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FACULTY OF BUSINESS AND LAW FACULTY OF BUSINESS AND LAW PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENTPROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT

MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE: STRATEGIC MANAGEMENT ACCOUNTING

MODULE CODE: APC309 MODULE CODE: APC309

MODULE TUTOR: MR MIKE BAKER MODULE TUTOR: MR MIKE BAKER

SUBMISSION DATE: 22ND MAY, 2009 SUBMISSION DATE: 22ND MAY, 2009

MANAGEMENT REPORT ON MANAGEMENT REPORT ON BUDGETING SYSTEM & M

BUDGETING SYSTEM & MANAGING WORKING CAPITAL ANAGING WORKING CAPITAL ANAGING WORKING CAPITAL

PREPARED BY PREPARED BY 089003624

089003624 AUSTIN SAMS UDEH AUSTIN SAMS UDEH

Life changing Life changi ng ng

TABLE OF CONTENT

1.0 GENERAL GENERAL INTRODUCTION INTRODUCTION INTRODUCTION

1.1 Budgeting, strategy and Organizational control system 2

1.2 Behavioural Aspect of budgeting 3

2.0 PART I: PART I: TRADITIONAL BUDGE TRADITIONAL BUDGE TRADITIONAL BUDGETING SYSTEM TING SYSTEM TING SYSTEM 7 7

2.3 ALTERNATIVES APPROACHES TO TRADITIONAL BUDGETING 9

2.3.1.2 Rolling Budget & forecasts 10 2.3.1.3 Activity-based budgeting 12

2.4 BUDGETING BUDGETING SYSTEMS SYSTEMS SYSTEMS & BUSINESS ENVIRONMENT& BUSINESS ENVIRONMENT& BUSINESS ENVIRONMENT 1515

2.4.1 Budgeting system and Stable environment 15 2.4.2 Budgeting system and Dynamic environment 17

3.0 PART II: WORKING CAPITAL M PART II: WORKING CAPITAL MANAGEM ANAGEM ANAGEMT T T 18 18

3.1 Objectives and Components of Working capital 18 3.2 Working Capital cycle of a manufacturing firm

1.0 GENERAL INTRODUCTION GENERAL INTRODUCTION GENERAL INTRODUCTION

t is an established dictum that, accounting is not an end in itself, but a means to an end The end is to facilitate business strategy towards achieving success Accounting theorists have long recognized that traditional accounting information provides critical decision-influencing and decision-facilitating information for organizational control [ e.g Baiman [1982]; Birnberg et

al 1988; Merchant, 1985a; Tiessen and Waterhouse, 1983]

Unfortunately, critics1 of management accounting argued that management accounting has failed

to provide relevant, useful and timely information for planning and control in the rapidly changing and highly competitive business environment The quest to overcome the weakness in

traditional management accounting system gave birth to “Strategic Management accounting 2 ”

Lying critically, at the heart of the managerial control functions is budgeting and budgetary control [as depicted in fig 1 below]

Figure [1] Phases of management control system [University of Sunderland, 2008 p 14

1

Critics of management accounting e.g Goldratt [1983]; Kaplan and Johnson, [1987]; Cooper and Kaplan [1988] Jayson, [1987]; Shank & Govindarajan, [1998]; Umble and Srikanth, [1990], shares similar views, that traditional management accounting systems is incompatible with modern production systems

2 The notion of “strategic management accounting” centre’s around linking business strategy & budgeting, and increasing competitive advantage with strategic accounting information see, Simmonds, [1981, cited in Drury, 2007]; Lord, [1996]; Wilson, [1995]; Bromwich, [1990]; Dixon, [1998]; Tim Blumerntritt, [2006]; Snow & Hambrick, [1980]; Philip Sadler,[ 2003]; Johnson and Scholes, [1998:55]

I

1.1 Budgeting, Strategy and Organizational control system

Budgeting as a conventional tool for management control system [Ekholm and Walin, 2000; Merchant and Van der Stede, 2003] has received an overwhelming popularity in recent times, regarding it strategic role in organizational control system

Budget has been defined as a “predictive model” of organizational activity, quantitatively

expressed, for a set time period “or simply a plan that is measurable and timely [Bruns & Waterhouse, 1975; Fredrick, 2001; Proctor, 2006; Terry Lucey, 1992:85] While budget can

simply be likened to a ‘financial road-map3, budgetary control is a technique whereby actual results are compared with budgets and corrective actions are taken should there arise any variance

The two basic categories of budgets [Cohen, et al, 1994:171] are operational and financial

budgets Both operational budget 4 and financial budget5 are usually transformed into what is

known as the “master budget” as an overall financial plan for the fiscal year ahead (See figure 3

below)

F Figure [2] components of Master’s budget

3

Budgeting and organizational strategy while budget is been likened to a financial road map, showing where an

organization is heading and how to get there, organizational strategy help provides answers to questions such as

4

The operational budget has components such as; sales budget, production budget, R&D budget; Administrative

expense budgets etc

5 Financial budget comprises of the cash budget; budgeted profit and loss, and budgeted balance sheets

1.2 Behavioural aspect of budgeting

The effectiveness of budgeting and budgetary control depends largely on the behavior and attitudes of managers6 and possibly other employees [CIMA, 2007] Researches7 on the behavioural effects of budget concludes that improperly administered budget is capable of generating conflicts in an organization (see fig 2 below)

Figure [2] the effect of level of budget difficulty on motivation and performance

6

Budget is positive and good for the organization when used as a motivating factor Ironically, human factor in budgeting process has a negative effect The lesson here for managers is that care should be exercise in budget design and implementation 7

Researches on the behavioural effects of budget e.g Argyris, [1952]; Vroom,[1960]; Hopwood, [1974]; Hofstede, [1968]; Horngren etal, [2005: 491], concludes that improperly administered budget is capable of generating conflicts in an organization

Researches on the purpose of budgeting and budgetary control concludes that budget serves a multiple of roles8 in an organization [Emmanuel etal, 1990 cited in Bhimani,(ed,2005)

The crucial role of the budget as an organizational control tool has long been recognized, see Bruns & Waterhouse [1975]; Khalladwalla, [1972]; Merchant, [1984]; Horngren etal, [2005]; Drury, [2008] Although authors such as Barrett and Fraser, [1977]; Churchill, [1984]; Epstein and Manzoni, [2002]; Merchant and Manzoni, [1989], McWatters, Morse and Zimmerman, [2001:242] have claimed that a given budgetary control system cannot serve multiple purposes (e.g., planning versus performance evaluation, planning versus motivation) equally well Their argument concludes that by implication, different purposes of budgetary control systems cannot

be the same if they are in conflict

The central purpose of budget as summarized by CIMA, [2008]; Atrill and Mclaney, [2007]; Drury, [2008]; Kral, [2006]; Anthony & Govindarajan, [2000]; Ronald Hilton, [2008: 348];

Fibirova etal, [2007] includes; a means of authorizing actions, focus for forecasting and compel planning a channel of communication and enhance coordination, a means of motivating organizational participants and a vehicles for performance evaluation and control

Unfortunately, Fraser & Hope [2005], took an entirely different view by questioning the relevance of budgeting in recent times At the forefront of anti-budgeting crusade with several titles9, canvassing for “dismantling” the budgeting system”is BBRT

The report is in two main parts: while part one critically analyses argument infavour and against the “traditional budgeting and budgetary control” in the light of its suitability to stable and dynamic business environment, part two extensively discusses managing working capital cycle

of xyz limited, a typical manufacturing organization

2.0 TRADIT TRADIT TRADITIONAL BUDGETING SYSTEM IONAL BUDGETING SYSTEM IONAL BUDGETING SYSTEM

Research conducted by Kennedy and Dugdale, [1999, cited in better budgeting forum report, 2004:2] claimed that today, 99% of European and US companies are still using traditional budgeting system10 and have no intention of abandoning it Paradoxically, [p.2] of the same

report stated that up to 60% of those companies still claim that they are not wholly satisfied with the traditional budgeting system but are working assiduously to improving the system

Traditionally, this type of budgeting system can be performed in several ways, the two extremes

are; are the bottom-up11, and the top-down approach12 See [appendix 4], for benefits and

problems

2.1 Argument in favour of traditional budgeting

It seems reasonable to describe traditional budgeting as a historic bag containing both benefits and problems within it Wildavsky et al, [2001:147], has argue that traditional budgeting is

simpler, easier, more controllable, flexible than advanced budgeting techniques13 and more likely to be the appropriate budgeting system for a firm operating in a stable market

Terry Lucey, [2003: 204, has claimed that benefit from traditional budgeting system does not accrue automatically, it must be properly designed and administered Lucey further explains, that

its a major formal way of translating organizational objectives into plans; an important medium for communication, coordination; helps in promoting a coalition of interest and increase motivation and saves managerial time an attention directed to areas of greatest concern by the exception principle at the heart of budgetary control

10

Traditional budgeting system basically, based next year’s budget on the current year’s results plus an amount for estimated growth or inflation [CIMA, 2004] It simply assumes that the activities will continue in the same fashion in an approach described as incremental budgeting system

2.2 Argument against traditional budgeting

Traditional budgeting has for long been criticized for its inadequacy as a means of management control Criticisms of its inadequacy in the fast-changing business world dates back to mid

1980’s with the emergence of Johnson & Kaplan, (1987) seminal book titled “Relevance Lost.”

The classical weaknesses inherent in traditional budgeting system as commonly examined by authors [ e.g Alan Upchurch 2002:495; Horngren et al 2005; Terry Lucey, 1992:99; Fraser and Hope, 2005; Drury, 2007] is that, past will dominate the future, with past inefficiencies being carried forward to future periods Bunce and Fraser, [1997]; Hope and Fraser, [1997]; Fanning, [1999], view traditional budgeting process as bureaucratic and protracted, full of inefficiencies and ineffectiveness

For a better understanding, Adams et al [2003: 23], classify weaknesses in traditional budgeting

practices under three principal headings, from research conducted by Cranfield School of

management as;

Competitive Strategy:

budgets are rarely strategically focused and are often contradictory;

budgets concentrate on cost reduction and not on value creation;

budgets constrain responsiveness and flexibility, and are often a barrier to change; and

budgets add little value- they turn to be bureaucratic and discourage creative thinking

Business process:

budgets are time consuming and costly to put together;

budgets are developed and updated too infrequently- usually annually;

budgets are based on unsupported assumptions and guesswork; and

budgets encourage gaming and vicious behavior

Organizational capability:

budgets strengthen vertical command and control;

budgets do not reflect the emerging network structures that organizations are adopting;

budgets reinforce departmental barriers rather than encourage knowledge sharing; and

budgets make people feel undervalued

Drawing from the foregoing, its seems logical, to infer that flaws14 in traditional budgeting

system collectively results in business underperformance and an alternative system is needed

2.3 Alternative approaches to traditional system

It is quite interesting to know that no other innovations in management accounting research have ever triggered such an overwhelming, highly divergence views and yet-unresolved debate than that of alternative to traditional budgeting system15 The current debate on the appropriate alternatives to traditional budgeting system has two approaches namely;

a Better budgeting group led by CIMA and ICAEW 16

The approach advocates17 improvement to traditional budgeting system [Fanning, 1999; Better budgeting report, 2004:2]

b Beyond budgeting group led by BBRT18

The “beyond budgeting” approach advocates19 a radical changes to budgeting process Now, what is the appropriate alternative to replace the traditional budgeting system? Is the question begging for an answer

2.3.1 Zero-based budgeting

In an attempt to overcome the weaknesses in traditional budgeting system, Zero-based approach

was born to help find answers to two basic questions: “Are current activities efficient and effective?” and should current activities be eliminated or reduced to fund higher-priority?” ZBB

is an approach that tries to find answers to these questions by using a decision-package ranking

14

The implications of flaws in traditional system tend towards promoting inward-looking, focuses on achieving a budget figure, rather than on implementing business strategy and shareholder value creation over a long-term 15

Movement of alternative to traditional budgeting system as initiated by practitioners in Europe and U.S.

process 20 [Pyhrr, 1977] This approach basically involves preparing one budget for each centre from a zero base and that each cost element be specifically justified to be included in the next year’s budget

The major benefits includes; efficient allocation of resources, removal of inefficiencies and obsolete operations Weaknesses on the other hand includes; high degree of skill in it

construction, consume managerial time and involves high volumes of paper work

2.3.2 Rolling Budgets and forecasts

The struggle for survival in highly competitive business environment was long recognized by

Herbert Spencer as early as 1851, when he coined a phrase “survival of the fittest” 21 Business

must be flexible and innovative What seems difficult is that of integrating the effects of innovations into traditional budgeting system, to worsen the case, is where fixed annual budget is

in use Firms operating in a rapidly changing industry have adopted a rolling budgets and forecasts, in an effort trying to overcome the rigidity in traditional systems and to cope with uncertainties [Hayes, 2002:116]

Rolling budget is simply a quantitative plans that is continually updated or simply “budget for life 22 ” A rolling budget [Drury, 2007; Atrill and Mclaney, 2007:173] will add a new month to

replace the month that has just passed, thereby ensuring that, at all times, and there will be a budget for a full planning period Figure [3 below] compare four-quarter rolling with traditional calendar-based budget

20 This process provides management with an operational tool to evaluate and allocate its resources efficiently and effectively, providing individual manager a system for identifying, evaluating and communicating his activities and alternatives to higher levels of management

CALENDAR YEARS

Source: Axson, 2003:196

Figure 3 Fixed traditional budget vs Rolling budget & forecasts

Benefits and problems of rolling budgets and forecasts

The classical benefits of continuous budgets as noted in Horngren, Foster, Datar, [2000:182]; Drury, [2007:270] is that, it usually result in a more accurate, up-to-date budget, incorporating the most current information available Often, rolling forecasts are used side-by-side with a budget but not to replace the budget In practice23, it play significant role in organization planning

One may ask “does rolling budget have weaknesses?” Yes, the approach consume reasonable time, highly expensive 24 , managers and employees must forecast responsibly every month or

quarterly instead of annually

23

In practice, its encourage business managers to think of planning as an ongoing process rather than as a one–off events, real time response to rapidly changing environment is another pronounced benefits of rolling budgets and forecasts and planning is not dictated by the calendar, but rather triggered by important events and changes

24

Expensive to run because, a number of budgets must be produced during the year, managers and employees must forecast responsibly every month or quarter instead of annually under traditional budgeting which increases work and cost related to budgeting

2.3.3 Activity-Based Budgeting

The problems of inaccurate cost information25 for decision-making gave birth to activity-based

costing with philosophy based on causation links clearly worded by proctor below

Proctor, state that26:

“Organization consume products, products consume activities and activities in turns consume costs” [Proctor, 2006 p 243]

Activity Based Budgeting model is new technique that link budgeting with organizational strategy which derives its philosophy from above causation link but in reverse Precisely, Cooper and Kaplan [1998] & Brimson,[1991], referred to activity-based budgeting as activity based costing in reverse [see figure 4 below]

Figure [4 ] Activity-Based Budgeting is Activity-Based Costing reversed

Proctor, [2006] Causation link- Organization cause products to be produced, products cause activities, activities cause costs to

be incurred He called this chain of causations ….a causation link.

The benefits and weakness of ABB

A critical analysis reveals that benefits of ABB outweigh it associated problems The information about costs is more scientific and relevant, its increases links between budgeting and strategic planning, accurate product costing, improved pricing and outsourcing decisions is more reasonable and real[CIMA, 2005] ABB equally has its own weaknesses; its compatibility with other costing systems is a major weakness

2.3.4 The balanced Scorecard

The constant search for appropriate alternative to traditional performance measurement and management led to the development of balanced scorecard by Kaplan and Norton of Harvard Business School

The central idea of balanced scorecard is translating organizational mission, aims and strategy into a comprehensive set of performance measures that provides the framework for a strategy measurement and management [Kaplan and Norton, 1996; Otley,1999: 373; Atrill and Mclaney, 2007:314] Its basically help managers27 to see clearly whether the objectives set have actually been achieved The balanced scorecard measures organizational performance across four main areas as depicted in figure 5 below [Atrill and Mclaney, 2007

27

The Managers of innovative firms employ balanced scorecard to manage their long term strategy as this

is more than a tactical or operational measurement mechanism

Translating Vision and Strategy

Figure [5] Balance scorecard

Benefits and problems of balanced scorecard

The most significant benefit of BSC ones is translating of strategy into measurable parameters, increase creativity, communication of strategy and aligning individual goals with the firm’s strategic objectives The superiority of BSc over traditional budgeting system is obvious but it lacks a well-defined strategy and the use of generic metrics are some of it major pitfalls [Mohan, 2004]

The Beyond budgeting model

The “beyond budgeting” movement advocates a radical changes to budgeting process The central theme of beyond budgeting model is that the whole budgeting system be replaced with a more pragmatic and adaptive model [Atrill & Mclaney, 2007:196]