Question

Mandalay Ltd. is a company that manufactures fishing equipment and is owned by Managing Director, Joseph Cooper. It began trading two years ago, and has seen sales and profit grow at a good rate over the past 12 months. Due to this recent growth, Mandalay Ltd is planning a programme of expansion and as part of this is looking to recruit to its existing Finance department. Presently, the company employs one accountant who has overseen all areas of work but is now looking to split this into distinct financial and management accounting roles.

Alongside this, the company is looking to formalise the budget process. Joseph is keen to learn about different approaches to setting the budgets. He has heard about the incremental approach and zero based budgeting, but knows very little detail about them.

Required: Write a business memo to Joe Cooper that:

(a) Explains the role of management accounting in an organisation.

(b) Explains the purposes of preparing organisational budgets for Mandalay Ltd

(c) Describes both of the approaches to budgeting mentioned in the detail above and explains the potential advantages of each approach.

Answer 1

Business Memorandum

To

Mr. Joe Cooper,

Managing Director-Mandalay Ltd.

Date-04.05.2020

Subject- Role of management accounting in an organisation, the purposes of preparing organisational budgets & description of approaches to budgeting in the detail with potential advantages of each approach.

As per your requirements information are available as follows-

(a)The Role of Management Accounting in an Organization are-

1. Forecasting the Future:

Forecasting aids decision-making and answering questions, such as: Should the company invest in more equipment? Should it diversify into different markets? Should it buy another company? Management accounting helps in answering these critical questions and forecasting the future trends in business.

2. Make-or-buy Decisions:

Is it cheaper to procure materials or a product from a third party or manufacture them in-house? Cost and production availability are the deciding factors in this choice. Through management accounting, insights will be developed which will enable decision-making at both operational and strategic levels.

3. Forecasting Cash Flows:

Predicting cash flows and the impact of cash flow on the business is essential. How much cost will the company incur in the future? Where will its revenues come from and will the revenues increase or decrease in the future? Management accounting involves designing of budgets and trend charts, and managers use this information to decide how to allocate money and resources to generate the projected revenue growth.

4. Knowledge of Performance Variances:

Business performance discrepancies are variances between what was predicted and what is actually achieved. Management accounting uses analytical techniques to help the management build on positive variances and manage the negative ones.

5. Analyzing the Rate of Return:

Before embarking on a project that requires heavy investments, the company would need to analyze the expected rate of return (ROR). If given two or more investment opportunities, how should the company choose the most profitable one? In how many years would the company break even on a project? What are the cash flows likely to be? These are all vital questions that can be answered through management accounting.

(b)The purposes of preparing organisational budgets are-

1. Forecast of income and expenditure

Budgeting is a critically important part of the business planning process. Mandalay Ltd. needs to be able to predict whether a business will make a profit or not after expansion its business . The purpose of budgeting is basically to provide a model of how the business might perform, financially speaking, if certain strategies, events, plans are carried out.

In constructing a Business Plan, the manager attempts to forecast Income and Expenditure, and thereby profitability.

2. Tool for decision making

The purpose of budgeting is to provide a financial framework for the decision making process i.e. is the proposed course action something we have planned for or not.

In managing a business responsibly, expenditure of expansion must be tightly controlled.

3. Monitoring business performance

The purpose of budgeting is to enable the actual business performance to be measured against the forecast business performance. If there is difference between budgeted expenditure and actual expenditure, decisions are taken to control the situations of Mandalay Ltd.

(c) Description of approaches to budgeting in the detail with potential advantages of each approach.

1. Incremental Budgeting Approach-

An incremental budget is a budget prepared using the previous period’s budget or actual performance as a basis with incremental amounts added for the new budget. The allocation of resources is based upon allocations from the previous accounting year. Here, the management assumes that the levels of revenues and costs incurred during the current year will also be reflected during the next year. Accordingly, it will be assumed that revenues and costs incurred during the current year will be the starting point for estimations for the next year.

Based on the results of the current year, an allowance will be added to the next year’s budget that takes into account possible changes in selling prices, associated costs and effects of inflation (general rise in price levels).

Advantage of Incremental Budgeting approach are

1. This method of budgeting is very easy to implement and does not entail any complex calculations. This can be achieved for various departments without much issue as one does not need any detailed analysis irrespective of the department in consideration.

2.Incremental budgeting ensures continuity of funding for the departments without much detailed analysis of funding requirement.

3·Incremental budgeting approach ensures no large deviations are seen in the budget year after year as it gradually changes the budget requirement. With this type of budgeting, a company is likely to have stable budgets year on year

4.Incremental budgeting is been used as a technique by many companies to help eliminate rivalry or build the value of equality among departments as all departments are given a similar amount of increase over previous year.

5.The impact of the change can be seen immediately in case of incremental budgeting.

2. Zero Based Budgeting Approach

Zero-based budgeting is a system of budgeting in which all revenues and costs must be justified for each new accounting year. Zero-based budgeting starts from a ‘zero base’ where every function within an organization is analyzed for its respective revenues and costs. These budgets may be higher or lower than the budget of the previous year.

Advantage of Zero-based budgeting approach are-

1.Zero-based budgeting is on “why” approach. It goes to the root of the expense. Zero-based budgeting aims towards achieving the objectives of the organization. For better decisions, Zero-based budgeting completely ignores the past years’ figures.

2.· Zero-based budgeting aims at cost-benefit analysis. It does not focus on studying the changes in expenses and preparing a variance analysis (such as why the expenses increased or reduced). However, it considers the necessity of the expense and the benefit which will be derived from the expense. In order to prepare an effective zero-based budget, more and accurate information is a must. Zero-based budgeting operates vertically as well as horizontally. And hence it enables all the levels of management to participate in the decision-making process of the organization.

3.The ultimate objective of any organization is to maximize the profitability of the organization and enhancing the wealth of the shareholders. The zero-based budget helps in achieving this objective. Zero-based budgeting ensures that the resources of the organizations are economically and efficiently allocated.

4.For each year, the preparation of the zero-based budgeting is with the same assumption of not taking a base for any previous period. Each department of the organization analyzes the expenses every year. They make sure that there is an inclusion of only those expenses in ZBB which are necessary and which derive benefits.

5.Zero-based budget identifies all the obsolete processes of the organization. If the process is not essential for the organization, the same has to be analyzed and scrapped by the management. Discontinuation of obsolete operation results in better costing, better pricing and better profitability of the organization.

According to the present situations of Mandalay Ltd should adopt Zero based budgeting as it is planning a programme of expansion which is new and fresh work for the co.

Thank You & all the best .................