- Analysis of the Master Budget - Answers
- Proposed Budget and Concerns
A budget is a financial document that is carried out by companies on a periodic basis to project future income and expenditures. The budgeting process is carried out by key individuals through a stringent process that takes into account the relevant activities of the company and any future activities it will undertake.
A budget forces the organization to go through the rigors of planning based on the amount of available resources and the time they are available. In the case of Competition Bikes, timing is an important facet of the budgeting process because the company is a publicly traded stock and its financial performance, especially how management times the use of their resources, is open to scrutiny.
If Competition Bikes’ investors analyse the performance of management through budgets, then it follows that budgets are also useful in tracking internal goals of managers. A budget that is prepared before the start of the operating period is an excellent guide post in reviewing the results of the company’s performance after the period. Not only does it guide managers, it makes managers feel the impending need to get their assignments right by doing diligent background work before actual implementation of business activities.
One of the critical assignments that have to be addressed is the source of funding for business activities. A budget tells you what to spend on and more importantly also tells you how much to raise. Determining the amount of financing required levels the expectations of the organization, because acquiring additional capital for business activities bring along calculable risks and additional financial obligations.
Lastly a budget helps the organization manage change. Because budgets come from the overall strategic objectives of the company which must be achieved ultimately, the changes required within the organization, whether these are organizational, tactical or strategic, stem from information that the budget will be telling the organization. In the case of Competition Bikes, the change in demand for their products initiates changes within the organization on a marketing aspect. These changes will drive future growth which is critical for sustainability.
- Sales Projections
Competition Bike’s (CB) sales projections for years 8 and 9 are shown below. The budget presented by CB indicates that the company used their year 8 budget as their static budget for the succeeding year. Taken on its merit, there is nothing wrong with doing so however, based on the year 7 to year 8 sales; the company experienced a reduction in sales which meant that the company is very aggressive in its outlook for sales in year 9. This bullish outlook is not supported by information received by the company that says that due to the global economy, sales will be sluggish for the next three years. A diligent operating business projection from CB’s executives is thus a serious concern.
The efficiency of the company is also of great concern. The table below shows that the company has projected an Accounts Receivable Turn-over of about 8.33 for years 7 and 8 and the same AR turn-over projection for year 9. Again, taken on its own it looks like the company has managed its AR since it has considerably lowered the AR turnover from year 6 operation’s high of 16.52 times.
When the competitor’s AR was examined, it is clear that CB is not operating as efficiently as its competitor, Two Wheel Racing, Inc. The average collection period, which measures the number of days when CB collects from its clients indicates that its operations is not as effective in managing cash as the competitors. This is compounded by the fact that the AR turnover is 12% of sales revenues, which is considerably high. A high AR means that CB is extending interest-free loans to its clients, and surely there are better uses of cash for the company so this must be managed by CB’s executives better. Managing cash is therefore a serious concern for CB.
It appears that CB’s management is not keen on improving its profitability. The projected budget for cost of goods sold has not changed much per unit. Additionally, calculating the profitability of the company using the Gross Margin Rate (calculated as Sales – COGS divided by Sales) indicates that for the last three years, the company has retained gross margins at 27% compared to its competitor’s 32% gross profit margin. To improve profitability, there are two items that can be controlled the first being sales (increase in sales increases revenue) and costs (decrease in cost increases revenue). With the pessimistic outlook on the global economy and the expected slowdown in sales, it is imperative that management find new ways of acquiring growth.
CB’s management also has not been able to acquire better payment terms from its suppliers. Its accounts payable turnover ratio was not utilized for budgeting for payment terms from CB’s suppliers. The AP turn-over increased from 1.3 times to 1.52 times.
This would naturally be done through the control of what the company spends on. If the company does not endeavour to control their costs (i.e. retain cost levels), then it is failing in that it is not maximizing its use of its resources. Therefore, the complacent projection of profitability, as shown below is a serious concern.
- Reported Variances
At the end of the reporting period, the following unfavourable variances were recorded:
- Net sales – decreased by 130 thousand
- Advertising and transportation expenses – increased by 6 thousand
- Admin salaries – increased by 1 thousand
- General admin costs – increased by 2 thousand
- Profitability – decreased by 38 thousand
The reported variances show that the company’s strategy for this period is wanting. They have developed a budget based on the previous year’s performance without much consideration for what market data they have gathered. At the end of the reporting period, these are the results that CB ended up with.
- Evaluation of the Flexible Budget
At the end of the period, the flexible budget and the variance analysis shows us the true picture of CB’s year. These variances are a matter of great concern whether these variances are positive or negative in nature, if these were foreseen or foreseeable, it if is of significant size and terms, the causes of the variances and whether this would be a persistent issue or a matter of external influence. The case files show us that net sales are lower than expected. There was sufficient evidence of a slowdown in revenues as a result of the slowing down of the economy. This was not heeded by the company in two ways. One, it aggressively (almost unrealistically) plotted higher sales of its bikes. Second, it did so without considering supporting activities that would give the company a chance to increase its sales.
Looking at the amount of money spent on selling (i.e. pushing sales) yields a “favourable” variance in that the amount of money spent versus the amount budgeted decreased. This is not a good sign for any positive management directive. Money must be spent to make more money and in the case of CB, knowing that the economy will be more challenging, they should have spent more on pushing for revenues.
The company is also complacent when it comes to managing its costs. While the total direct costs for production have decreased, its contribution margins have also decreased and are unfavourable. The company has not managed its costs well, starting with a very complacent policy on paying its suppliers and an even more complacent policy on collecting from its customers. This is therefore a critical item for discussion by management.
Managers of CB are showing how they enjoy sitting on their lofty office chairs by receiving the same levels of compensation in bull and bearish times. While it is understood that the fixed components of the company’s costs are set without reference to any of the company’s performance, their mandates are. Managers are tasked to look after the company’s welfare and the fact that the company is not reacting to the changes in the marketplace is alarming, even if the period that is being examined is over a 2 year period. It is important that managers always feel the sense of urgency to compete; the numbers show that CB’s managers don’t have that sense of urgency still. The net result is that the company is less profitable that it was a year ago. I suspect that its competitors are enjoying some increase in profitability, having seen the financial ratio comparisons. The variance in terms of overall profitability is of great concern to management.
Based on the variance analysis and the findings from the calculations shown above, the following recommendations are made:
- Invest in better research
Investment in research is important to a company such as CB. The company’s inability to make a better intelligent guess on future sales indicates that the company is not in touch with the market. This could be an indicator of how poorly the company is keeping up to date with its clients and competitors and risks the company falling into obsolescence. Research should have driven management to make the budgeting process more realistic. Their year 9 budget indicated that they utilized the previous year’s performance, thinking that the chips would fall in their favour. Unfortunately, it has not and the company suffered a degraded financial bottom line as a result.
- Improve accounts management
Cash management is an important for any business enterprise. For a company such as CB who has invested in a lot of fixed assets, it cannot afford being lax on managing its cash since they already have a very high asset base to work with. If the company can manage its suppliers and creditors as well as its clients, it would be able to free up cash for other business activities such as marketing, research and maybe investing in other major cost items to streamline their expenditures. As it is, the company does not exercise these capabilities well enough to make a significant effect on the financial bottom line.
- Link management compensation with corporate performance
One aspect of management control is the correlation of managerial compensation with corporate performance. Managers of CB may have not received more, but it is apparent that the budget for year 9 and their activities in year 9 mean they did less. CB’s managers have failed to react properly to the changing environment, instead using their previous financial performance as gauge. This lack of concern is a very red flag, considering that many companies today are looking at their ability to budget more efficiently as a the first sure step in remaining competitive. Concepts such as zero-based budgeting are now re-emerging, indicating that even the creation of static budgets could spell the difference between operating next year or not. A specific case is the unfavourable variance of Net Sales. CB must improve its sales through better marketing research and promotions, given that they understand that the coming year will be economically challenging. Net Sales should have been linked to management performance as well to ensure that managers take proactive actions to improve the company’s financial position. This is the intuitive task but seeing that the marketing (advertising) costs and transportation costs are unfavourable as well and have no effect on sales makes it a prerogative to review the advertising strategy of the firm and its contracts for transportation. A more efficient transportation scheme should be devised and a more focused advertising strategy must be crafted. CB is not getting their money’s worth having increased expenses for these two items and yet yielding no results. Management should have seen this and should be able to formulate solutions soon.
- Management by Exception
The case mention of Management by Exception or MBE. MBE is a policy that focuses on investigation situations wherein actual results differ from projected outcomes. While performance evaluation is conducted on an annual basis by management executives, MBE focuses on material variances only, with material variance being defined as those that influence the company’s strategic future.
MBE does not follow performance audit guidelines. In MBE, managers meet to discuss and react to environmental changes as they arise while conventional performance audits normally happen at the end of a certain operating period. The MBE approach is thus very powerful, in that it enables the company to be more competitive through closer observation of the market, the firm’s competitors and the firm’s capabilities.
However, the MBE is criticized for creating a myopic view of the company. Simply put, there are too many details to be examined and managers may lose their focus looking at all the variances that appear “important”. This may result in decisions that are logical for the firm in the “short run” but are detrimental to success in the “long run”.
Is MBE applicable in the case of Competitive Bicycles, Inc.? I believe so but only to a limited degree. CB must focus on long-term growth and sustainability, something that the MBE does not focus on. However it may still utilize the power of the approach but not through top-management. I believe that for a manufacturing company such as CB, the MBE approach would best be handled by middle line managers, those that have Key Result Areas (KRAs) to show by the end of the year. If these middle line managers have access to updated information on their performances and a clear understanding of their targets in the short term and long term, then it would be impossible for them not to make meaningful decisions that would be beneficial to the company.
Business Diagnostics. 2012. Financial Ratios. Retrieved from
Business Dictionary. 2012. Management by Exception. Retrieved from
Murray, J. 2012. Budgets. About.com. Retrieved from
News Morning Star. 2012. Efficiency Ratios. Retrieved from
Essortment. 2012. Why Is Having A Budget Important For A Business? Retrieved from