Flexible Budget And Budgetary Control For Financial Planning – Analysis

Flexible Budget

The increasing complexity within the business environment is causing the firms to adopt better system of cost management for maximizing their operational efficiency. In this context, the businesses are largely adopting the use of budgetary control for developing a sound financial plan that helps in attaining the financial as well as operational goals. Budget can be regarded as the framework that helps in determining the strategic plan of a firm that assists in attaining its organizational goals and objectives (Shim, 2011). In this context, the application of flexible budget and the budgetary control for demonstrating their usefulness to the management team of the telecommunication company ‘Real Madrid Sdn Bhd’ can be discussed as follows:

Flexible budget can be described as a budget that can be adjusted as per the fluctuations in the volume of the activity. The flexible budget provides the major advantage to the management by taking accurate decisions based on its realistic position. It is associated with the major benefit of providing adaptability to the businesses as the budget developed is highly flexible and can be adjusted as per the changes in volume of production based on the marketplace conditions. The flexible budget provides the major advantage to the management by identifying the difference between fixed and variable costs on the basis of fluctuations in the output achieved. It enables in providing different type of budgeted costs on the basis of various level of activity of production. It enables the management in effectively classifying the expenses between the variable and fixed expenses that assist the management in reducing the operational expenses by eliminating the unnecessary activities (Dugdale, 2010).

However, the flexible budgeting method is also criticized by the business managers as it requires tracking the changes in a continuous manner and as such the process can be time-consuming. Also, it incurs high amount of cost for monitoring continuously the business changes and therefore is not feasible method of budgeting for organizations all the time. The authenticity of the flexible budgeting system is also questioned by the business managers on account of its authenticity. This is because the outcome determined by the use of flexible budgeting system can be inaccurate if the information gathered is not reliable.

Budgetary control refers to the method adopted by the business managers for monitoring and controlling costs that helps in determining the financial and performance goals by comparing the actual results with the budgeted outcomes. The major advantage that the method of budgetary control provides to the management is finding out the discrepancies that help in taking proper decisions. The major objective of the budgetary control is to develop future planning by determining the various budgets and maximize the operational efficiency. The telecommunication company involves different types of operational activities that can result in consuming large amount of resources. Thus, development of budget will help in gaining an estimate of overall cost to be realized in carrying out different business operations. This will help in making accurate planning for meeting the expenses and thereby reducing the financial risk. The major point of criticism for the method of budgetary control is that is lacks reliability as it adopts the use of various estimates and thus the results can be misleading.  The revision of the budgets again and again can lead in enhancing the business expenses involved in development of budgets (Weygandt, 2015). 

Budgetary Control

Economic order quantity (EOQ) model is used by businesses for managing the inventory level by establishing a tradeoff between the holding and ordering costs of inventory. The model is sued for reducing the overall inventory costs. The overall inventory cost can be minimized by reducing both the ordering and holding costs of inventory. Holding cost refers to all the significant costs that are associated with holding the inventory such as material handling or logistic costs. On the other hand, ordering costs involves the cost that is associated with ordering the inventory such as packaging or delivery cost (Choi, 2013). As given in the case scenario, Tootenhand Berhad management is concerned related for maintaining the stock levels and thus need to reduce the holding costs associated with inventory. Thus, the management team of the company is recommended to adopt the use of EOQ model that will help in ordering the right amount of inventory that help in reducing the costs involved in maintain the stock levels.  The accurate determination of required inventory can be done with the use of EOQ model by determination of three variables that are, demand, ordering and carrying cost. The economic ordered quantity is calculated by the use of following formula: 

The economic ordered quantity determined will help in keeping the inventory costs as low as possible. The determination of accurate inventory level will help in maintaining a budgetary control and maximizing the operational efficiency. However, the method is criticized due to the assumptions used in the model that are too simplistic. Also, it does not take into account the real cost of stock in operations and is also regarded to be largely descriptive. In addition to this, the model cannot be accurately used for the products that have seasonal fluctuations (Muckstadt, 2010). 

(a)The goal of the management as per the agency theory should be to maximize the share process for creating enhanced value for the shareholders. Thus, it is essential for the management team to consider the future growth prospect of the firm before accepting the bid offer. The offer provided by another company to pay RM40 is not worthy of accepting of the firm value is expected to increase in the future years. This acceptance of this hostile bid will not prove to be worthy of accepting as it will act against the interest of the owners by not considering the long-term value that the firm can provide to them in the future (Ehrhardt & Brigham, 2016).

(b)The continued growth and success of an organization remains on its ability to realize profits that is necessary for it to remain attractive for its investors. The increasing competition in the external market is causing the business entities to deliver maximum profits for outperforming their competitors. The pressure can derive the business managers to adopt the short-term growth strategies for achieving the determined financial targets. The business companies for delivering maximum results for its stakeholders tend to adopt the short-term growth strategy rather than exploring the best long-term strategy. The decisions taken by business executives to drive larger profits instantly can negatively impact the long-term growth and sustainability of a company. This is because it can be at the expense of the sustainability of a company that is essential for deriving its long-term growth. For example, the business managers if chooses to achieve the short-term results by ignoring the business ethics that it can negatively impact the long-term growth prospects of an organization. The long-term sustainability of an organization depends on its ability to create profit and at the same time being ethically and morally responsible to all its stakeholders. Thus, it involves promoting environmental, economic and social development and not just placing emphasis on deriving its profitability by ignoring the interests and welfare of its stakeholders (Eich, 2016).

Advantages and Disadvantages of Flexible Budgeting Method

(c) An agency relationship exists in the corporate form of an organization as it leads to an establishment of a contract between the owners and the business managers. The contract is established as a corporate form of an organization makes it legally recognized as a separate entity. Thus, it requires that all the corporate actions are taken by the business managers, acting as principal, on the behalf of the owners, who are the agents. This leads to the establishment of an agency relationship in which the principal provides the decision-making authority to the agent but the legal control is possesses by the owners that are the shareholders of a firm (Ross, 2014). 

The key financial ratios that can be used by the management team of Everton Sdn Berhad for evaluating the company’s performance are profitability, solvency, efficiency and market ratios that help in determining its future growth prospects. These key financial rations can help in developing a benchmark for measuring the performance of all another players operating within the same industry. The understanding of the ratios provides larger help to the business managers and also to the investors for gaining an analysis of the strengths and weakness and thus facilitate in their decision-making process. The weakness in the performance can help the management team in developing effective strategies for overcoming it for driving the sustained growth of the businesses. The ratio analysis can also prove to be useful for management team for acquiring another entity operating within the similar industry as it provides standardized method for comparing the companies and industries. It helps in adequately comparing the performance of a firm in relation to its competitors so that business managers can effectively take decisions for outperforming another company on the basis of its weakness and strengths analyzed with the use of key financial ratios outcomes (Gibson, 2008). 

Answer 1: Economic Order Quantity

This question in on economic order quantity and finding some information related to inventory management. In order to solve the question, there is need look at the information provided:

Given Information
Number of units in one order	100	units
Annual Units Required	250000	units
Carrying Cost	10%	of purchase price
Purchase price	10.00	per unit
Ordering Cost	100.00
Desired Safety Stock	5000	Units
Delivery Time	1 week

1. a) Optimal Economic Order Quantity Level

Formula: Square Root of (2SO/C) (Arnold, 2013)

Where:

S = Total number of units needed by firm in a period

O = Cost needed to pay for ordering one order

C = Carrying cost required to be paid for keeping the stock

Applying formula in the equation, we get:

Note: Calculation can be seen in excel file

EOQ: = 7071.07 units

1. b) Orders need to be placed annually

Number of units needed annually	250000	units
Units can be ordered	7071.07	Units
Number of ordered to be made	35.36	or 34 orders

1. c) Average inventory level

In case when Napoli Sdn Bhd want to keep the safety stock of 5000 units that the average inventory level will be computed by the following formula:

Formula: Order Quantity units/2 + Safety Stock (Arnold, 2013)

= (7071 units/2) + 5000 units

Average Inventory Level
Units to be ordered	7071	units
Safety Margin	5000	units
Average Inventory Level	8535.5	Units
	or 8536	Units

1. d) Change in EOQ level when carrying cost doubles

Change in Given Information
Number of units in one order	100	units
Annual Units Required	250000	units
Carrying Cost	20%	of purchase price
Purchase price	10.00	per unit
Ordering Cost	100.00
Desired Safety Stock	5000	Units

EOQ

5000.00

Units

1. e) Change in EOQ when selling price is doubled

EOQ will remain the same as there is no role of selling price while calculating the EOQ.  

Given Information
Years	Particulars	Project Monaco	Project Ajax
0	Initial Outlay	-RM 5,000,000.00	-RM 5,000,000.00
1	Cash Inflow	RM                       –	RM  1,250,000.00
2	Cash Inflow	RM                       –	RM  1,250,000.00
3	Cash Inflow	RM                       –	RM  1,250,000.00
4	Cash Inflow	RM                       –	RM  1,250,000.00
5	Cash Inflow	RM  6,500,000.00	RM  1,250,000.00

A: Payback Period

Calculation of project payback period
Years	Project Monaco	Cumulative Cash flows
0	-RM 5,000,000.00	-RM                 5,000,000.00
1	RM                       –	-RM                 5,000,000.00
2	RM                       –	-RM                 5,000,000.00
3	RM                       –	-RM                 5,000,000.00
4	RM                       –	-RM                 5,000,000.00
5	RM  6,500,000.00	RM                  1,500,000.00
Payback Period	4.77	or 4 years 9 month
Years	Project Ajax	Cumulative Cash flows
0	-RM 5,000,000.00	-RM                 5,000,000.00
1	RM  1,250,000.00	-RM                 3,750,000.00
2	RM  1,250,000.00	-RM                 2,500,000.00
3	RM  1,250,000.00	-RM                 1,250,000.00
4	RM  1,250,000.00	RM                                       –
5	RM  1,250,000.00	RM                  1,250,000.00
Payback Period	4 years

B: Net Present Value

Formula = Present value of cash inflows – present value of cash outflows (Moles & Kidwekk, 2011)

Project Net Present value
Years	Project Monaco	PVF @ 10%	PV @ 10%
0	-RM 5,000,000.00	1.000	-RM  5,000,000.000
1	RM                       –	0.909	RM                         –
2	RM                       –	0.826	RM                         –
3	RM                       –	0.751	RM                         –
4	RM                       –	0.683	RM                         –
5	RM  6,500,000.00	0.621	RM   4,035,988.600
		NPV	-RM     964,011.400
Project Net Present value
Years	Project Ajax	PVF @ 10%	PV @ 10%
0	-RM 5,000,000.00	1.000	-RM  5,000,000.000
1	RM  1,250,000.00	0.909	RM   1,136,363.636
2	RM  1,250,000.00	0.826	RM   1,033,057.851
3	RM  1,250,000.00	0.751	RM      939,143.501
4	RM  1,250,000.00	0.683	RM      853,766.819
5	RM  1,250,000.00	0.621	RM      776,151.654
		NPV	-RM     261,516.538

C: Calculation of Project IRR

Project Internal Rate of Return
Given Information
Years	Particulars	Project Monaco	Project Ajax
0	Initial Outlay	-RM                 5,000,000.00	-RM    5,000,000.00
1	Cash Inflow	RM                                       –	RM     1,250,000.00
2	Cash Inflow	RM                                       –	RM     1,250,000.00
3	Cash Inflow	RM                                       –	RM     1,250,000.00
4	Cash Inflow	RM                                       –	RM     1,250,000.00
5	Cash Inflow	RM                  6,500,000.00	RM     1,250,000.00
	IRR	5.39%	7.93%

D: Profitability Index

Formula: Net present value + Initial Outlay / Initial Outlay (Moles & Kidwekk, 2011)

Profitability Index of Projects
Particulars	Project Monaco	Project Ajax
Initial Outlay	RM  5,000,000.00	RM                  5,000,000.00
NPV	-RM   964,011.400	-RM                   261,516.538
Profitability Index	0.81	0.95

Advantages and Disadvantages of Budgetary Control Method

Information given for question A and B

Given Information
Project	Beta	Expected Return
Barcelona	0.7	11%
Juventus	0.85	14%
PSG	1.3	16%
Chelsea	1.5	18%
T-Bill Rate or risk free rate	9%
Market Rate	12%

 .A: Analyzing of expected return of all the projects and identification of projects that has higher expected return

Expected return of the project can be calculated through using the CAPM model

Formula of CAPM model is = Risk free rate + Beta (Market return – Risk free rate)

As expected return of each project has already been provided and here it is need to evaluate that whether which project has more expected return as compared to cost of capital of the company of 12%. As it is clearly seen that project Juventus, PSG and Chelsea have higher expected return as compare to cost of capital of 12%. So, finally it can be said that Barcelona has lower expected return and all other projects have higher expected return.

B: Assessment of Projects that are incorrectly accepted or rejected when cost of capital has been selected as the hurdle rate

Cost of capital of the company is 12% which states that projects that provides expected return higher than the cost of capital are being correctly accepted and projects that have low expected return than cost of capital is being correctly rejected.  

In order to check which projects are being accepted there is need to calculate the expected return using CAPM model.

Project	Risk free rate	Beta	Market Return	Expected Return	Accepted or Rejected
Barcelona	9%	0.7	12%	11.10%	Rejected
Juventus	9%	0.85	12%	11.55%	Rejected
PSG	9%	1.3	12%	12.90%	Accepted
Chelsea	9%	1.5	12%	13.50%	Accepted

As Porto Berhad has considered four projects and they are accepted by the company but when cost of capital has been chosen as the hurdle rate then it is clear that project Barcelona has been correctly rejected, project Juventus has been incorrectly rejected and PSG & Chelsea has been correctly accepted (Madura, 2014). 

Based on the information given and question asked, it is important to calculate the present value of obligation before calculating the weights of proportion of each type of bonds

Present obligation of Porto Berhad (PV of perpetual obligation) = (RM 2000000/0.16) = RM 12.5 million

Number of years the perpetuity has to be kept by the company can be found through calculating the duration of perpetuity   = (1.16/0.16) = 7.25 years

Now in order to estimate the weights of each type of bonds, let assume W be the weight of 5 year maturity bond (duration 4 years) then (1-W) will be the weight of 20 years maturity bond (duration 11 years).

The equation will be:

W*4 + (1-W)*11 = 7.25

Solving this equation, the value of W will be 0.5357 and (1-W) will be 0.4643

So the weight of 5 year maturity bond (duration 4 years) is 0.5357 and weight of 20 years maturity bond (duration 11 years) is 0.4643.

Amount invested in 5 year maturity bond (duration 4 years) = 0.5357 * RM 12.5 million = RM 6.7 million

Amount invested in 20 years maturity bond (duration 11 years) = 0.4643* RM 12.5 million = RM 5.8 million 

In order to calculate the par value of holding in 20 year bond there is need to estimate the price if bond now.

Price of bond can be estimated by formula = coupon amount * annuity value at 16% for 20 years + par value * present value factor at 16% of 20^th year (Davies & Crawford, 2011)

In the present case the values will be:

• Coupon amount = RM 60
• Annuity factor for (16%, 20) = 5.92
• Par value = RM 1000
• Present value factor (16%, 20) = 0.051

Putting above values in above formula, we get:

= RM 60* 5.92 + RM 1000 *0.051

= RM 406.2 approx

It states that bond is selling at 0.4062 times it par value

Therefore the market value will be = Par value * 0.4062

Market value is RM 5.8 million

Then, Par value will be = RM 5.8 /0.4062 = RM 14.27 million  

Value of bond can be calculated by formula:

Coupon amount * annuity value at 14% for 20 years + par value * present value factor at 14% of 20^th year (Damodaran, 2011)

Coupon Amount	400.00
Par Value	2000.00
Rate of Return	14%
Maturity Years	20	years
Annuity factor (14%, 20 years)	6.623
Present value factor (14%, 20 years)	0.073

Value of bond = RM 400 * 6.623 + RM 2000 * 0.073

= RM 2795.2 

When rate of return increase to 19%
Coupon Amount	400.00
Par Value	2000.00
Rate of Return	19%
Maturity Years	20	years
Annuity factor (14%, 20 years)	5.1008
Present value factor (14%, 20 years)	0.031

Value of bond = RM 400 * 5.1008 + RM 2000 * 0.031

= RM 2102.32

When rate of return decrease to 10%
Coupon Amount	400.00
Par Value	2000.00
Rate of Return	10%
Maturity Years	20	years
Annuity factor (14%, 20 years)	8.5135
Present value factor (14%, 20 years)	0.149

Value of bond = RM 400 * 8.5135 + RM 2000 * 0.149

= RM 3703.4

C: When the interest rate risk decreases value of bond increase and it is sold at premium. In case interest rate risk increase than value of bond decrease and it is sold at discount (Brigham & Michael, 2013). 

When rate of return is 19% and maturity is 15 years
Coupon Amount	400.00
Par Value	2000.00
Rate of Return	19%
Maturity Years	15	years
Annuity factor (14%, 20 years)	4.8758
Present value factor (14%, 20 years)	0.079

 Value of bond = RM 400 * 4.8758 + RM 2000 * 0.079

= RM 2108.32

When rate of return is 10% and maturity is 15 years
Coupon Amount	400.00
Par Value	2000.00
Rate of Return	10%
Maturity Years	15	years
Annuity factor (14%, 20 years)	7.606
Present value factor (14%, 20 years)	0.239

 Value of bond = RM 400 * 7.606 + RM 2000 * 0.239

= RM 3520.40 

References

Arnold, G., (2013). Corporate financial management. Pearson Higher Ed.

Brigham, F., & Michael C. (2013). Financial management: Theory & practice. Cengage Learning.

Choi, T. (2013). Handbook of EOQ Inventory Problems: Stochastic and Deterministic Models and Applications. Springer Science & Business Media.

Damodaran, A, (2011). Applied corporate finance. John Wiley & sons.

Davies, T. & Crawford, I., (2011). Business accounting and finance. Pearson.

Dugdale, D. (2010). Budgeting Practice and Organisational Structure. Elsevier.

Ehrhardt, M. & Brigham, E. (2016). Corporate Finance: A Focused Approach. Cengage Learning.

Eich, R. (2016). The Long-Term Danger of Short-Term Goals. Retrieved 15 November, 2018, from https://www.industryweek.com/growth-strategies/long-term-danger-short-term-goals

Gibson, C. (2008).  Financial Reporting and Analysis: Using Financial Accounting Information. Cengage Learning.

Madura, J. (2014). Financial Markets and Institutions. Cengage Learning.

Moles, P.  & Kidwekk, D. (2011). Corporate finance. John Wiley &sons.

Muckstadt, J. (2010). Principles of Inventory Management: When You Are Down to Four, Order More. Springer Science & Business Media.

Ross. (2014). Corporate Finance 8E. Tata McGraw-Hill Education.

Shim, J. (2011). Budgeting Basics and Beyond. John Wiley & Sons.

Weygandt, J. (2015). Financial & Managerial Accounting. John Wiley & Sons.