Benefits of Preparing a Budget
1. Discuss the benefits to an entity in preparing a budget for the coming financial year; and List and briefly discuss four general problems with, or limitations of, budgetary control through variance analysis.
2. Explain what is meant by the term non-GAAP reporting;Given the objective of financial reporting, discuss how non-GAAP reporting supports or detracts from this objective.
3. Why is an uderstanding of cost behaviour important. Explain the meaning of ‘contribution’, and ‘break-even analysis’ and discuss their usefulness. Break-even/CVP analysis seems to be a great tool. Does it have any weaknesses?
A budget is prepared by the management of the company to keep a track of its expenses and income. There are many types of budgets that are prepared such as Sales budget, Purchase budget, Cash budget etc. All these budgets benefit the company in some way or the other. The benefits of preparing a budget are as follows:
- It helps the company to plan for the future. A company manages its current expenses and short term expenses anyhow but it is also very important to plan for the future so that the company has a proper financial performance and health in the future as well (Atkinson 2012).
- There are several activities that are carried out in an organisation. It is not necessary that the company makes profit in all its activities; there might be some activities that results in losses also. Budget helps to identify the activities that contribute the major profits and also the activities that results in losses.
- Budget helps the company to plan for the funds that will be required by the company. It makes the management aware of the shortage of funds before it happens. So, the management is able to take steps accordingly(Berry 2009).
- It helps the management to make proper allocation of the cash available with them between the fixed assets and working capital in the best possible manner.
- It helps the company to evaluate performance. It helps the management to compare between the estimated performance and actual performance. If there is a variation between the actual and estimated data then corrective measures should be taken (Boyd 2013).
The four major problems and limitations of the budgetary control through variance analysis are as follows:
- As we know, budgets play a major role in the performance evaluation, so the inefficient employees of the organisation may not support and co ordinate with the managers in the preparation of these budgets.
- The budgets are prepared based on various estimates and forecasts. Therefore, there is a high probability that the budgets prepared may not be accurate.
- It is a well known fact that business is of dynamic nature. So the static budgets may be proved to be useless and making a flexible budget is a very difficult job. The task of budgeting is very time consuming as well as tiring(M. S. Datar 2015).
- The preparation of the budgets are highly dependent on the calibre of the administration of the company. It is equally important to supervise that the operations are carried out according to the planned budgets.
(a) All the companies are required to report their earning and income at the end of the year. Usually, the company computes these earning and income in compliance to the generally accepted accounting principles (GAAP). But sometimes along with this, the company also prepares a report that is not in compliance with the GAAP. This is known as Non – GAAP reporting. (S. Datar 2016)
It is believed by some managers that these reports provide more accurate information about the financial performance and position of the company. Few examples of Non GAAP earning measure are depreciation, earnings before interest and tax , cash earnings and also operating earnings.
(b) The Non GAAP reporting supports as well as detracts the objective of financial reporting. The ways in which it does so are stated below:
- It is considered to be more predictive because of the exclusion of the unusual items and its effects.(Edwards 2014)
- It makes easier to compare over the year performance of the same company because it excludes the non- recurring items such as charges of restructuring, loss or gain on sale of assets while accounting.
- It becomes difficult for the inter company comparison because there is no standard defined.
- There is a lack of consistency that might mislead the investors. Sometimes the company fails to include the expenses that it was recording in the past years.
- It provides relevant information by providing a true and clear picture of the earnings of the company. (Donanldson 2012)
(a) Cost behaviour means tracing the changes in cost due to change in the level of activity of a company. It is useful for the company to learn about cost behaviour because it helps the management to plan and control the costs in the organisation. An understanding about the cost behaviour also helps the management to calculate the break - even point and carry out the cost-volume-profit analysis (Edwards 2014). All the companies prepare budget as it a very important tool of management. However, these budgets can be prepared more correctly and will be more effective if they reflect the pattern of cost behaviour.
Limitations of Budgetary Control
There are usually two types of costs that are involved in an organisation. They are fixed costs and variable cost. Fixed costs are those that do not change with the change in the level of production in a company. They remain stable in the long run. This means the company has to pay such costs even if they shut down production. Some examples of fixed cost are rent and electricity. Variable costs are those that are highly dependent on the level of production of the company. These costs increase with the level of production and decrease along with it. However, these costs can be avoided when there is no production. Some examples of variable costs are raw material, direct labour and direct overhead (Flood 2017).
Contribution can be calculated by subtracting the cost of all direct costs from the earnings. The amount that is remaining after the deduction is used to pay off the fixed costs of the company. If there is any amount left after the payment of fixed cost then that is considered as the profits earned. It follows accrual basis of accounting The usefulness of contribution is that it helps the company to prepare an estimate of the sales, direct costs as well as the fixed costs of the company. Contribution also helps the company to ascertain the amount it should use for the capital expenditures and what impacts it might have on the company.
Break even analysis is carried out to determine the level of revenue that a company has to generate to meet all its expenses. This analysis can be used for a particular product as well as for the entire production. The breakeven analysis helps to compute two types of break even point, one in respect of units and another in respect of sales. Break even analysis is useful to the company because it helps the company to determine the point of profitability and also helps the management in pricing a particular product or service that it has produced. It also provides the company with various strategies by analysing information that would help them in future. (Holtzman 2013)
Break even analysis is often name as Cost – volume- profit analysis. There are alot of advantages and usefulness of using this as a tool in the management accounting. However, there are certain weaknesses also. Few of them are as follows:
- The calculation in the breakeven analysis is based on many assumptions. Therefore, we cannot think it to be accurate and precise. For example- It assumes that the selling price is always same at all the levels of output; it also assumes that the level of production is same always.
- This analysis is time consuming and tiring to perform.(Horngren 2012)
- It assumes that all the costs can be divided into variable costs and fixed cost. However, there may arise difficulties is dividing such costs into categories.
- It assumes that there is a linear relationship between the variable costs and sales of the company. This may not hold good sometimes because it may happen that the sales have increased over a period of time but the variable costs have not increased proportionately because of the efficiency of the management.
- There is also an assumption made that the level of efficiency will remain constant. But this is not possible because the efficiency of the company may vary from time to time. The management might be efficient at sometimes and may also be inefficient during sometimes.(Mattessich 2016)
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