Assignment Task....................................................................................................................................4
Answer Task A: Question 1: Present an Argued case for one of the Machines for the Firm to invest...5
Answer Task A: Question 2 Using two methods: Pay Back Period and Net Present Value Method.......7
2.1 Pay Back Period Method..........................................................................................................7
2.2 NPV at 4.5%.....................................................................................................................................9
2.3 NPV at 5.0%...................................................................................................................................10
2.4 NPV at 5.5%...................................................................................................................................11
2.5 NPV at 6.0%...................................................................................................................................12
2.6 Costs & Benefits (Advantages Vs Disadvantages) of Investment Appraisals Pay-Back-Period
Method and Net-Present-Value Method.............................................................................................13
Advantages of Net Present Value Method..........................................................................................15
Answer Task A: Question 3..................................................................................................................16
NON - Quantitative Factors Analysis....................................................................................................16
Task B..................................................................................................................................................17
Task C Budgets.....................................................................................................................................18
Introduction.........................................................................................................................................18
BUDGETS.............................................................................................................................................19
MULTIPLE FUNCTIONS/USES OF BUDGETS..........................................................................................20
Planning...............................................................................................................................................20
Objectives............................................................................................................................................20
Coordination........................................................................................................................................20
Communication...................................................................................................................................21
Framework..........................................................................................................................................21
Motivation...........................................................................................................................................21
Monitoring and Control.......................................................................................................................21
STAGES IN BUDGETING PROCESS........................................................................................................21
Various Budget examples and their practical usage in planning and decision making........................22
Sales budget........................................................................................................................................22
Practical usages in planning and decision making of sales budget..................................................22
Production budget...............................................................................................................................24
Practical usages in planning and decision making of production budgets.......................................24
Direct materials budget.......................................................................................................................24
Practical usages in planning and decision making of direct material budget...................................25
Direct labour budget...........................................................................................................................26
Practical usages in planning and decision making of direct labour budget..........................................26
Manufacturing overhead.....................................................................................................................27
Practical usages in planning and decision making of manufacturing overheads.............................27

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Selling expenses budget......................................................................................................................29
Practical usages in planning and decision making of selling expenses budget................................29
FLEXIBLE BUDGETING..........................................................................................................................31
Steps in flexible budgeting...............................................................................................................31
Uses of flexible budgets......................................................................................................31
MASTER BUDGETING...........................................................................................................................32
Advantages and Disadvantages of a Master Budget:.......................................................................32
CONCLUSIONS OF BUDGETS................................................................................................................33
Internet research on a company and how the budgets are prepared.................................................34
Hampton Freeze Inc Sales Budget.......................................................................................................34
Hampton Freeze Cash Collection Budget.............................................................................................35
After the Sales Budget the Production budget follows........................................................................35
Explanation of Production Budget of Hampton Freeze Inc..................................................................36
Hampton Freeze Ltd. Direct Material Budget......................................................................................36
Explanation of the Direct Materials Budget for Hampton Freeze Inc..................................................37
Direct labour budget for Hampton Freeze Inc.....................................................................................38
Explanation of the direct labour budget for Hampton Freeze Inc.......................................................38
Manufacturing overhead Budget of Hampton Freeze Ltd...................................................................39
Explanation of the Manufacturing Overhead Budget for Hampton Freeze Inc....................................39
Finally we look at the Hampton Freeze Selling and Administrative Expense Budget..........................40
Explanation of Selling and Administrative Expense Budget for Hampton Freeze Inc..........................40
Conclusions of Planning Budgets.........................................................................................................41
Flowchart of Budget plans and types..................................................................................................42
Bibliography.........................................................................................................................................43
References...........................................................................................................................................43

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Assignment Task
Description
The boost in sales for Starlight Ltd’s range of dark chocolate had been unexpected. Demand increased for
natural organic chocolate produced by the firm. Market research suggested that this was not a short-term fad
and forecasts of future sales were healthy. The Board accept the recommendations and want to invest in a
new piece of equipment for the production line that would automate some of the work allowing the current
staff to be utilised elsewhere, it would also speed up the production and meet expected demand.
Four possible equipments have been identified:
Machine 1
A German firm producing a high precision piece of equipment with software allowing different production runs
to be catered for.
Machine 2
The same equipment without the software option secured from a firm in Taiwan.
Machine 3
A different machine manufactured in Armenia, significantly cheaper!
Machine 4
Another machine with a different specification but which is suitable for the job required, produced by a firm in
the United States.
The costs associated with each machine are as follows:
Table A
Initial Cost Machine 1 Machine 2 Machine 3 Machine 4
£550,000 £550,000 £290,000 £460,000
Expected Cash Flow (£)
Year 1 20,000 50,000 15,000 30,000
Year 2 75,000 175,000 80,000 95,000
Year 3 125,000 200,000 120,000 150,000
Year 4 250,000 175,000 100,000 210,000
Year 5 200,000 70,000 60,000 300,000
The firm believes that the likely discount rate will vary from between 4.5% and 6%. The discount
tables for selected rates are shown below:
Table B
Rate in percentage
YEAR 4.5% 5.0% 5.5% 6.0%
1 0.9569378 0.9523810 0.9478673 0.9433962
2 0.9157300 0.9070295 0.8984524 0.8899964
3 0.8762966 0.8638376 0.8516137 0.8396193
4 0.8385613 0.8227025 0.8072167 0.7920937
5 0.8024510 0.7835262 0.7651344 0.7472582
Task A
1. Your task is to present an argued case for one of the machines that the firm should
invest in.
2. You should use at least two appropriate methods of investment appraisal in your
presentation and you should highlight relative costs and benefits of each method.
3. Advise the Board on other factors that will need to be considered in taking the
decision in addition to the quantitative analysis above.

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Answer Task A: Question 1: Present an Argued case for
one of the Machines for the Firm to invest.

Starlight Ltd has a choice of 4 machines to choose from. Below are the calculations for the
investment project appraisal. If the company considers numerative value under the Pay-
back-Period method then machine 2 would be recommended, as the payback period is the
shortest of 3 years and 257 days, compared to machine 1, 3 and 4. However as discussed
below there are disadvantages of this method. These disadvantages should be taken into
consideration before deciding to invest. Therefore the Net Present Value investment
appraisal method has been conducted to assist in the decision making for the machines. The
previously mentioned disadvantages such as time value and other factors are taken into
consideration under the Net present value method. The discounted rate has taken into
consideration rates from 4.5%, 5%, 5.5% and 6.0% providing four tables below. All four
calculations have concluded the same indication that machine 4 is the most positive NPV
rate on investment and has the highest value. Therefore if Starlight Ltd is to base its decision
under the NPV value then machine 4 is preferred. However other factors need to be
consider in conjunction with the investment appraisal methods, these factors have been
discussed below under ‘NON- Quantitative factors.’ Combining all the research it can be
concluded on the table below for all 4 machines:

Initial Investment Machine 1 Machine 2 Machine 3 Machine 4

Cost £550,000 £550,000 £290,000 £460,000
TOTAL Description of Machines
German, high No software Made in Suitable for the
precision with made in Taiwan Armenia, job made in
software, cheapest USA
allowing
different
production runs
PROFIT after 5yrs 670,000 670,000 375,000 785,000
Pay-Back-Period 4yrs, 144days 3yrs, 257 days 3yrs 270days 3yrs, 317days
NPV 4.5% 17.4862 (+) 36.2788 (+) 34.7712 (+) 203.9802 (+)

NPV 5% 7.4353 (+) 27.9365 (+) 29.7905 (+) 192.1402(+)

NPV 5.5% 2.376 (-) 19.7675 (+) 24.9175 (+) 180.5869(+)

NPV 6.0% 11.955 (-) 11.7676 (+) 20.1498(+) 169.3117(+)

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From the analysis already conducted below regarding the investment appraisals; together
with the points of non-quantitative factors taken into consideration. As well as the
concluding facts presented in the table above. It would be advisable for Starlight Ltd to
accept the investment project of Machine 4. The reasons for this are:
 The initial investment cost of £460,000 is not as high as machine 1 and 2.
 It is however higher than machine 3, but machine 3 is riskier in the sense of quality
and output, viability and profitability.
 According to the Payback method machine 2 is preferred, however machine 4 is still
recommendable as the difference in payback length of time is minimal. For machine
2 it is 3yrs and 257 days, for machine 4 it is 3yrs and 317 days; the difference in
payback of the two machines is only 60 days or 2 months. Therefore the profitability
and viability machine 4 is better if the difference is just a couple of months. Here we
need to consider also that the initial investment of machine 2 is much higher of
£550,000 for a Taiwan (associated poorer quality) and machine 4 of £460,000 of USA
quality.
 If machine 4 is compared to machine 1-of German quality and reliability as well as
the software, this too would seem feasible. However after performing the
investment appraisal methods we can note on the above table that the German
machine 1 has produced NEGATIVE NPV at 5.5% and 6.0%. Again this investment
would be too risky.
 Comparing the total profit value after 5 years on the above table, it can be concluded
that machine 4 is more profitable than machine 1, 2 and 3. Also bearing in mind
machine 3 is of Armenia quality (a brand that is not well known).
 According to all NPV calculations of 4.5%, 5%, 5.5% and 6% again machine 4 has
results that it is the most profitable choice.
Finally, machine 4 is recommended as it is the most profitable, the payback period has little
difference in length compared to machine 2, it has the highest rate of return according all
the NPV methods, its quality is also of USA standards.
Starlight Ltd should choose: Machine 4.

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Answer Task A: Question 2 Using two methods: Pay Back
Period and Net Present Value Method
There are three methods of project investment appraisals to evaluating whether a project is
of value to the organisation.
 The accounting rate of return (ROI). This method calculates profit that will be earned
and shows this in percentages of the capital invested. The higher the rate of return
the higher the project is ranked.
 The Pay Back Period (PBP). This method calculates the length of time a project will
take to recoup the initial investment. This method is based on cash-flows.
 Discounted Cash Flow has two methods:
o The Net Present Value (NPV). This calculates all the cash flows associated
with the project over the whole of its life and adjusts the future years to their
present value. Each project (machine) is then compared to each other to find
the difference between them. If the NPV is negative then that project should
not be considered. If the NPV is positive then that projected should be
recommended.
o The internal rate of return (IRR) calculates rate of return and compares the
rate of return with the cost of capital. If the project earns a higher rate of
return than the cost of capital then it is recommendable.
The two methods of appraisal that are chosen to answer this question are:
1. The Pay Back Period (PBP) method
2. The Net Present Value (NPV) method

2.1 Pay Back Period Method decides which machine pays back the amount invested at
the earliest time is the best choice under PBP.
Table 1 calculations show the cumulative return for all four machines over a period of 5
years.

Table 1: Pay Back Period Method of Investment Appraisal

Machine 1 Machine 2 Machine 3 Machine 4
Invested Cost
£550,000 £550,000 £290,000 £460,000
CF CF CF CF
         
£000's £000's £000's £000's
Year 1 20 20 50 50 15 15 30 30
Year 2 75 95 175 225 80 95 95 125
Year 3 125 220 200 425 120 215 150 275
Year 4 250 470 175 600 100 315 210 485
Year 5 200 670 70 670 60 375 300 785

Machine 1

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From Table 1 the value at year 4 is 470 from this value to year 5 is where the pay back is
received, to calculate the actual PBP the value 470 is subtracted from the total value at year
5. The calculations are as follows:
470 – 670 = 200
The total amount of investment is £550’s – 470 = 80

Therefore the actual pay back is 80 x 360 days = 144 days = 4 years and 144 days
200
Machine 2
From Table 1 the value at year 3 is 425 from this value to year 4 is where the pay back is
received, to calculate the actual PBP the value 600 is subtracted from the total value at year
4. The calculations are as follows:
425 – 600 = 175
The total amount of investment is £550’s – 425 = 125

Therefore the actual pay back is 125 x 360 days = 257 days = 3 years and 257 days
175
Machine 3
From Table 1 the value at year 3 is 215 from this value to year 4 is where the pay back is
received, to calculate the actual PBP the value 315 is subtracted from the total value at year
4. The calculations are as follows:
215 – 315 = 100
The total amount of investment £290’s – 215 = 75

Therefore the actual pay back is 75 x 360 days = 270 days = 3 years and 270 days
100
Machine 4
From Table 1 the value at year 3 is 275 from this value to year 4 is where the pay back is
received, to calculate the actual PBP the value 485 is subtracted from the total value at year
4. The calculations are as follows:
485 – 275 = 210
The total amount of investment is £460’s – 275 = 185

Therefore the actual pay back is 185 x 360 days = 317 days = 3 years and 317 days
210

Applying the pay back period method machine 2 has the shortest pay back period.
Therefore applying this form of investment appraisal machine 2 is preferred.

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2.2 NPV at 4.5%
2. The Net Present Value (NPV) method has been calculated for all four machines from year
1-5 at the percentage rate of 4.5% , in Table 2 below, using the information provided from
Table A and B above. The calculated answers are given to 4 decimal places rounded.

Table 2 NPV at 4.5% Discounted Rate

Present
Machine 1 (550) Machine 2 (550) Machine 3 (290) Machine 4 (460)
Value of
Cash-Flow £000's £000's £000's £000's

20 x 0.9569378 = 50 x 0.9569378 =  15 x 0.9569378 = 30 x 0.9569378 =

Year 1
19.1388 47.8469 14.3541 28.7081

75 x 0.9157300 =  175 x 0.9157300 =  80 x 0.9157300 =  95 x 0.9157300 =

Year 2
68.6798 160.2528 73.2584 86.9944

125 x 0.8762966 =  200 x 0.8762966 =  120 x 0.8762966 =  150 x 0.8762966 =

Year 3
109.5371 175.2593 105.1555 131.4445

250 x 0.8385613 =  175 x 0.8385613 =  100 x 0.8385613 =  210 x 0.8385613 =

Year 4
209.6403 146.7482 83.8561 176.0979

200 x 0.8024510 =  70 x 0.8024510 =  60 x 0.8024510 =  300 x 0.8024510 =

Year 5
160.4902 56.1716 48.1471 240.7353
Total 567.4862  586.2788  324.7712  663.9802
567.4862 – 586.2788 – 324.7712 – 663.9802 -
NPV 550,000 (money 550,000 (money 290,000 (money 460,000 (money
Value invested) = invested) = invested) = invested) =
NPV17.4862 (+) NPV36.2788 (+)  NPV34.7712 (+)  NPV203.9802(+) 

The Net Present Value at 4.5% discounting rate machine 4 has the best value. Where the
NPV is positive and the present value of benefits exceeds the present value of costs. This
means that the machine 4 will earn a return in excess of the cost of capital.
Machine 1 = NPV 17.4862
Machine 2 = NPV 36.2788
Machine 3 = NPV 34.7712
Therefore machine 4 under NPV at 4.5% = NPV 203.9802 should be accepted.

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2.3 NPV at 5.0%
2. The Net Present Value (NPV) method has been calculated for all four machines from year
1-5 at the percentage rate of 5.0% , in Table 3 below, using the information provided from
Table A and B above. The calculated answers are given to 4 decimal places rounded.

Table 3 NPV at 5.0% Discounted Rate

Present
Machine 1 (550) Machine 2 (550) Machine 3 (290) Machine 4 (460)
Value of
Cash-Flow £000's £000's £000's £000's

20 x 0.9523810 50 x 0.9523810  15 x 0.9523810 30 x 0.9523810

Year 1
=19.0476 =47.6191 =14.2857 =28.5714

75 x 0.9070295  175 x 0.9070295  80 x 0.9070295  95 x 0.9070295

Year 2
=68.0272 =158.7302 =72.5624 =86.1678

125 x 0.8638376  200 x 0.8638376  120 x 0.8638376  150 x 0.8638376

Year 3
=107.9797 =172.7675 =103.6605 =129.5756

250 x 0.8227025  175 x 0.8227025  100 x 0.8227025  210 x 0.8227025

Year 4
=205.6756 =143.9729 =82.2703 =172.7675

200 x 0.7835262  70 x 0.7835262  60 x 0.7835262  300 x 0.7835262

Year 5
=156.7052 =54.8468 =47.0116 =235.0579
Total 557.4353 577.9365 319.7905 652.1402
557.4353 – 577.9365 – 319.7905 – 652.1402 -
NPV 550,000 (money 550,000 (money 290,000 (money 460,000 (money
Value invested) = invested) = invested) = invested) =
NPV7.4353 (+) NPV27.9365 (+)  NPV29.7905 (+)  NPV192.1402(+) 

The Net Present Value at 5.0% discounting rate machine 4 has the best value. Where the
NPV is positive and the present value of benefits exceeds the present value of costs. This
means that the machine 4 will earn a return in excess of the cost of capital.
Machine 1 = NPV 7.4353
Machine 2 = NPV 27.9365
Machine 3 = NPV 29.7905
Therefore machine 4 under NPV at 5.0% = 192.1402 should be accepted.

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2.4 NPV at 5.5%

2. The Net Present Value (NPV) method has been calculated for all four machines from year
1-5 at the percentage rate of 5.5% , in Table 3 below, using the information provided from
Table A and B above. The calculated answers are given to 4 decimal places rounded.

Table 4 NPV at 5.5% Discounted Rate

Present
Machine 1 (550) Machine 2 (550) Machine 3 (290) Machine 4 (460)
Value of
Cash-Flow £000's £000's £000's £000's

20 x 0.9478673 50 x 0.9478673  15 x 0.9478673 30 x 0.9478673

Year 1
=18.9573 =47.3934 =14.2180 =28.4360

75 x 0.8984524  175 x 0.8984524  80 x 0.8984524  95 x 0.8984524

Year 2
=67.3839 =157.2291 =71.8762 =85.3530

125 x 0.8516137  200 x 0.8516137  120 x 0.8516137  150 x 0.8516137

Year 3
=106.4517 =170.3227 =102.1936 =127.7421

250 x 0.8072167  175 x 0.8072167  100 x 0.8072167  210 x 0.8072167

Year 4
=201.8042 =141.2629 =80.7217 =169.5155

200 x 0.7651344  70 x 0.7651344  60 x 0.7651344  300 x 0.7651344

Year 5
=153.0269 =53.5594 =45.9080 =229.5403
Total 547.624 569.7675 314.9175 640.5869
569.7675 – 314.9175 – 640.5869 -
547.624 – 550,000
NPV 550,000 (money 290,000 (money 460,000 (money
(money invested)
Value invested) = invested) = invested) =
= NPV2.376 (-)
NPV19.7675 (+)  NPV24.9175 (+)  NPV180.5869(+) 

The Net Present Value at 5.5% discounting rate machine 4 has the best value. Where the
NPV is positive and the present value of benefits exceeds the present value of costs. This
means that the machine 4 will earn a return in excess of the cost of capital.
Machine 1 = NPV 2.376 (-)
Machine 2 = NPV 19.7675
Machine 3 = NPV 24.9175
Therefore machine 4 under NPV at 5.5% = 180.5869 should be accepted.

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2.5 NPV at 6.0%

2. The Net Present Value (NPV) method has been calculated for all four machines from year
1-5 at the percentage rate of 6.0% , in Table 3 below, using the information provided from
Table A and B above. The calculated answers are given to 4 decimal places rounded.

Table 5 NPV at 6.0% Discounted Rate

Present
Machine 1 (550) Machine 2 (550) Machine 3 (290) Machine 4 (460)
Value of
Cash-Flow £000's £000's £000's £000's

20 x 0.9433962 50 x 0.9433962  15 x 0.9433962 30 x 0.9433962

Year 1
=18.8679 =47.1698 =14.1509 =28.3019

75 x 0.8899964  175 x 0.8899964  80 x 0.8899964  95 x 0.8899964

Year 2
=66.7497 =155.7494 =71.1997 =84.5497

125 x 0.8396193  200 x 0.8396193  120 x 0.8396193  150 x 0.8396193

Year 3
=104.9524 =167.9239 =100.7543 =125.9429

250 x 0.7920937  175 x 0.7920937  100 x 0.7920937  210 x 0.7920937

Year 4
=198.0234 =138.6164 =79.2094 =166.3397

200 x 0.7472582  70 x 0.7472582  60 x 0.7472582  300 x 0.7472582

Year 5
=149.4516 =52.3081 =44.8355 =224.1775
Total 538.045 561.7676 310.1498 629.3117
310.1498 – 629.3117 -
538.045 – 550,000 561.7676– 550,000
NPV 290,000 (money 460,000 (money
(money invested) (money invested) =
Value invested) = invested) =
= NPV11.955 (-) NPV11.7676 (+) 
NPV20.1498(+)  NPV169.3117(+) 

The Net Present Value at 6.0% discounting rate machine 4 has the best value. Where the
NPV is positive and the present value of benefits exceeds the present value of costs. This
means that the machine 4 will earn a return in excess of the cost of capital.
Machine 1 = NPV 11.955 (-)
Machine 2 = NPV 11.7676
Machine 3 = NPV 20.1498
Therefore machine 4 under NPV at 6.0% = 169.3117 should be accepted.

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2.6 Costs & Benefits (Advantages Vs Disadvantages) of
Investment Appraisals Pay-Back-Period Method and Net-
Present-Value Method

The above calculations used two different approaches to the investment appraisals of the 4
machines over 5 years with various initial costs and various different expected cash flows.
The methods used are 1: Pay Back Period Method and 2: Net Present Value Method. The
following information examines:
 Advantages of using Pay-Back-Period Method
 Disadvantages of using Pay-Back-Period Method
 Advantages of Net Present Value Method
 Disadvantages of Net Present Value Method
Advantages of using Pay-Back-Period Method
The payback period method is one which gives greater weight to cash flows generated in
earlier years. The payback period is the length of time required before the total cash inflows
received from the project is equal to the original outlay. It is the length of time the
investment takes to pay itself back. The main advantages are:
 Fast method of calculating the length of time a firm can receive its original
investment.
 Simple to compute
 Provides some information on the risk of the investment
 Provides a crude measure of liquidity
 It is used widely as a supplement to more advanced methods
 Provides a quick insight to the investment project
 Able to make fast comparisons
 Its use will tend to minimise the effects of risk
 Its prediction is probably more accurate regarding the investment pay back
 Useful method as one of the first steps in project investment appraisals
 A good method to use for little sums of investments and not high risk investments
 Helps to provide a good estimation of when a firm can expect to receive its return on
investment, even when other methods are applied the payback method can be used
as an indicator to tell the firm when to expect its money back.
Disadvantages of using Pay-Back-Period Method
The main disadvantages relate to its viability and profitability. The Payback period has
limitations, decisions are made according to the projects shortest time to receive the
investment back and all other factors are not taken into consideration. Example: If an
investment of £100,000 is for a project and it will earn £20,000 every year which will be
recovered at the end of each year. Then according to the payback period method it will be
calculated as follows:

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 £100,000 = 5 years payback period
£20,000

Another example of its limitations:

If two machines require the same investment but provide different cash-inflows the payback
method profitability is not taken into consideration after the payback period:

Machine A Machine B
Cost of initial investment £10,000 £10,000

Cash Inflows per year

Year 1 1,000 5,000
Year 2 2,000 5,000
Year 3 6,000 1,000
Year 4 7,000 500
Year 5 8,000 500
£24,000 £12,000

This example shows that Machine B at the end of year 2 would be the chosen project for
investment according to the payback period method because the firm can recoup its initial
outlay by year 2. When compared to Machine A the payback period is not recouped until
the end of year 4. Therefore machine B would be preferred. Obviously profitability B is
ignored as well as depreciation and viability. Machine B from year 3 is no longer viable is
starts to deteriorate and produces a small amount of revenue and this could mean by the
end of year 5 the firm could be making a loss and negative return on the investment made.
From this example it can be noted that in actual fact Machine A is more viable and
profitable.
Summary of main disadvantages:
 No concrete decision criteria to indicate whether an investment increases the firm's
value
 Ignores cash flows beyond the payback period
 Ignores the time value of money
 Ignores the risk of future cash flows
 Depreciation value not considered
 Inflation rate whether it increases or decreases it not part of the Payback method
 Risk factor not considered
 No assessing of the total value of the projects
 Priority of decisions given on the shortest payback only
 Does not consider the value to shareholders and all relevant stakeholders
 Payback method does not specify any required comparison to other investments or
investment decision making

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  It indicates the maximum acceptable period for the investment.
 Does not consider NON-financial benefits
Because of these reasons, other methods of capital budgeting like net present value,
internal rate of return or discounted cash flow are generally preferred.

Advantages of Net Present Value Method

The impact of NPV on a project is to reflect on the projects cost’s and forecast its benefits.
The basic decision rule for a project appraisal using certainty equivalent values as inputs and
discounted at a rate adjusted for risk is simply to accept or reject the project depending on
whether its NPV is positive or negative, respectively. Similarly, when choosing among
alternative projects, the decision rule is to select the one with the highest NPV, provided
that it is positive. Investment criteria for a distribution of NPV’s generated through the
application of risk analysis are not always as clear-cut as this. NPV (Net Present Value) is
calculated in terms of currency while Payback method refers to the period of time required
for the return on an investment to repay the total initial investment. NPV, payback, and
many other measurements form a number of solutions to evaluate project value. NPV is the
best single measure of profitability. While NPV measures the total monetary value of
project benefits. NPV, payback period fully considered, is the better way to compare with
different investment projects. NPV is the standard method for the financial appraisal of
long-term projects. NPV is used for two main reasons; Assessing the value of a project and
choosing which project gets priority. Main advantages:
 NPV is used to understand the future value of money in today’s terms, for example if
we invest £1,000 today then this is its present value; however in 10 years time the
value of £1,000 will be different
 It helps to present the cost benefit of a project.
 It helps compare the value of different projects against investment targets.
 Tells whether the investment will increase the firm’s value
 Considers all the cash-flows
 It is a direct measure of the monetary contribution to the stockholders if the NPV
method is followed the shareholder wealth will be maximised, providing the value is
positive, shareholders will be better off if the project is accepted
 Considers the time value of money
 Considers the risk of future cash-flows (through the cost of capital)
 Profitability is considered after the payback period
NPV is a useful starting point to value investments, but certainly not a definitive answer that
an investor can rely on for all investment decisions. There are problems with the NPV
method.

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Disadvantages of Net Present Value Method
 NPV is NOT useful when a project’s benefits are only going to run short-term such as
less than one year.
 Similarly if a project’s benefits are NON-financial then NPV is not viable.
 A small increase or decrease in the discount rate will have a considerable effect on
the final output.
 Using NPV method, the disadvantage is that the project size is not measured
 It doesn’t consider the intangible benefits
 It doesn’t account for flexibility/uncertainty
 Expressed in monetary value not percentages
 Time consuming calculations
 There is a possibility that the investment won't have the same level of risk
throughout its entire time horizon, NPV takes a certain amount of risk factor but not
a variation of levels of risks
 A major disadvantage to using NPV as an investment criterion is that it wholly
excludes the value of any real options that may exist within the investment. For
example, opportunities that may arise such as growth, increases/decreases in
demand.
 Quality is also not taken into consideration

Answer Task A: Question 3

NON - Quantitative Factors Analysis

Although investment appraisal forces a complete financial analysis of any proposed
investment, there are other factors that also need to be considered before a decision to
invest is made. These factors include:
 Can staff handle the changes brought about by investment; can they be trained to
use new technology?
 Impact on existing products. Will managers concentrate on new products/
investment to the detriment of existing output?
 The state of the economy. Is the economy booming? Or is a recession, which is likely
to reduce demand, on the way?
 Action of competitors. Are they investing, improving their products?
 Availability of new technology. New technology is one of the main factors that
encourage further investment. Perhaps it is better to wait for the latest
machinery/equipment if it is not too far in the future. For Example, if a much better
value for money and output machinery is about to be launched on the market then it
maybe better to wait.

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  Confidence of managers. Optimistic managers are more likely to invest.
 Need to consider if there will be a reduction in manufacturing operating lead time
 Considerations whether the project will increase in manufacturing flexibility
 Consider the quality of the machinery and its output quality, does it provide fewer
product failures and better service
 The planned action may be unethical and is thus damaging, there is no point for
Starlight Ltd Company to produce organic chocolate at the expense of ruining the
environment, it will result in bad publicity.
 Will the new project improve the firm’s competitive position?
 Need to consider the quality in reduction in product design and development time
 Is the quality of the machinery providing faster response to marketing changes and
customer needs
 Corporate objectives also have to judge if the investment is aligned to your
corporate objectives
 Industrial relations – what is the impact on the work force – does it decrease jobs?
Eventual decision may rest on the balance between the perceived effects of quantitative
and qualitative. If the long term effect on the workforce for example was to reduce
productivity or increase absence because of the impact on motivation and morale,
the fact that a decision makes financial sense in quantitative terms, does not mean it is
viable in qualitative terms regarding the machinery, company, workforce etc.

Task B

ABC Company is a manufacturer of industrial machines and the following data is available

for the first half of the year 2007.

Cost of material: £10,000

Wages paid: £15,000 (£7,500 [half was due at the start of the year])

Other factory Expenses: £10,000

Rent of Factory: £5,000 (12 months therefore £2,500)

Marketing and other expenses £2,000

Provided that 500 units were made, what is the unit cost in the first half of the year? The

selling price is £1,000 per machine; calculate the profit made during the period.

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 Answer Task B

Calculation of Cost and Profit for 1st half year 2007 for ABC Company
£000’s Total Cost per unit Calculation
Material Costs 10,000 10,000/500units = £20
Wages 7,500 7,500/500units = £15
Other Factory 10,000 10,000/500units = £20
Expenses

Factory sub-total 27,500 Sub-total cost of unit = £55

Rent of 2,500 2,500/500units = £5

Factory
Marketing 2,000 2,000/500units = £4
Expenses

Total costs 32,000 Total cost of unit = £64

Selling price £500,000 =(£1,000 - £64) = £936

Therefore the profit of 500units x £936 = £468,000

Task C Budgets
Write an Essay: “Identify different types of budgets and analyse the use of budgets with
different practical examples”.

Introduction
The following essay will define a budget and the different types of budgets. An explanation
of each budget shall be provided in more detail with practical examples. Also an analysis on
how budgets help in the financial planning and decision making of an organisation; together
with practical examples where applicable. In addition to this a conclusion regarding the
budgets shall be given. Finally additionally research of 2 companies identifying their
investment options and how the budgets are prepared will be examined to supply
information on the reality and practicality of budgets and their uses.

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 BUDGETS

Definition of a Budget
A budget is a plan for the future. Hence, budgets are planning tools, and they are usually
prepared prior to the start of the period being budgeted. However, the comparison of the
budget to actual results provides valuable information about performance. Therefore,
budgets are both planning tools and performance evaluation tools. It is expressed in
monetary term. The plan covers income, expenditure and capital investment. There are
various types of budgets that need to be constructed before the master budget is finalised.
Budgets are part of a company's long-range planning system. While some portions of a long-
range plan are concerned with the organization in five to ten years, the budget is the short-
range portion of the plan. The following figure 1.1 shows that how the budgetary process
fits into an overall general framework of planning, decision-making and control.
See flow-chart below, figure 1:

1. Establish objectives

2. Identify potential courses of action (i.e. strategies)

3. Evaluate alternative strategic options

Long-term
planning
4. Select alternative courses of action
process

5. Implement long-term plan in the form of the annual budget

Annual
6. Monitor actual results
budgeting
process
7. Respond to divergences from plan

Figure 1 the role of long-term planning and budgeting within the

planning, decision-making and control process

A budget is a quantitative plan for the future that assists the organization in coordinating
activities. All large organizations prepare budgets. Many organizations prepare detailed
budgets that look one year ahead, and budgets that look further into the future that contain
relatively less detail and more general strategic direction.

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MULTIPLE FUNCTIONS/USES OF BUDGETS

Budgets serve a number of useful purposes. They include:

1. To ensure planning, decision making and annual operations
2. Helps to strive to achieve the organizational goals and objectives
3. Coordinating the activities of the various parts of the organization, departments,
sub-units, and ensuring that the parts are in harmony with each other
4. Communicating plans and ideas to the various responsibility centre managers;
making sure that there is a formal system and that all persons are included
5. It provides a framework for responsibility so managers are responsible for the
achievement of budget targets
6. Motivating managers and employees to improve their performance through giving
feedback of actual results, with expectations of a minimum level and a desired level.
7. It should provide a system of monitoring and controlling activities, performance and
results. Evaluating the performance of managers, individuals and departments

Planning
The budgeting process ensures that managers do plan for future operations, and that they
consider how conditions in the next year might change and what steps they should take
now to respond to these changed conditions. This process encourages managers to
anticipate problems before they arise, and hasty decisions that are made on the spur of the
moment, based on expediency rather than reasoned judgment will be minimized.

Objectives
The budget must ensure the achievement of the organisation’s objectives. Objectives for the
organisation as a whole, and for individual departments and operations within the
organisation are set. Quantified expressions of these objectives are then drawn up as
targets to be achieved within the timescale of the budget plan.

Coordination
The budget serves as a vehicle through which the actions of the different parts of an
organization can be brought together and reconciled into a common plan. Without any
guidance, managers may each make their own decisions, believing that they are working in
the best interests of the organization. All units and departments need to be coordinated.
For example the purchasing department should base its budget on production requirements
and the production department must base its budget on the sales expectations.

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Communication
Through the budget, top management communicates its expectations to lower level
management, so that all members of the organization may understand these expectations
and can coordinate their activities to attain them.

Framework
The budget must include a framework for responsibility. Budgetary planning and control
systems require that managers of cost and profit centres are made responsible for the
achievement of budget targets for the operations under their personal control.

Motivation
The budget can be a useful device for influencing managerial behaviour and motivating
managers to perform in line with the organizational objectives. A budget provides a
standard that under certain circumstances, a manager may be motivated to strive to
achieve.

Monitoring and Control

A budget assists managers in managing and controlling the activities for which they are
responsible. By comparing the actual results with the budgeted amounts for different
categories of expenses, managers can ascertain which costs do not conform to the original
plan and thus require their attention.

STAGES IN BUDGETING PROCESS

Identify limiting factor’s, a firm must also consider any outstanding limiting factors, such as
raw materials, machinery output, labour, power etc. If there are no limiting factors then the
forecasting of sales needs to be conducted and a budget based around the sales forecast
should be prepared. This would be a typical procedure, as organisations exist because of the
sales that they profit from, the budget may also include any existing capital that the
company may have. The budget must be formulated according to the company’s overall
objectives. After identifying whether there are any limiting factors the important steps are
as follows:
1. Limiting factors (as mentioned above)
2. Preparation of the sales budget

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 3. Preparation of a finished goods stock budget
4. Preparation of a production budget
5. Preparation of budgets of resources for production
 Materials budget
 Machine utilisation budget
 Labour/wages/personnel budget
6. Preparation of overhead cost budget
 Production overhead budget
 Administration overhead budget
 Selling and distribution overhead budget
 Research and development department overhead budget
7. Co-ordination and review of budgets
8. Preparation of a master budget

Various Budget examples and their practical usage in

planning and decision making

Sales budget

The sales budget is the starting point in putting together a comprehensive budget for a
business. It includes the number of units to be sold and the selling price per unit. It is
important to agree to the sales budget first because many other budgets are based on this
data. The sales budget is the primary budget. The necessary forecasts need to be studied
and concluded before preparing the sales budget. Although its components are simple,
getting a management team to agree on the number of units to be sold and the selling price
per unit, the two items needed to prepare the budget, is often difficult and time-
consuming.

Practical usages in planning and decision making of sales budget

It is the first step in the planning process of the budget. Without the sales budget decision
cannot be established by other departments regarding their budgets. A sales budget takes
into consideration number of factors and helps the management to make decisions on the
production capacity of the organisation with target sales objectives. It assists managers to
match the demand for the products to the machines capability and decide how much should
be produced at what price.
The Russian Pickup Trucks Company www.RPTC.com which makes trucks has just completed
its budgeting process for next year. Total expected sales are 100,000 trucks at a price of
Rs.15.00 each. Its sales budget has been prepared on a quarterly basis as follows:

The Pickup Trucks Company Sales Budget For the Year Ended
December 31, 20X1

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 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units 15,000 17,000 28,000 40,000 100,000
Selling Price Rs.15 Rs.15 Rs.15 Rs.15 Rs.15
Total Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000

In addition to annual and quarterly sales budgets, monthly budgets are often prepared so
sales can be tracked against expectations more frequently than once every three months.
We need to forecast the volume of sales to understand the possible revenue that the
business will generate. Sales are estimated in physical units of production and monetary
values. It assists in the planning and decision making process so that decisions on possible
changes in the market and identification of new markets to move their products and
services into. This type of budget provides an insight into the Statistical Analysis of output
and revenue. Statistical analysis will enable those preparing the budget to predict possible
future demand. Statistical analysis can be as simplistic as calculating averages based on past
sales to identify trends that can be extrapolated into the future. It converts these into
expectations on the basis of sales forecasting.

Another example let’s assume a firm produces 4 products, involving $20 million in annual
sales. Let us assume that projections suggest that sales of 400,000 units at an average price
of $100 can be confidently included in the budget. The decisions regarding the sales budget
could be divided such as the following:

This allows managers to decide which product takes priority in allocating certain amounts of
the budget and making predictions. To confirm its feasibility other budgets need to be
prepared and analyzed.
Before preparing the direct materials, direct labor, and manufacturing overhead budgets,
the production budget must be completed.

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Production budget

The production budget shows the number of units that must be produced. To budget for
annual production, three things must be known: the number of units to be sold, the
required level of inventory at the end of the year, and the number of units, if any, in the
beginning inventory. If quarterly budgets are required, this same information is needed on a
quarterly basis.

Practical usages in planning and decision making of production

budgets

Using the Pickup Trucks Company's quarterly sales budget and given that 15% of the next
quarter's sales volume must be on hand before the quarter begins, the production budget
by quarter can be prepared. Further assumptions are a 10% increase in sales in quarter one
of next year compared to the current year's quarter-one sales and 2,250 units in inventory
at the beginning of the year.
Pickup Trucks Company Production Budget in Units for 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Sales 15,000 17,000 28,000 40,000 100,000
Required Ending Inventory 2,550 4,200 6,000 2,475 2,475
Units Required 17,550 21,200 34,000 42,475 102,475
Beginning Inventory (2,250) (2,550) (4,200) (6,000) (2,250)
Units to be Produced 15,300 18,650 29,800 36,475 100,225

The benefit of production budgets allows managers to maximize on inventory; it enables them to
make decisions regarding the control of stock and the already existing stock that needs to be sold. By
performing a budget for production it avoids the wastage of time, money, machinery depreciation
and storage space. As unsold goods need storage so it needs to be considered within the whole
production budget so that over producing or under producing of goods is avoided .

Direct materials budget

The direct materials budget determines the number of units of raw materials to be
purchased. It uses the number of units to be produced from the production budget, the
required level of ending inventory for raw materials, and the number of units in beginning
inventory. Once the number of units to be purchased is determined, it is multiplied by the
cost per unit to determine the budgeted amount for raw materials purchases.

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 Practical usages in planning and decision making of direct
material budget

The Pickup Trucks Company requires 10% of next quarter's production requirement for raw
materials to be in its ending inventory. For example, because it takes five Tyres to make the
special pickup truck (four plus the spare tire mounted on the side), at a cost of Rs.0.50 per
tire, the raw materials purchases budget calculates 501,890 tires required at a cost of
Rs.250,945. The units in the production budget are adjusted for units in ending and
beginning inventories, multiplied by five (number of tires per pick up) to determine total
tires to be purchased and then multiplied by Rs.0.50 to determine the cost of the tires
needed. As a reminder, the production budget showed the following units for 20X1:

Units = Quarter 1 - 15,300 Units = Quarter 2 - 18,650 Units = Quarter 3 - 29,800

Units = Quarter 4 – 36,475
Total = 100,225
Pickup Trucks Company Raw Materials Budget For the Year 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units to be produced 15,300 18,650 29,800 36,475 100,225
Number of tires per unit ×5 ×5 ×5 ×5 ×5
76,500 93,250 149,000 182,375 501,125
Required ending inventory 9,325 14,900 18,238 8,415 8,415
Total units required 85,825 108,150 167,238 190,790 509,540
Beginning inventory (7,650) (9,325) (14,900) (18,238) (7,650)
Units to purchase 78,175 98,825 152,338 172,552 501,890
Cost per unit × × × × ×
Rs.0.15 Rs.0.15 Rs.0.15 Rs.0.15 Rs.0.15
Cost of raw materials Rs.11,726 Rs. 14,824 Rs. 22,851 Rs. 25,883 Rs. 75,284
purchases

This process is repeated for all the other raw material components used in producing a
pickup truck. The materials budget is an essential element to the planning process. Without
the necessary materials and the amount of materials budgeted for the end product would
not be viable. It also assists managers in the purchasing department to predict what and
how much raw materials are needed for the duration. It is also important to the overall
calculation of cost of unit and this will determine eventually the price of the product. A
company uses the planning of a direct-materials budget to determine the adequacy of their
storage space, to institute or refine Just-in-Time (JIT) inventory systems, to review the ability
of vendors to supply materials in the quantities desired, and to schedule material purchases
inline with the flow of funds into the company.

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Direct labour budget

The direct labor budget shows the number of direct labor hours and the cost of the labor to
determine the total cost of direct labor. Assume it takes one-half hour of labor to put
together one pickup truck and each labor hour costs Rs.14.00. The total direct labor budget
is for 50,113 (100,225 units × .5 hours per unit) hours at a cost of Rs.701,575 (Rs.14.00
per hour × 50,113 hours). The break out by quarter is shown in the following table.

Practical usages in planning and decision making of

direct labour budget
Once a company has determined the number of units of production, it calculates the
number of direct-labour hours needed. A company states this budget in the number of units
and the total dollar costs. A company may sort and display labour-hours using parameters
such as: the type of operation, the types of employees used, and the cost centres involved.
Again using the Pickup Trucks Company as an example:
Pickup Trucks Company Direct Labour Budget For the Year 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units to be produced 15,300 18,650 29,800 36,475 100,225
Direct labor hours per × .5 × .5 × .5 × .5 × .5
unit
Total direct labor hours 7,650 9,325 14,900 18,237.5 50,112.5
Cost per hour ×Rs.14.00 ×Rs.14.00 ×Rs.14.00 ×Rs.14.00 ×Rs.14.00
Cost of direct labor Rs.107,100 Rs.130,550 Rs.208,600 Rs.255,325 Rs.701,575

The budgeted rates per hour for direct labour are provided by the human resource
department. Frequently the labour (union) contract provides the source for this
information. Many different types of labour may be required with different levels of
expertise and experience. The labour/wages budget helps managers and the various
departments to include the costs in the calculation towards the overall cost of production
before the final selling price and numerical output can be finally determined. It provides a
strong guideline to managers regarding the hours and costs. It also allows managers to
estimate if there is a need to increase the human resource element in order to improve the
production target to meet the sales budget targets.

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Manufacturing overhead

Production overhead contains numerous items. Managers include in their decisions some of
the following factors:
 Indirect materials factory supplies which are used in the process but are not an
integral part of the final product, such as parts for machines and safety devices for
the workers; or materials which are an integral part of the final product but are
difficult to assign to specific products, for example, adhesives, wire, and nails.
 Indirect labour costs supervisors' salaries and salaries of maintenance, medical, and
security personnel.
 Plant occupancy costs rent or depreciation on buildings, insurance on buildings,
property taxes on land and buildings, maintenance and repairs on buildings, and
utilities.
 Machinery and equipment costs rent or depreciation on machinery, insurance and
property taxes on machinery, and maintenance and repairs on machinery.
 Cost of compliance with federal, state, and local regulations meeting safety
requirements, disposal of hazardous waste materials, and control over factory
emissions.

Practical usages in planning and decision making of

manufacturing overheads

The manufacturing overhead budget identifies the expected variable and fixed overhead
costs for the year (or other period) being budgeted. The separation between fixed and
variable costs is important because the Pickup Trucks Company uses a predetermined
overhead rate for applying overhead to units produced. In preparing its budget, the Pickup
Trucks Company has identified the following variable and fixed costs: indirect materials
Rs.0.50 per unit, indirect labor Rs.1.00 per unit, maintenance Rs.0.75 per unit, annual
depreciation Rs.12,000, supervisory salaries Rs.24,000, and property taxes and insurance
Rs.21,000. The budget by quarter is:

Pickup Trucks Company Manufacturing Overhead Budget

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Variable Costs
  Indirect Materials Rs.7,650 Rs.9,325 Rs14,900 Rs.18,238 Rs.50,113
  Indirect Labor 15,300 18,650 29,800 36,475 100,225
  Maintenance 11,475 13,988 22,350 27,356 75,169

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 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
    Total Variable Costs 34,425 41,963 67,050 82,069 225,507
Fixed Costs
  Supervisory Salaries 3,000 3,000 3,000 5,700 14,700
  Property Taxes and Insurance 6,000 6,000 6,000 6,000 24,000
  Depreciation 5,250 5,250 5,250 5,250 21,000
    Total Fixed Costs 14,250 14,250 14,250 16,950 59,700
Total Manufacturing Overhead Rs.48,675 Rs.56,213 Rs.81,300 Rs.99,019 Rs.285,207
Total Direct Labor Hours 7,650 9,325 14,900 18,238 50,113
Predetermined Overhead Rate Rs.5.70

The importance of budgets for overheads is a vital management tool as can be seen from
the above table there are large sums of costs involved in the overheads. Overheads costs
may not be easily identifiable but contribute to the organisations total cost. To determine
the appropriate level of fixed costs at budget time, an Activity Based Costing (ABC) system
may be very helpful. It can help answer questions like, "How many clerks will we need to
hire to process the anticipated the number of purchase orders next year?"

Selling expenses budget

The selling and administrative expenses budget is a plan for all non-manufacturing
expenses. This particular budget gives you a guideline for selling and administrative

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activities during your budget period. Factory or manufacturing overheads includes the cost
of indirect material, indirect labour and indirect expenses. Manufacturing overheads may be
classified into
 Fixed overheads i.e., which tend to remain constant irrespective of change in the
volume of output,
 Variable overheads i.e., which tend to vary with the output,
 Semi-variable overheads, i.e., which are partly variable and partly fixed.
The manufacturing overhead budget will provide an estimate of these Overheads to be
incurred during the budget period. Fixed manufacturing overhead can be estimated on the
basis of past Information and knowledge of any changes which may occur during the
ensuring budget period. Variable overheads are estimated after considering the scheduled
production and operating conditions in the budget period.

Practical usages in planning and decision making of selling

expenses budget

As a practical example we assume the Pickup Trucks Company's variable expenses are sales
commissions and delivery expense. Sales commissions are 4% of sales dollars, and delivery
expense, also called freight out by some companies, is Rs.0.10 per unit sold. The company
also has fixed sales salaries of Rs.50,000. The calculations for sales commissions and delivery
expense, followed by the selling expenses budget, are shown in the following tables.

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Pickup Trucks Company Sales Commission and Delivery Expenses Budget Calculations For
the Year 20X1

Sales Commission
Expense

  Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000

  Commission Rate 4% 4% 4% 4% 4%
    Sales Commissions Rs.9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs.60,000

Delivery Expense
  Units Sold 15,000 17,000 28,000 40,000 100,000
  Cost per Unit Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10
    Delivery Expense Rs. 1,500 Rs. 1,700 Rs. 2,800 Rs. 4,000 Rs.10,000
Pickup Trucks Company Selling Expenses Budget For the Year 20X1

Variable Expenses
  Sales Commissions Rs. 9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs. 60,000
  Delivery Expense 1,500 1,700 2,800 4,000 10,000
  Total Variable Expenses 10,500 11,900 19,600 28,000 70,000
Fixed Expenses
  Sales Salaries 12,500 12,500 12,500 12,500 50,000
  Total Selling Expenses Rs.23,000 Rs.24,400 Rs.32,100 Rs.40,500 Rs.120,000

FLEXIBLE BUDGETING

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A flexible budget is a budget that is prepared for a range i.e. for more than one level of
activity. The flexible budget is also known as a variable, dynamic, sliding scale, step budget.
The underlying principle for a flexible budget is that every business is dynamic and ever
changing. Thus, a flexible budget is developed for a range, say 8000-10000 units of
production. Under this approach, if the actual production is 9000 units compared to the
projected amount of 10000 units, the manager uses the flexible budget to project the costs
for 9000 units of output in place of the budgeted 10000 units. The flexible budget covers a
range of activity, is easy to change with a variation in production levels, and thus facilitates
correct performance measurement and reporting.

Steps in flexible budgeting

The following steps are involved in developing a flexible budget:

 Deciding the range of activity to which the budget is to be prepared
 Determining the cost behaviour patterns (fixed, flexible, semi-variable) for each
element of cost to be included in the budget
 Selecting the activity levels in terms of production levels to prepare budgets at those
levels
 Preparing the budget at the pre-determined level of activity

Uses of flexible budgets

Accurate budgeting
Flexible budgets result in the preparation of more accurate budgets. Such budgets consider
the output and accordingly estimate the costs to be incurred at that level of output

Accurate performance measurement

Flexible budgeting incorporates changes in activity levels and compares actual performance
with the budget in terms of output achieved. This facilities more meaningful comparison
and evaluation of performance.
Coordination
Flexible budgeting results in proper coordination between various departments of a
company. For instance, if production is planned in relation to estimated sales, materials and
labour are acquired to meet expected production needs
Control tool
Such a budget acts as a control tool. Comparisons between the budgeted costs (at the actual
production level) and actual costs form the basis for analyzing cost variances and fixing
responsibility for the same.

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MASTER BUDGETING

The most common budgeting technique is to create a master budget which is the overall
collection of budgets for the operation of the organization. It consists of the budgets for
sales, manufacturing costs (materials, labour, and overhead) or merchandise purchases,
selling expenses, and general and administrative expenses. These budgets are fixed, static or
expected budgets. The master budget is established at the end of comprehensive collection
and finalisation of all the other budgets that the firm has set.
It usually consists of a number of separate but interdependent budgets. One budget may be
necessary before the other can be initiated. More one budget estimate affects other budget
estimates because the figures of one budget are usually used in the preparation of other
budget. This is the reason why these budgets are called interdependent budgets.

Advantages and Disadvantages of a Master Budget:

Some advantages of a master budget are that it can give an idea of where a company wants
to go and what it has to do in order to get there. It will also allow the company to
realistically project future cash flows which in turn would help in getting certain types of
financing. Some disadvantages of a master budget include the time involved in producing
such a budget. This is primarily the reason a smaller company may not make a master
budget if the company has a very small managerial staff.

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CONCLUSIONS OF BUDGETS

Like other control methods, budgets have the potential to help organizations and their
members reach their goals. Budget control offers several advantages to managers. Some of
these are:

 The major strength of budgeting is that it coordinates activities across departments.

 Budgets translate strategic plans into action. They specify the resources, revenues,
and activities required to carry out the strategic plan for the coming year.
 Budgets provide an excellent record of organizational activities.
 Budgets improve communication with employees.
 Budgets improve resources allocation, because all requests are clarified and
justified.
 Budgets provide a tool for corrective action through reallocations.

However, budgets control can also create problems. The disadvantages of budgets are:

 The major problem occurs when budgets are applied mechanically and rigidly.
 Budgets can de-motivate employees because of lack of participation. If the budgets
are arbitrarily imposed top down, employees will not understand the reason for
budgeted expenditures, and will not be committed to them.
 Budgets can cause perceptions of unfairness.
 Budgets can create competition for resources and politics.
 A rigid budget structure reduces initiative and innovation at lower levels, making it
impossible to obtain money for new ideas.

These dysfunctional aspects of budgets systems may interfere with the attainment of the
organization's goals. One generally accepted guideline for effective budgeting is to establish
goals that are difficult but attainable.

Therefore, skilled managers who understand budgets and how to use them have a powerful
control tool with which to attain departmental and organizational goals.

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Internet research on a company and how the budgets
are prepared

This assignment has already referred to a researched organisation “Pickup Truck Company”
to show evidence of its practical usage in budget planning, control; implementation and
examples are provided throughout regarding the different types of budgets and how these
budgets are used to assist the financial decision making.

The second company will also demonstrate how the organisation makes practical usage of
the budgetary planning process that contributes to the overall master budget. The chosen
company is Hampton Freeze Inc. They are a company that specialised in the production of
ice-cream and ice-lollies and other types of frozen luxury sweets and deserts. Their
investment option is dependent upon seasonal cycles; therefore the company intends to
invest in production output in response to the higher demand for such cold luxury food-stuff
during the hotter seasons. Therefore the firm’s objective is to maximise sales during the
summer months. This involves various forms of research as well as historic trading in sales
etc. The investment is based upon Profit planning it is the set of steps that are taken by the
firm to achieve the desired level of profit. Planning is accomplished through the preparation
of a number of budgets, which, when brought through, from an integrated business plan.

Hampton Freeze Inc Sales Budget

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Hampton Freeze Cash Collection Budget

This example contains the sales budget for Hampton Freeze for the year 2009, by quarters.
Notice from the example that the company plans to sell 100,000 cases of popsicles during
the year, with sales peaking in the third quarter. Here the 3 rd quarter is where the seasonal
demand is higher in the projected forecast and past years trading experience.
Cash collections consist of sales made to customers in prior periods plus collections on sales
made in the current budget period. In our example, 70% of sales are collected in the quarter
in which the sales are made and the remaining 30% are collected in the following quarter.
For example, 70% of the first quarter sales of $200,000 (or 140,000) is collected during the
first quarter and 30% (or $60,000) is collected during the second quarter.

After the Sales Budget the Production budget follows

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Explanation of Production Budget of Hampton Freeze Inc

At Hampton Freeze, management believes that an ending inventory equal to 20% of the
next quarter's sales strikes the appropriate balance. Example contains the production
budget for Hampton Freeze. The first row in the production budget contains the budgeted
sales, which have been taken directly from the sales budget. The total needs for the first
quarter are determined by adding together the budgeted sales of 10,000 cases for the
quarter and the desired ending inventory of 6,000 cases. The ending inventory is intended
to provide some cushion in case problems develop in production or sales increase
unexpectedly. Since the budgeted sales for the second quarter are 30,000 cases and
management would like the ending inventory in each quarter to 20% of the following
quarter's sales, the desired ending inventory is 6,000 cases (20% of 30,000 cases).
Consequently, the total needs for the first quarter are 16,000 cases. However, since the
company already has 2,000 cases in beginning inventory, only 14,000 cases need to be
produced in first quarter.

Hampton Freeze Ltd. Direct Material Budget

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Explanation of the Direct Materials Budget for Hampton
Freeze Inc

The only raw materials include in this budget is high fructose sugar, which is the major
ingredient in popsicles (finished goods of Hampton Freeze Inc.) other than water. The
remaining raw materials are relatively insignificant and are included in variable
manufacturing overhead. As with finished goods, management would like to maintain some
minimum inventories of raw materials as cushion. In this case, management would like to
maintain ending inventories of sugar equal to 10% of the following quarter's production
needs.
The first line in the direct materials budget contains the required production for each
quarter, which is taken directly from the production budget. Looking at the first quarter,
since the schedule of production budget calls for the production of 14,000 cases of popsicles
(finished goods of Hampton Freeze Inc.) and each case requires 15 pounds of sugar, the
total production needs are for 210,000 pounds of sugar (14,000 cases × 15 pounds per case).
Direct materials budget is usually accompanied by a schedule of expected cash
disbursements for raw materials. This schedule is needed to prepare the overall cash
budget. Disbursement of raw materials consists of payments for purchases on account in
prior periods plus any payments for purchases in the current budget period.

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Direct labour budget for Hampton Freeze Inc

Explanation of the direct labour budget for Hampton

Freeze Inc

The first line in the direct labour budget consists of the required production for each
quarter, which is taken directly from production budget. The direct labour requirement for
each quarter is computed by multiplying the number of units to be produced in that quarter
by the number of direct labour hours required making a unit. For example, 14,000 cases are
to be produced in the first quarter and each case requires 0.40 direct labour hours, so a
total of 5,600 direct labour hours (14,000 cases × 0.40 direct labour hours per case) will be
required in the first quarter. The direct labour requirements can than be translated into
budgeted direct labour costs. How this is done will depend on the company's labour policy.
In direct labour budget schedule above the management of Hampton Freeze Inc. assumes
that the direct labour force will be adjusted as the work requirements change from quarter
to quarter.

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Manufacturing overhead Budget of Hampton Freeze Ltd

Explanation of the Manufacturing Overhead Budget for

Hampton Freeze Inc

At Hampton Freeze the manufacturing overhead is spread into variable and fixed
components. The variable component is $4 per direct labour-hour and the fixed component
is $60,600 per quarter. Because the variable component of the manufacturing overhead
depends on direct labour, the first line in the manufacturing overhead budget consists of
the budgeted direct labour hours from the direct labour budget
The budgeted direct labour hours in each quarter are multiplied by the variable rate to
determine the variable component of the manufacturing overhead. For example, the
variable manufacturing overhead for the first quarter is $22,400 (5,600 direct labour hours ×
$4.00 per direct labour-hour). This is added to the fixed manufacturing overhead for the
quarter to determine the total manufacturing overhead for the quarter. The total
manufacturing overhead for the first quarter is $83,000 ($22,400 + $60,600).

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Finally we look at the Hampton Freeze Selling and
Administrative Expense Budget

Explanation of Selling and Administrative Expense

Budget for Hampton Freeze Inc

Like the manufacturing overhead budget the selling and administrative expense budget is
divided into variable and fixed cost components. In the above example the variable selling
and administrative expense is $1.80 per case. Consequently, budgeted sales in cases for
each quarter are entered at the top of the schedule. These data are taken from the sales
budget. The budgeted variable selling and administrative expenses are determined by
multiplying the budgeted sales in cases by the variable selling and administrative expense
per case. Depreciation is also considered in this example.
Most companies would also prepare a flexible budget as already discussed above.

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Conclusions of Planning Budgets

The conclusion of the overall budget planning, usefulness in assisting organisations and their
management in decision making have already been mentioned above. The above conclusion
focuses on the advantages and disadvantages of each one. It can be noted from the two
companies chosen that they provide practical examples and their usage, the overall
conclusion shows that budgeting planning, control, forecasting and many other factors that
are involved throughout the process is a complex procedure. There is no concrete evidence
that the organisation will operate smoothly according to the budgets prepared. However it
is a necessary step and should be conducted no matter how small or large an organisation is.
The company is more likely to be successful if it follows the budgeting procedure.
Budgets are the most widely used control system, because the plan and control resources
and revenues are essential to the firm's health and survival. Budgeting is the formulation of
plans for a given future period in numerical terms. By stating plans in terms of numbers and
breaking them into parts of an organization, budgets correlate planning and allow authority
to be delegated without loss of control.

Finally the budgeting categories examined and discussed above are the main budgets that a
firm would undertake. There are several more budgets that can also and would probably be
prepared such as cash-budget, zero-based budget etc. To present concluded steps in the
budget process that the above two companies have used it is best displayed as a flowchart.

See Flowchart below. This procedure may change depending on the organisation and its
objectives, resources, revenue, opportunities etc. However the general course of action is as
constructed below.

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 Flowchart of Budget plans and types

LIMITING
FACTORS

SALES
BUDGET

FINISHED GOODS STOCK

BUDGET

PRODUCTION BUDGET

RESOURCE
BUDGET

MACHINERY BUDGET MATERIALS LABOUR/WAGE

BUDGET BUDGET

OVERHEAD
BUDGET

SELLING PRODUCTION ADMINISTRATION OVERHEAD

OVERHEAD OVERHEAD

CO-ORDINATION/MONITOR/REVIEW

FLEXIBLE
BUDGETS

MASTER BUDGET

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Bibliography
Business Essentials Managing Financial Resources and Decisions
BPP-Learning Media
Course Book HNC/HND/Foundation Degree

Business Studies 3rd Edition

Ian Marcouse
Hodder Education

A-Z Business Studies Handbook

5th Edition
Professor David Lines
Hodder Education

References

The above information has been adapted from

http://www.accountingformanagement.com/sales_budget.htm
http://search.conduit.com/ResultsExt.aspx?ctid=CT2438727&q=flowchart%20showing
%20budget%20planning&SearchSource=15
http://www.accountingformanagement.com/human_factors_in_budgeting.htm
http://www.strategic-control.24xls.com/en202
http://www.accountingformanagement.com/overhead_budget.htm
http://www.strategic-control.24xls.com/en205

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