a) Cost and cost behaviour is a very important aspect of management decision making- In the light of the above statement, you are required to discuss cost and cost behaviour impacts on the preparation of an organisation's budget
b) Break-even-analysis is an important tool in management decision making, you are required to discuss how break-even- analysis can be used to support management decision making in the preparation of the organisation's budget
Cost Behavior Analysis in Budget Preparation
For analysing the suitability of the project in the context of Benetton Plc, the methods of investment appraisal include net present value, payback period and internal rate of return. In this case, payback period is calculated as 2.08 years and the economic life of the project is five years. However, it is noteworthy to mention that payback period is not effective for evaluating two projects having unequal economic lives. Hence, it becomes difficult to undertake investment decisions based on the payback period of the project only. However, as the concerned organisation has to evaluate one project only, this method could be applied and it is evident that the project would prove profitable. This is because Benetton Plc would be able to recover its initial outlay within 2.8 years, which is well below the economic life of the project.
Net present value is another investment appraisal method used for analysing the feasibility of the proposed project for Benetton Plc. As this method considers time factor, initial monetary flows as well as succeeding monetary flows over the project lifecycle, it is considered as the superior investment appraisal method (Langfield-Smith et al. 2017). In addition, it provides adequate attention to the various risk aspects and profitability associated with the project. In case of the concerned project, NPV is obtained as £158,921.41. If the NPV is positive and it has higher value, the project is deemed to be favourable for the organisation. In this case, NPV has both aspects and hence, accepting this project would assist in increasing the overall profitability for Benetton Plc.
The final technique that has been taken into consideration for analysing the proposed project is internal rate of return. One of the most interesting aspects of this method is that it becomes simple to explain after its computation. When the cost of capital is lower than internal rate of return, it implies that the project has the ability of generating favourable returns and vice-versa (Otley 2016). It has been observed that it becomes quite difficult to ascertain the hurdle rate. In case of IRR, hurdle rate is not needed in order to compute it. For this project, IRR is obtained as 42.93% and the cost of capital is provided as 12%. This clearly implies that the internal rate of return is higher than the cost of capital. Hence, based on this technique, it could be said that the project would prove to be profitable for Benetton Plc.
By considering the outcomes of all the three chosen methods of investment appraisal, Benetton Plc is recommended to accept the project, as it would help in maximising its profitability level through which further expansion opportunities could arise in future.
The strengths and weaknesses of "payback period" are discussed below-
A significant proportion of companies provide employment to newcomers who come from various backgrounds for examining their financial projects, which are not only prejudicial but also very difficult to understand (Risinger et al. 2015). Moreover, payback discusses the ('n' of years), it also allows the newcomers to understand this method with ease.
Types of Costs
Authenticating which projects could generate quicker earnings is vital to those organisations, which do not have adequate resources. The managers utilise the method to produce quicker analysis regarding to the projects with minimum investment and a restricted payback period (Carvalho, Meier and Wang 2016).
The most noteworthy drawback of this process is the ignorance of time factor while analysing the suitability of a project. The cash flows generated from the initial years of a project are generally more than those generated in the later years (Eberhardt, Bruine De Bruin and Strough 2017). The payback period could be identical for many projects; however, two projects could generate more cash flows in the initial years and later years respectively. Therefore, using only the payback period for project selection or investment decision might not be a feasible option.
For specific projects, the highest cash flows would not take place after the completion of payback time. Such projects would fetch better return on investment and they would be suitable to projects having restricted payback periods (Goetsch and Davis 2014).
The strengths and weaknesses of "net present value" (NPV) are discussed below-
- NPV puts emphasis on time value of money.
- During the calculation of NPV, preliminary cash flows and following cash flows over the duration of the project is taken into account (Hirshleifer, Jian and Zhang 2016).
- Proper focus is given to the benefit and risk elements associated with the project.
- The value of the company rises owing to the implementation of this method.
- Implementation of this method is not always possible.
- NPV declines to give accurate decision if the total of the investment of conflicting projects are not similar (Ingram et al.2015).
- Calculation of authentic discount rate is not always possible.
- This method declines to provide feasible decisions when the duration of the projects are not identical.
The strengths and weaknesses of "internal rate of return" (IRR) are discussed below-
The most interesting fact about this method is that it is well defined after the (IRR) has been calculated. If IRR surpasses cost of capital, then the project would be accepted (Levin, James and Nolan 2014). It could be very easily understood by the managers and that is why it is accepted till the period they arrive at a specific point when the projects are conflicting and so on.
The (hurdle rate) is a very difficult and one sided element to regulate. In "IRR", this rate or the (required rate of return) is not required for computing the "IRR". It is not based on this rate and hence, the danger of an inappropriate calculation of (hurdle rate) could take place (Williams et al. 2015). Calculation of (NPV), (Profitability) rate require (hurdle rate).
Generally, finance managers arrive at positions when the project under examination produces a compulsion of investing in various projects. For example, if a person invests in an expensive car, they would need to arrange a place for parking also. These projects are defined as dependent upon or unpredicted projects, which need to be taken into account by the manager (Chambers, Echenique and Saito 2016). IRR could approve of purchasing the vehicle, furthermore, if the total anticipated benefits are excluded in arranging the parking space, there is no point investing.
Periodically the investors would encounter conflicting projects, which implies that if one is accepted, then the other cannot be accepted. Constructing a hotel or commercial penthouses on a particular piece of land is an example of conflicting projects. In such a situation, predicting whether it would be good for investing would not be enough (Frydman and Camerer 2016). The problem is to know which one is the best. IRR would give a proportional explanation value which would not be enough.
The "impact of cost and cost behaviour on the preparation of budget" is depicted below:
Break-Even Analysis in Budget Preparation
Cost behaviour analysis discusses the ways through which certain costs behave in a particular business environment. Thus, the managers are required to understand cost behaviour for ensuring effective cost control. In this relation, a brief discussion of cost behaviour and the different types of costs a manager needs to examine is depicted here.
Firstly, analysing costs requires understanding and examining main operations of the company. The operating levels are explained in financial location and they might be in the form of miles driven, sales dollars and others. The operation level would be incorporated with changes in costs. The operational indicators identify the operation, which leads to variation in cost behaviour. Hence, the managers undertake decisions so that costs could further be controlled. Costs could be categorised into fixed cost, variable cost and mixed cost.
They are discussed briefly as follows:
Variable costs are prices of a company that would vary in aggregate directly and additionally with the changes in a functional level. For example, with the increase in functional level by 20%, there would be rise in variable costs by the same percentage. The proportion would be the same with the downfall in functional level. Variable costs mainly include direct materials and direct labour. For instance, if an organisation uses its vehicles more, it would have to bear additional fuel expenses. Thus, if the functional level driving increases by 25%, the costs for fuel and other driving expenses would increase by 25% as well (Lu, Won and Cheng 2016). In order to compute variable costs, least square regression method is deemed to be suitable. Computer spreadsheet program is needed like calculator or MS Excel, as it uses all points of data instead of two points such as high-low method.
Fixed costs are prices that have identical aggregate despite the functional level modifications. Examples include rent, salary, property taxes, insurance and so on (Shahid, Ahmad and Badar 2017). As fixed costs would not change with functional level and quantity increases, there would be decline in cost per unit. For instance, it is assumed that an organisation incur $10,000 as rent per month. Even though the rent expense is fixed irrespective of production, the unit price of per commodity produced would decline in cost with rise in quantity. When there is production of additional 10% each month, the aggregate cost per commodity manufactured would decline by 10%.
Mixed costs include those costs, which have both variable costs and fixed costs. A truck rental is sound example of mixed cost (Shepherd, Williams and Patzelt 2015). For instance, leasing a truck might bear variable cost of $0.50 per kilometre and $100 as fixed cost. The managers of business organisations use high-low method for categorising and evaluating mixed costs. This method is involved in utilising the aggregate prices incurred at both low and high levels of functions for mixed cost classification into fixed factor and variable factor. The cost difference between low and high levels provides variable costs, as only the variable cost could change with the variation in functional levels. Steps in computing fixed and variable prices utilising high-low method are discussed as follows:
- Helps in controlling variable costs each unit.
- Helps in authenticating the fixed prices by decreasing the total variable costs at either the high or low functional level from the aggregate costs at that functional level.
Investment Appraisal Methods for Budget Preparation
The support management gains from "break-even analysis" while preparing budget is discussed below:
Break-even analysis is used in giving answers to question such as "what is the basic level of sales that ensures the company would not sustain loss" or "how much care sales be decreased and the company would still keep on earning revenues". Break-even analysis is very crucial before initiating a new business or launching a new commodity, as it gives answers to essential questions such as- "how exquisite is the revenue to the company, to either decrease its sales or increase the costs". This analysis could be also extended to initial level of business in order to check how accurate the first prediction was and monitor whether the company is on the correct track or not. Even global companies require to take into account their current break-even point along with finding quick-fix to reduce that standard in order to increase revenue (Rick et al. 2018).
Entrepreneurs and managers constantly face with issues related to decisions regarding selling costs and controlling prices. Break- even analysis is the examination of the level of sales at which a company or a project would make no profit. This method controls the sales needed for break-even. Break-even analysis could be very useful in the following practical conditions:
- Setting a new function.
- While preparing new commodities into manufacturing, such a situation could authenticate the yield for the new commodity.
- When expanding basic level of functions of the company.
- When developing projects in fixed assets and so on.
A company could use break-even analysis to answer the above questions from a pure cost and from the point of view of profit and when marketing departments are developing strategies, which involve approving discounts or carrying out promotional campaigns (Diabat et al. 2016).
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