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Defining budget, Break-even analysis, Cash budget, Full (absorption) costing, Capital investment appraisal ...

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Contents Executive summary.....................................................................................................................................1 Defining budget..........................................................................................................................................1 Break-even analysis....................................................................................................................................1 Cash budget................................................................................................................................................2 Full (absorption) costing.............................................................................................................................2 Capital investment appraisal......................................................................................................................3 Executive Summary.....................................................................................................................................4 References...................................................................................................................................................4

Executive summary Pooma Sports Ltd is a UK-based company, which distributes sport clothing and equipment. Recently, I have become the new general manager of the company. After a meeting with some of the senior managers of the company, I have noticed that the current financial situation and budgeting system of the company is not working effectively. The past seven years have been really tough for the company, which owes £10,039,000 to its parent company. In the report below all the challenges, which are facing the company and their solutions are described. Also, there are some advises which the company should take into account. Some of the problems Pooma Sports Ltd is dealing with are new product line boots, where the management need to decide whether to manufacture the product in In-house manufacture, or in Outsourced manufacture. Also, there is a problem with their budget system, where the net cash flow stays negative, even though the company returns to profit. There are two methods to charge overhead costs to products in the company – original and revised. The management should choose the original one because it gives more information. There are two options for a new piece of equipment as well. It is about the method of production. The company should choose Superstitcher for couple of reasons, which are said in the report. There is also a brief discussion about the four investment appraisal methods. For more details read the whole report below. Defining budget A budget can be defined as “an estimate of costs, revenues, and resources over a specified period, reflecting a reading of future financial conditions and goals.” (Business Dictionary 2017) It is one of the most important thing in the administration of an organization. The main purpose of a budget is to be used as a guide during the budget period. Another role that the budget plays is in the systematic planning. It is future-oriented. Also, the budgeting process consists of coordination, cooperation and communication among the organization. Another two roles of the budgeting process are quantification and cost awareness, as well as control and evaluation. The most important benefit that a budget can bring to a business is motivation. Using budgetary control, management accountants can motivate employees and improve managers. In that way they will give the best in their work, which will gain more success to the organization. (Raghunandan, Ramgulam, Raghunandan-Mohammed 2012)

However, budgeting can cause several problems as well. Budgeting can de-motivate employees if it is not negotiated. Also, if managers are setting unrealistic goals, it will have the same effect. (Tutor2U 2017) Sometimes budgets can be time consuming. Usually, the time consumed is up to five months. It involves many people as well. Budgeting is one of the most complex process within an organizations and goals can only be obtained when all these factors are taken into account. Break-even analysis Fixed cost is a business cost, for example rent, which is a constant. Variable costs are linked with the level of productivity. An example might be the amount of raw materials needed, depending on the level of output. Another one is semi-fixed cost, which has elements of both fixed and variable cost. Lastly, stepped fixed cost means that the fixed cost could increase if the business goes over their thresholds. This means that if the business continues to grow all the fixed costs will increase after a certain level. There is high operating gearing when the fixed costs are significantly higher than the variable cost. This means that a small change in the output volume could have a big change in the profits. There is a risk when the reductions in the volume of the output can have a more damaging effect on profit where the operating gearing is at higher level. (Pennington: 319) Considering the two manufacturing options, Inhouse manufacture has a bigger level of fixed cost, which means that if there is more output, there is going to be more profit. Backing up that fact, in Document 3 we can clearly see that In-house manufacture require less units to achieve their profit of £250,000. However, if there is not a significant amount of demand, the outsourced manufacture could be better because the break-even point is lower compared to the In-house one. This means that the outsourced one will start achieving a profit at an earlier stage. Despite that, if there is a lot of demand, the In-house manufacture will produce a lot more profit for the business. Referring to both options, In-house manufacturer would be the better option because considering that the firm is trying to cut down costs and increase income it will produce the best results, regarding the needs of the company. Cash budget The budgeted income statement, also called statement of financial performance shows what’s the current financial performance of an organization over a specific period. It measures all the revenues, expenses, profits and losses. The difference between budgeted income statement and cash budget is that cash budget is developed after all the sales and purchases are already made. A management is using the cash budget to control the cash flows of an organization. Also, it allows forecasting large amount of cash. (My Accounting Course 2017) However, the main difference between the two of them is in the trade receivables and trade payables. In Document 4 is said that credit customers are allowed one month’s credit on sale and credit suppliers allow one month credit on raw materials purchases. In the cash budget table the data is written after one month, while in the budgeted income statement one is written immediately. Another thing is the depreciation. It is a reduction in the value of an asset over time. To calculate it, four factors need to be considered: the cost (or fair value) of the asset, the useful life of the asset, the residual value of the asset and the depreciation method. (Pennington: 94) By doing this we can clearly see that there is depreciation in the budgeted income statement. These are the reasons why net cash flow lag behind net profit. For the net cash flow, the total amount for January is bigger than the amount in February. But in

the total expenses, the amount is bigger in February. This is caused by the trade receivables and trade payables. From Document 4 we can clearly see that after six months the whole cash budgets remains negative, while the income statement is positive. There are some possible reasons for this to happen: over-investment in capacity, too much stock, allowing customers too much credit, overtrading and seasonal demand. (Tutor2U 2018) Also, another reason for a negative cash flow is a possible debt, except the one Pooma Sports Ltd owes to their parent company. Full (absorption) costing In accounting, apportionment is “division of income and expenses in certain proportion and, in contrast to an allocation, over two or more accounts, departments, or entities.” (Business Dictionary 2018) In Document 5, the apportionment basis chosen may be appropriate because it is based mainly on costs, which is good for the business if there is a possible loss. In both tables the total apportioned overhead cost and total re-apportioned overhead cost are the same – 1,930,000. However, in this scenario using apportionment may be not so appropriate, because there is no focus on sales. Based on the information given by the two tables, using the original method seems more superior. The reason for that is because it is focusing on one more thing, which is the direct labor. Like the revised method, the original one is focusing on floor are, machine hours, machine values, and employees as well. The original method gives us more information. “Overhead is an accounting term that refers to all ongoing business expenses not including or related to direct labor, direct materials or third-party expenses that are billed directly to customers.” (Investopedia 2018) Overheads are fixed costs which the company should pay regularly even if their business is a small one or they have losses. They may be the same month to month, or they can be variable depending on decrease or increase of their activity. Usually, these costs include administrational costs and general business operations, for example, the need for accountants. Most of the times the overhead costs appear at the annual income statement of the company. Capital investment appraisal There are four investment appraisal methods used by businesses to evaluate investment opportunities, which are accounting rate of return (ARR), payback period (PP), net present value (NPV), and internal rate of return (IRR). Most businesses, like Superstitcher and Gluemaster are using more than one method, as we can see in Document 6. (Pennington: 435) The accounting rate of return (ARR) is the amount of profit, or return, an individual can expect based on an investment made. (Investopedia 2018) To calculate it we need to take both the annual average operating profit and the average investment. There are couple of advantages and disadvantages using ARR. One advantages is that ARR provides percentage of return. It can be compared with a target return. Another one is that it looks at the whole profitability of the company and focuses on it. However, the disadvantages are that it does not take in account cash flows and the time value of money. (Tutor2U) Also, some of the problems, which ARR deals with are use of average investment, use of accounting profit and competing investments. (Pennington: 437,438) Another method is the payback period or PP. This is the time taken for an initial investment to be repaid out of the net cash inflows from a project. (Pennington: 439) For a well-developed project the payback period should be no longer than a maximum payback period set by the company. The advantages using

payback period are that it is really easy to calculate and understand the results, also it focuses on cash flows, which is good for the business. Another thing is that emphasizes on the speed of return, which is good for the business if there is a possible market change. Compared with the ARR, the payback period does not take in account the time value of money as well. Ignores qualitative aspects of the decision making process and may encourage short-term thinking. (Tutor2U 2018) Problems that may occur using payback period are that not all relevant information may be taken into account, also it is not concerned with maximizing the prosperity of the shareholders. (Pennington: 422) Another problems are required payback period and using a short payback period, which is sometimes risky for the business. (Pennington: 433) The third method is the net present value, which both considers all of the costs and benefits of each investment opportunity and makes a logical allowance for the timing of all the costs and benefits. Again there are some advantages and disadvantages that need to be consider if using this method. Using NPV may be more complicated, because it can be hard for understanding and its calculation is very sensitive to the initial investing cost. However, it takes account of time value money and has a great emphasis on cash flows. It looks at all of the cash flows in the project and has a very good decision-making system. Problems, facing the company using NPV may be interest loss, risk taking, and inflation. (Pennington: 444, 445) The last investment appraisal method that businesses use is internal rate of return, or IRR. It is closely related to the NPV, because it involves discounting future cash flows as well. However, IRR is the discount rate that, when applied to its future cash flows, will produce a NPV of 0. (Pennington: 451) The main advantage using IRR is that it shows the return on the original money invested, but sometimes it may give complicated answers. (Investopedia 2018) The problems that the IRR suffer from are the same as the ARR’s ones. Considering the information that Superstitcher and Gluemaster have been provided, the best decision that Pooma Sports Ltd can make is to choose Superstitcher. Their NPV and profit are bigger than the Gluemaster’s ones. It will be more risky, because of the long payback period, but having in mind the debt that Pooma Sports Ltd has, the information about the profit is more important. Executive Summary As we have noticed from the report, Pooma Sports Ltd is currently facing some serious financial problems. There are solutions to all of their problems. For example, for budgeting the managers need to motivate the employees more in order to get more effective work from them. For their new product line they should choose to work with In-house manufacturer to increase income and reduce costs. Also, the company’s cash budget and budgeted income statement shows us why there is a negative cash flow. Another thing is that the company introduced two methods – original and revised for absorption costing. The right thing to do is the company to choose the original method, based on more information shown in it. Lastly, the sports department is considering purchasing a new piece of equipment. The management has two options – Superstitcher and Gluemaster. They should choose Superstitcher, because they have more profit, even though this option is the risky one, based on their long payback period. References Business Dictionary (2018) Budget [online] available from [29 December 2017]

Raghunandan, Ramgulam, Raghunandan-Mohammed (2012) ‘International Journal of Business and Social Science’ Examining the Behavioural Aspects of Budgeting with particular emphasis on Public Sector/Service Budgets [online] available from [29 December 2017] Tutor2U (2017) Limitations and Potential Problems of Budgeting [online] available from [29 December 2017] Pennington, R (2017) Accounting for Business, Pearson My Accounting Course (2018) What is a Cash Budget? - Definition | Meaning | Example [online] available from [02 January 2018] Tutor2U (2018) What are the main causes of a cash flow problem? [online] available from [02 January 2018] Investopedia (2018) Accounting Rate of Return - ARR [online] available from [03 January 2018] Tutor2U (2018) Accounting Rate of Return ("ARR") [online] available from [03 January 2018] Tutor2U (2018) Payback Period (PP) [online] available from [03 January 2018] Business Dictionary (2018) Apportionment [online] available from [03 January 2018] Investopedia (2018) Overhead [online] available from [03 January 2018]...