Budgeting and its Behavioral Problems

Budgets are basically use to control the management and are specifically made to stimulate the appropriate use of resources and to support other managerial functions. Budgeting helps in identifying the organizational goals and allocation of responsibilities to achieve those goals. It provides assistance in the implementation of a chosen strategy by the organization. Once properly understood and implemented, it can turn out to be the most useful technique of management accounting (Shim, Siegel and Shim, 2011).

There are various benefits which can be derived from preparing budgets. Following are:

• Systematic planning: the process of budgeting provides an organized framework for implementation of major strategic decisions and make sure that all the available resources are optimally used (Raghunandan, Ramgulam and Mohammed, 2012).
• Communication and co-ordination: budgets helps in promoting a proper cooperation and communication between the different departments of organization. It links the various units with each other, thus results in the achievement of overall objective.
• Cost awareness and Quantification: through proper allocation of the resources, budgets provides the benefit of cost awareness and quantification (McWatters and Zimmerman, 2015).
• Control and Evaluation: budgeting system provides a basis for evaluating the performance by comparing the actual results with the budgeted ones. It identifies the areas which need modifications, analysis and investigation, resulting in better control (Weygandt, Kimmel and Kieso, 2009).

Budgeting is a complex process and most of its problems are behavioural. The success of a budget mainly depends upon the human behaviour which includes the attitude of people toward it. The focus of behaviour include the degree of participation that top management willing to delegate to middle level management in course of preparing budgets. The mangers may draw up the budgets as per their personal priorities by using top-down approach. This will cause many problems to the workers as they may find it unrealistic. Sometimes, budgets are used in the form of punishment. Managers use them to penalize the employees for overspending and putting restrictions on them. As a result, workers become aggressive and may not willing to do their job anymore. So to achieve the targets, these behavioural problems should be minimized (Raghunandan, Ramgulam and Mohammed, 2012).

Cost behaviour means the way a particular cost reacts to the changes in the level of production. The cost is classified into three categories on the basis of its behaviour and that are fixed, Variable and mixed. Fixed cost is the one which remain same at all the production level. Variable costs are the costs that fluctuates according to changes in activity levels. Mixed costs are also known as semi-variable costs that have the properties of both fixed and variable costs (Basavachari, 2017).

Stepped cost is the one which remains fixed for a certain level of activity. It increases as and when the business activity exceeds a certain level. Fixed costs usually remains constant at all levels but it become stepped cost at some point when the level of output changes. For example, cost incurred in starting up of a new production unit, which require utilities and supervisors salary. The fixed cost remain persistent to a certain level but as and when there is an increase in the level, it changes and become stepped cost (Horner, 2017).

Cost Behavior and Its Classification

Operating gearing defines the relationship between a company’s fixed and variable cost. If the portion of fixed cost is high, it means greater operational gearing and vice-versa. Higher operational gearing results in profits becoming sensitive to change in sales. It is one of the factor used in assessing business’s risk (Bamber and Parry, 2014). Firm having large proportion of fixed cost will have high operating leverage which indicates that the company has more business risk. Similarly, firms having high proportion of variable cost will have low operating leverage and less business risk (Hampton, 2011).

Pooma Sports Ltd. has two options for manufacturing Rugby boot. Either it manufacture the boot in the new factory or outsource the production to a partner company. Total fixed cost involve in, in-house manufacture is £190,000 and in outsource manufacture it is £90,000. It can be clearly seen that the first option has high fixed cost which mean the operating gearing will be high and more risk will be there. On the other hand, the second is less risky as it does not include fixed manufacturing overheads. Pooma Sports should go for option2. Reasons being, it has less cost involved both fixed and variable and has a high margin of safety level as compare to option1.

There are several reasons for net income and cash flows for being different from each other. Operating activities in cash flow statement include specific items that are differently treated in the income statement. Noncash expenses such as depreciation, amortization are used to calculate the net profit but such expenses does not reduce the cash. Timing is another reason for the differences. The income statement is prepared on accrual basis that is, an amount is recorded as and when it becomes due whereas cash flow is prepared on cash basis in which the transaction is recorded as and when the cash is received or paid. As a result, value of net income and cash flow is different from each other (Ward, 2013).

The budgeted income statement of Pooma Sports Ltd. Reported a profit at the end of six-month period, yet the cash flow of the company at the end is negative. The reason behind this is the engagement of firm in the profitable activities that do not results in positive cash flows. The company uses accrual method of accounting to record its expenses and incomes. Under this method, non-cash revenue which do not affect the cash flow is added to net profits whereas actual cash pay-outs can decrease the cash flow and may not be considered as an expense to deduct from net income. As a result, non-cash revenue helps in achieving profits and non-expense cash pay-out leads to negative cash flows. Timing is the reason for all these differences.

Operating Gearing and Business Risks

In original costing method, the product costing team of Pooma Sports Ltd has apportioned the overheads by cost centres with the following apportionment bases:

Expenses	Basis of Apportionment
Rent and Heating	Floor area
Insurance and depreciation	Machine value
Power	Machine hours
Indirect labour	Direct labour

Expenses	Basis of Apportionment
Rent, Heating and Indirect labour	Number of employees
Insurance, depreciation and power	Machine hours

In original costing method, rent and heating expenses are incurred by individual cost centre, so in order to distribute the cost between appropriate cost centres, floor area is taken as a basis of apportionment. Depreciation and insurance charges are apportioned on the basis of machine value because depreciation is calculated on the cost of machine and insurance expenses are also occurred on the basis of machine value. Allocation basis of power expense is appropriate because power charges can only be determined as per the number of hours a machine is used. Indirect labour overheads are treated as direct labour costs (Rajasekaran, 2010).

In proposed costing method, expenses related to rent, heating and indirect labour are allocated on the basis of number of employees. This basis of apportionment is appropriate because the amount of rent can be more accurately calculated and distributed between different departments, depending upon the employees working in each department. Calculation of indirect labour charges again depend upon the number of employees working in each cost centre. Machine hours is taken as a basis of allocation for the expenses such as insurance, depreciation and power. Revised or proposed costing method is superior and appropriate to use.

The main purpose of overhead absorption is to include overhead in the production cost and to determine the cost per unit after the production is completed. It also helps in applying the overhead over the production on equitable basis (Lal, 2009). The sales director of Pooma say that the proposed costing method is superior to the original costing method. The statement stands out to be true because the revised method reduces the overheads chargeable to the sports clothing and sports equipment. Moreover, the basis of apportionment used in revised costing is more appropriate than that of in original costing. Because of the suitable allocation of the costs, clothing and equipment department is able to cut down their costs respectively. 

Investment appraisal is the collection of methods and techniques used to identify the viability of a project and the attractiveness of an investment proposal. The sport equipment department of Pooma Sports has two option for purchasing a new piece of equipment. One is Superstitcher and the other is Gluemaster. The company does an investment appraisal of both the option by using the methods such as Net Present Value, Payback Period, Accounting Rate of Return and Internal Rate of Return. Combination of these methods provides a conflicting advice related to the project (McLaney and Atrill, 2014).

Investment Appraisal Methods

NPV is the method used for determining the profitability of the project in which the investment is done. Generally, projects having higher NPV will consider to be more appropriate for making investment (Bierman and Smidt, 2012).

Payback period method simply means the number of year taken by a proposal to recover the initial investment. It is very important to determine the time taken by a project to know that whether to continue the project or not. The proposal with less payback period should be accepted (Ahmed, 2013).

IRR is the rate at which the PV of cash inflows is same as the cash outflow. A project having high IRR value is more desirable (Brealey, et al., 2012).

ARR is the ratio of the average accounting profit to the average investment in the project. If the ARR of the project is greater than the required rate of return, then the project should be accepted (Brealey, et al., 2012).

S.No.	Methods	Advantages	Disadvantages
1	Payback period	· It is very simple method. · Widely used to evaluate the projects quickly.	· Does not concern with the time value of money. · Liquidity is given more priority than profitability.
2	Net Present Value.	· Value of firm can be increased. · Used in determining the risk and profitability.	· Finding a suitable discount rate is a difficult task. · Not feasible for the projects having unequal investments.
3	Internal Rate of Return.	· True profitability is calculated. · Advanced determination of cost of capital is not required.	· Tedious calculations. · Assumption made may prove to be wrong.
4	Accounting Rate of Return	· Easy to calculate and simple to understand. · It identifies the concept of net earnings.	· Creates problem in decision making when results are different. · Time value of money is not considered.

(Scott, 2016).

S.No.	Methods	Superstitcher	Gluemaster
1	Payback period	. 4 years 5 months	3 years 4 months
2	Net Present Value.	£158,844	£140,775
3	Internal Rate of Return.	9.1%	9.6%
4	Accounting Rate of Return	14.0%	9.0%

The combinations of the methods like NPV v Payback, NPV v IRR, Payback v ARR, ARR v IRR give conflicting advices as two of the methods favour one option whereas other two favours the other option. Looking at the NPV and Payback period of both the equipment, superstitcher’s NPV is comparatively more than the Gluemaster but the payback period of Gluemaster is less as compare to Superstiticher which means it take less time to recoup the initial cash outlay. Concerning NPV and IRR, project having high value of both is considered to be more desirable. In this case, option 1 has high NPV but low IRR as compare to option 2. Comparing Payback and ARR, the ARR of Superstitcher is 14% which is more than the ARR of Gluemaster, but the payback period of the same option is less than the second one. Similarly, combining ARR v IRR, one option has high IRR whereas other has high ARR. So it is very difficult to conclude which option is better as two methods ARR and NPV supports first option and the other two IRR and payback period supports second option.

As NPV of any asset is based the future cash flows which includes risk. If the future cash flows are lesser than the expected, then the whole project will be not viable and making investment in it will be risky. The NPV of both the options is positive which means the PV of cash inflows of is greater than cash outflow. As a result, no risk is involved in each option. The concept of payback period is that longer the payback period, greater will be the risk. Superstiticher’s payback period is more than Gluemaster, which implies that it involves some risk as compare to the option second (Ahmed, 2013). IRR and ARR both are compare to the cost of capital of company. If both the rates are lower than it, then the project will be riskier to invest in. Superstiticher and Gluemaster, both have IRR and ARR higher than the cost of capital which implies that investing in these option will be riskless.

The NPV of option 1 is more than option 2. It implies that project 1 is able to generate more returns or profits than project 2. However, option 2 has low pay back period which means it can pay back the initial cash outlay in less time than that of option1. As the IRR and ARR of both the projects is greater than the cost of capital of 5%, so more returns are generated, but there will be a difference because IRR of option 1 is less than option 2 and ARR of option 2 is less than option 1.

The best method of capital investment appraisal is Net Present Value. It is said that the project having high NPV is more appropriate among the present alternatives. So, according to this, Pooma Sports should go for the purchase of Superstiticher as it requires less capital investment comparatively and its NPV is also more than Gluemaster that is £158,844. Also the Accounting rate of return of the equipment is 14% which is way more than the ARR of second option. Although the Gluemaster will also be a feasible option because it reduces the cost and increases the efficiency but as per the techniques of the capital investment appraisal, first option should be recommended.  

Reference 

Ahmed, I.E., 2013. Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2), pp.77-88.

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Basavachari, V., 2017. Cost and Costing Techniques in Managerial Economics. DHARANA-Bhavan’s International Journal of Business, 7(1), pp.19-27.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

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Hampton, J.J., 2011. The AMA handbook of financial risk management. AMACOM Div American Mgmt Assn.

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Raghunandan, M., Ramgulam, N. and Raghunandan-Mohammed, K., 2012. Examining the behavioural aspects of budgeting with particular emphasis on public sector/service budgets. International Journal of Business and Social Science, 3(14).

Rajasekaran, V., 2010. Cost Accounting. Pearson Education India.

Scott, P., 2016. Accounting for Business. Oxford University Press.

Shim, J.K., Siegel, J.G. and Shim, A.I., 2011. Budgeting basics and beyond (Vol. 574). John Wiley & Sons.

Ward, K., 2013. Financial aspects of marketing. Routledge.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2009. Managerial accounting: Tools for business decision making. John Wiley & Sons.