FACULTY OF BUSINESS AND LAW FACULTY OF BUSINESS AND LAW FACULTY OF BUSINESS AND LAW FACULTY OF BUSINESS AND LAW PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE CODE: APC309 MODULE CODE: APC309 MODULE CODE: APC309 MODULE CODE: APC309 MODULE TUTOR: MR MIKE BAKER MODULE TUTOR: MR MIKE BAKER MODULE TUTOR: MR MIKE BAKER MODULE TUTOR: MR MIKE BAKER SUBMISSION DATE: 22ND MAY, 2009 SUBMISSION DATE: 22ND MAY, 2009 SUBMISSION DATE: 22ND MAY, 2009 SUBMISSION DATE: 22ND MAY, 2009 MANAGEMENT REPORT ON MANAGEMENT REPORT ON MANAGEMENT REPORT ON MANAGEMENT REPORT ON BUDGETING SYSTEM & M BUDGETING SYSTEM & M BUDGETING SYSTEM & M BUDGETING SYSTEM & MANAGING WORKING CAPITAL ANAGING WORKING CAPITAL ANAGING WORKING CAPITAL ANAGING WORKING CAPITAL PREPARED BY PREPARED BY PREPARED BY PREPARED BY 089003624 089003624 089003624 089003624 AUSTIN SAMS UDEH AUSTIN SAMS UDEH AUSTIN SAMS UDEH AUSTIN SAMS UDEH Life changi Life changi Life changi Life changing ng ng ng Word counts 3450
Transcript
FACULTY OF BUSINESS AND LAWFACULTY OF BUSINESS AND LAWFACULTY OF BUSINESS AND LAWFACULTY OF BUSINESS AND LAW
PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENTPROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENTPROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENTPROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT
MODULE TUTOR: MR MIKE BAKERMODULE TUTOR: MR MIKE BAKERMODULE TUTOR: MR MIKE BAKERMODULE TUTOR: MR MIKE BAKER
SUBMISSION DATE: 22ND MAY, 2009SUBMISSION DATE: 22ND MAY, 2009SUBMISSION DATE: 22ND MAY, 2009SUBMISSION DATE: 22ND MAY, 2009
MANAGEMENT REPORT ONMANAGEMENT REPORT ONMANAGEMENT REPORT ONMANAGEMENT REPORT ON
BUDGETING SYSTEM & MBUDGETING SYSTEM & MBUDGETING SYSTEM & MBUDGETING SYSTEM & MANAGING WORKING CAPITAL ANAGING WORKING CAPITAL ANAGING WORKING CAPITAL ANAGING WORKING CAPITAL
Life changiLife changiLife changiLife changingngngng
Word counts 3450
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TABLE OF CONTENTTABLE OF CONTENTTABLE OF CONTENTTABLE OF CONTENT 1
1.01.01.01.0 GENERAL GENERAL GENERAL GENERAL INTRODUCTIONINTRODUCTIONINTRODUCTIONINTRODUCTION 1.1 Budgeting, strategy and Organizational control system 2 1.2 Behavioural Aspect of budgeting 3
2.02.02.02.0 PART I: PART I: PART I: PART I: TRADITIONAL BUDGETRADITIONAL BUDGETRADITIONAL BUDGETRADITIONAL BUDGETING SYSTEM TING SYSTEM TING SYSTEM TING SYSTEM 7777
2.1 Argument infavour of traditional budgeting 7 2.2 Argument against traditional budgeting 8
2.3 ALTERNATIVES APPROACHES TO TRADITIONAL BUDGETING 9
2.42.42.42.4 BUDGETING BUDGETING BUDGETING BUDGETING SYSTEMS SYSTEMS SYSTEMS SYSTEMS & BUSINESS ENVIRONMENT& BUSINESS ENVIRONMENT& BUSINESS ENVIRONMENT& BUSINESS ENVIRONMENT 15151515
2.4.1 Budgeting system and Stable environment 15 2.4.2 Budgeting system and Dynamic environment 17
3.03.03.03.0 PART II: WORKING CAPITAL MPART II: WORKING CAPITAL MPART II: WORKING CAPITAL MPART II: WORKING CAPITAL MANAGEMANAGEMANAGEMANAGEMTTTT 18181818
3.1 Objectives and Components of Working capital 18
1.01.01.01.0 GENERAL INTRODUCTION 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 accounting2” .
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
4
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 budget4 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 “where are we now?; where are we going? And how do we get there? 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
5
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
6
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
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.
8 The multiple roles of the budget
9 e. g “The End of traditional Budgeting”, “Time to Replace traditional budgeting”; “Traditional Budgeting time is Up” etc],
7
2.0 TRADITTRADITTRADITTRADITIONAL BUDGETING SYSTEMIONAL BUDGETING SYSTEMIONAL BUDGETING SYSTEMIONAL 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. 11 In bottom-up approach- unit managers prepare their own budgets and these are reviewed and consolidated by a central department. Changes are then suggested from the centre and eventually, after some negotiation, a budget is agreed. 12 In top-down approach - an initial estimate is prepared by the centre, with targets for each unit. This is then expanded by unit managers to form a detailed budget. 13
The name given to ‘Better budgeting’ and ‘Beyond Budgeting’ techniques
8
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.
9
�
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 ICAEW16
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. 16 Source:www.bbrt.com 17 Improving the traditional budgeting system with tools such as rolling forecasts, balance scorecard etc to make budget forward-looking, flexible and dynamic to cope with the fast-changing environment rather than abandoning it. 18 Better Budgeting Reports available at http://www.icaew.com/index.cfm/route/117649/icaew_ga/pdf 19
It’s of the philosophy, that the whole budgeting system be abolished and be replaced with a more pragmatic, more adaptive, a decentralized and participative model. See, Hope and Fraser, [1997]; better budgeting report, [2004:2]; Atrill & Mclaney,[ 2007:196].
10
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
life22” . 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 21
In 1851, Herbert Spencer coin the phrase “Survival of the fittest” to explain competition in free market economies.
22 Rolling budget is often called “budget for life” by many.
11
CALENDAR YEARS
2008 2009
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 expensive24, 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.
12
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
25 The traditional approach to costing was discovered to be misleading in terms of cost information and as a result, leads to sub-optimal managerial decision-making. An efforts to address the problem gave birth to ABC 26 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.
13
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.
14
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].
15
The BBRT28 maintains that “better budgeting” is not the answer to problems of traditional
planning and budgeting caused by fast-changing business world [Better budgeting report,
2004:8]. Adding that the only radical way is by “dismantling budgeting system and move
towards” a more adaptive planning model as depicted in figure [5] below.
Figure 5 Tradtional versus Beyond budgeting model
Benefits and problems of beyond budgeting
28 BBRT- denote; Beyond Budgeting Round Table
16
One of the fundamental benefits of the model as opined by Fraser & Hope is that, its eradicate
the traditional mentality of performance measurement and in the fast-changing business
environment, the “adaptive” model enables quick response to changing circumstances.
Unfortunately, beyond budgeting is only a set of best practices which requires a combination of
management tools to be customized29 to firm’s budgeting system for the model to work.
A snapshot of how various techniques discussed above has been able to attack a specific
weakness of traditional budgeting is diagrammatically represented in Figure [6] below.
Figure [6] A snapshot of attach launched to address weaknesses in traditional budgeting system
29
In reality, only companies that operates in a highly competitive market and have successfully implement various management tools such as BSC, ABM or rolling forecasts, should be ideal candidates for the Beyond Budgeting model.
17
2.4 2.4 2.4 2.4 BUDGETING SYSTEM & BUSIBUDGETING SYSTEM & BUSIBUDGETING SYSTEM & BUSIBUDGETING SYSTEM & BUSINESS ENVIRONMENTNESS ENVIRONMENTNESS ENVIRONMENTNESS ENVIRONMENT
An appropriate budgeting system for an Organization largely depends on the nature, industry and
general business environment of operations. This report makes recommendations of appropriate
budgeting system for business operating in a stable and dynamic market below.
2.4.1 The Stable environment
For the purpose of this report, a business is said to operate in a relatively stable environment
when there is little changes in method of operations, and in terms of either its products or
demand on a year to year basis.
Apart from been the most compatible budgeting system with other costing approaches and less
expensive. Traditional budgeting is simpler, easier, more controllable, and flexible than
advanced budgeting techniques30 and the most appropriate for a firm operating in a stable
market.
It seems reasonable, drawing from critical evaluation of various budgeting approaches, to
recommend traditional budgeting for a firm in a stable environment.
2.4.2 Dynamic environment
Dynamism in today’s business environment renders a rigid approach to budgeting and budgetary
control obsolete [ Adams et al 2003; Hope and Fraser, 1997].
Budgeting system must be aligned with organization’s strategic planning on a continuous basis
towards responding to the ever-changing needs of customers and compete successfully.
Tanaka, [1993], say’s that an unpredictable corporate environment makes it difficult to prepare
plans in advance, rolling budgeting proves effective as it increases the frequency of feedback as
well as budget revisions by shortening the budget period, see figure [3] above.
There is no doubt of the suitability of rolling budget/ forecasts in the presence of other
approaches31, in such environment. Therefore, rolling budget is recommended for firm operating
in a dynamic market.
30
The name given to ‘Better budgeting’ and ‘Beyond Budgeting’ techniques 31
Zero-based, Activity based, Kaizen budgeting, flexible budgeting, probabilistic budgeting etc.
18
3.0 3.0 3.0 3.0 PART II: PART II: PART II: PART II: WORKING CAPITAL MANAGEMENT WORKING CAPITAL MANAGEMENT WORKING CAPITAL MANAGEMENT WORKING CAPITAL MANAGEMENT
Fundamentally, there is virtually no other “sensitive” aspect of business organization that boosts
performance when efficiently managed and drag an organization prematurely into bankruptcy
when inefficiently managed than working capital. Studies have shown that 85% of bankrupt
companies around the world have been traced to poor working capital management.
The quote of Naughton32 that “a well-managed working capital can be a competitive advantage
to a firm” is a confirmation of the importance of working capital management to the firm.
The concept of “working capital33” is a fundamental concept in finance literature, though has
been a source of controversy34 on the true meaning of working capital as the concept is easily
misunderstood even among board members and professionals managers [Bhattacharya, 2006].
Hence, discussions of this nature should start clearly with the meaning of working capital.
The term “Working capital” as used by authors e.g Atrill and Mclaney, [2007]; Watson & Head,
[2004]; Arnold, [2004], Proctor, [2006]; pike & Neale, [2003]; Ross & Westerfield, [1999], is
simply current assets less current liabilities. They added further, that while “gross working
capital” is the total investment in current assets, “net working capital” is the term used to
describe net investment in short-term assets.
Managing working capital simply denotes the administration of the firm’s current assets and the
financing needed to support current assets. Most likely, working capital management will direct
impact on corporate profitability and liquidity [Shin & Soenen, 1993]. A clear specification of
objectives and policies are required to help achieve success.
32
Todd R. Naughton ,Vice President, Finance Zebra Technologies Corporation
33 The concept was traceable, first to the monumental work of Karl Max’s,”Das Kapital” (1867, cited in Bhattacharya, 2006). Karl Max constracts in his word “constant capital” vs “variable capital” and the working capital as we understand today was originally embedded in his “variable capital”. 34 While an accountant will regard working capital as the excess of current assets over current liabilities and call this “net working capital” a financial analyst will consider gross current assets as working capital. Both may be right, because concerns of the accountant differ from that of the financial analyst. The accountant major concern is arithmetical accuracy of the two sides of the balance sheet while the analyst concerns is to find fund for each items of current assets at such costs and risks that the evolving financial structure remains balanced between the two.
19
3.1 3.1 3.1 3.1 THE OBJECTIVE AND COMPONENTS OF THE OBJECTIVE AND COMPONENTS OF THE OBJECTIVE AND COMPONENTS OF THE OBJECTIVE AND COMPONENTS OF WORKING CAPITALWORKING CAPITALWORKING CAPITALWORKING CAPITAL
In a typical manufacturing firm like xyz ltd, the basic elements of investment in current asset
may includes; inventory of raw materials, work-in-progress, finished goods, debtors, short-term
investments and cash while current liabilities [i.e sources of finance] may includes; trade
creditors, overdrafts and short-term loans.
The two main objectives of working capital management are; to maintain sufficient liquidity35 for
effective and efficient functioning and to improve the profitability of the business36 [Watson and
Head, [2004]. In addition, minimization of risk and maximizing returns on assets from current
assets still fall under the objective [Arnold, 2004].
Unfortunately, liquidity and profitability objectives37 are not easily achieved at the same time as
both often conflicts in practice. On this ground, Watson and Head, [2004], argued that while
liquidity is needed for a firm to operate, a firm may choose to hold more cash than is needed for
transactional motive38 [ Keynes, 1936].
This report emphasis on the concept of time value of money and that Cash kept in safe generate
no returns which otherwise should have earned should it be deposited in a bank for a time period.
Finance managers should strive for a balance between liquidity and profitability.
35 For meeting day-to-day cash flow needs; pay wages and salaries when they fall due; pay creditors; pay taxes and providers of capital and ensure the long term survival of the business entity 36 Adequate liquidity & profitability [Pass and pike, 1984; Arnold, 2004; Watson & Head, 2004; Proctor, 2006; Atrill and Mclaney, 2007; University of Sunderland, 2008), are the main objectives of working capital management. 37 There is a trade-off between the two primary objectives of liquidity and profitability in practice. 38 J.M Keynes (1936), The General Theory of Employment, Interest and Money available at http://www.marxists.org/reference/subject/economics/keynes/general-theory/
20
Working capital Policies and Principles
Experience has shown that firms only achieve these objectives with clear working capital policy
and principles [i.e Principle of Risk variation39 , cost of capital40 , equity position,41 and maturity
of payment42] regarding the quantum of various components of working capital required as
depicted in figure 1 below [Kavitha, 2007].
The level of investment in working capital is directly dependent on the firms policies regarding
the level of current assets considered sufficiently and reasonably safe, in terms of risk and returns
Figure 2 [a] Principles of working capital management [b] working capital policies
39
The principle holds that the inability of a firm to meet its short term obligations, as they fall due breeds risk and stresses the inverse
relationship between the degree of risk and return(profitability). Management who prefers to minimize risk by maintaining a higher level of current assets or working capital end up making low returns. 40
The principle of cost of capital indicated the existence of a strong correlation between risks and cost of capital. Stressing further, that the
higher the risk the lower is the cost and lowers the risk, higher is the cost of capital. Management should always strike to achieve a proper balance between these two. 41
The Principles of equity position is concerned with planning the total investment in Current Asset in such that every pounds invested in the
current assets should contribute to the net worth of the firm. 42
This principle holds the need for adequate planning for sources of finance for working capital and that firms should make every effort to
relate maturities of payment to its flow of internally generated funds.
21
Firms may adopt conservative43, moderate44 and aggressive45 working capital policies [see figure
2b] above, depending on risk taking capability as adoption of any of the approaches specific
impact on corporate profitability.
3.2 Working capital cycle of a XYZ ltd
Working capital cycle is the period of time which elapses between the point at which cash begins
to be expended on the production of a product and the collection of cash from a customer46
[Watson & Head, 2004]. Figure [3] below depict a typical working capital cycle of a
manufacturing firm. While the upper part of the diagram in blue boxes shows a simplified chain
of events in xyz, each of the boxes can be seen as tanks through which funds constantly flow into
and out of them resulting from daily activities
Figure 3 Source: adapted from [Arnold, 2004]
Figure [4] working capital cycle of manufacturing firm
43
In conservative policy, firms prefers to hold more cash on hands and finance part of the current assets with long term funds
which are more expensive. This actually leads to low-risk but with associated low returns as excess cash in hand yield no returns. Firms may decide to adopt approach called matching policy, which simply matches’ assets and liabilities ie long term sources to finance fixed assets and permanent current assets and short term financing for temporary current assets. 44 Firms may decide to adopt approach called matching [moderate] policy, which simply matches’ assets and liabilities ie long term sources to finance fixed assets and permanent current assets and short term financing for temporary current assets. 45 When a firm adopts aggressive policy, it takes high-risk where short term funds are used to a very high degree to finance all current and even part of fixed assets and the returns are usually high.
22
3.3 Improving the Working capital cycle of Xyz Ltd
Improvement in working capital cycle of xyz ltd requires efficient management of the various
components of working capital. This report emphasis seriously, on the implications of
overcapitalization and overtrading as shown in figure [3] below.
Figure [5] implications of overcapitalization and undercapitalization
3.3.1 Managing inventory
One of the most significant components of working capital of xyz with considerable impacts on
corporate profitability is the inventory. Manufacturing concern hold three classes of inventory
namely; raw material, semi-finished goods and finished goods. A fundamental question in
23
inventory management is why firms hold stock? A good inventory management should address
strategic inventory management questions shown on figure 3.
Xyz holds inventories for several motives, but the most common is that of meeting the day-to-
day production and customers demand requirements. Holding inventory is associated with costs.
So, there is always a trade –off of risk of too low and tool high inventory.
To improve the working capital cycle, requires efficient inventory management which in turn
needs, appropriate forecast for future customer demand, good recording & re-ordering system,
applying the use of models[ e.g e.g EOQ, JIT, ERP,MRP etc] to strike a balance between
inventory trade-off as shown in figure[5].
Figure [5] Inventory trade-off [Risk of too low or too high
24
3.3.2 Managing of Debtors
Strategically, xyz may have allowed credit to their customers in attempt to the achieve corporate
objective of gaining good market share and in order to improve working capital cycle, efficient
debtors’ management which aim at striking a balancing the risk of illiquidity as consequence of
reasonable amount in customers hands and losing customers, should address certain questions47.
xyz policy of giving customers cash discount encourages prompt (earlier) collection of
receivables, the use of factor agents where necessary and analysis of debtors and probably stop
the supply of more goods to customers with load of excuses. Xyz should always make provision
for bad and doubtful debts for the purpose of planning while finance managers are warn of the
use of factoring agent in debt collection for it implications.
3.3.3 Cash management
The fundamental question48 of why do xyz ltd holds cash saw what is regarded as a convincing
answer in the work of J.M Keynes [1936]49. The Keynesian economists posit that, firms prefer to
hold part of their assets in the form of cash for what they described as “transactionary”,
speculative” and precautionary50” motive.
Cash is the most sensitive components of working capital of firms of all kinds and may be held
for reasons identified above. To improve cash inflow and outflow, models51, such as upper &
lower limit cash balance, cash budget are essentially good cash management tools.
Maynard Rafuse, [1996]52, noted that improving working capital cycle by delaying payment to
creditors is counter-productive and has implication of reducing xyz credit standing with its
47 Do we allow all customers credit? Who should receive credit? Are there criteria for checking credit worthiness of customers? What is potential customers score for 5Cs of credit? What is the maximum credit period allowed to customers? How much credit do we allow? How do we encourage prompt payment? 48 Why do we prefer to hold part our assets in the form cash? How much cash should be held? Does amount of cash held impact on profitability? Studies have shown that cash management policies of successful firms tend to provide answers to these questions. 49J.M Keynes (1936), The General Theory available at http://www.marxists.org/reference/subject/economics/keynes/general-theory/ 50 According to Keynesian economists, transactionary motives means holding cash for day-to-day operations, speculative motives denote holding cash for profit reason and precautionary motives is holding cash for emergency in the future. 51
Exercising control over inflows and outflows of cash balance with models such as: upper and lower limit, cash budgeting model; cash operating cycles models are good means of enhancing cash management. 52 Managing Director, Bennecon Limited, Process Analysis and Stock Management Consultants, London, UK available @ http:
//www.emeraldinsight.com/Insight
25
suppliers. He added that, inventory reduction generates system-wide financial improvements.
Although caution must be taken in reducing the level of inventory as consideration should be
given to current customers demand.
Xyz can opt for earlier payment from customers and delay to make payments on the last due
dates or negotiate for extension with their suppliers all aimed at boosting cash flows. In period of
surplus cash, xyz should invest in marketable securities and sell the securities or arrange to
borrow when cash shortage are envisaged through the cash budget. Outlined in figure [3] are,
other techniques for improving cash management [Atrill and Mclaney, 2007; Proctor, 2006].
Operating cash cycle
Cash operating cycle is basically, the time lapse between cash out and cash in from sales. The
shorter the cash operating cycle the better for xyz ltd [see figure 4 below].
Source: [Atrill and Mclaney, 2007 p. 410] Figure 4. Operating cash cycle
26
While Besley and Brigham, (2005) confirm that, the average cash conversion cycle of European
firms are twice that of US firms, summary of strategic approaches employed in reducing the
operating cash cycle53 are highlighted in figure appendix 1.
3.3.4 Managing trade payables
Managing the relationship between xyz ltd, their suppliers and other sundry creditors desires
serious attention as an important element of working capital cycle. According to Maynard,
[1996], creditors’ management is essentially a Darwinian situation54.
To improve the working capital cycle, creditors management need to optimize the use of trade
payables otherwise known as interest-free source of finance or what Brealey et al, (2007),
described as implicit loan from suppliers. Negotiating a long period of payment with suppliers,
making payments on the due date and negotiating a better credit terms are steps towards
improving the trade payables [see figure 3].
The strategy of delaying payment to creditors may reduce xyz credit rating as suppliers may
simply misconstrue the financial situation of xyz for a symptom of working capital deterioration
which may brings drastic restrictions on supplies. Care must be taken in employing delay tactics
with suppliers.
4.0 Conclusion
Efficient working capital cycle lies at the heart of successful firms, playing increasing role
towards shareholders wealth maximization.
Xyz manufacturing limited can successively improves its working capital cycle by optimizing
inventory; recievables, cash and payables.
53
suggestions on ways to reduce the length of cash operating cycle includes; lowering the level of inventories held, imposing tighter credit
control, offering discounts, charging interests on overdue accounts, and extending the period of credit taken to pay suppliers could all help. 54Darwinian situation, according to Maynard,� the survival of the fittest�. Large companies enforce their terms with smaller com
panies, who in turn enforce their terms with those smaller yet.
27
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