CHAPTER 8 ro 4 CAPITAL BUDGETING g, Critically examine the yar capital expen, 1, What do you understand by capital budgotings bee Gols ae vaca imparnest There are a number of methods in use investment proposals, Different firms iny im ing the project proposals. Wh, rinciples are kept in view namely the bige f preferable to small ones and that early bene than the deferred ones. The following methah n for evaluation. 1. Pay Back Period Method Charles T. Homgreen has defined capital budgeting as term planning for making and financing proposed capital o 2. Accounting Rate of Return Method. 3. Discounted Cash Flow Method a) Net Present Value Method 1g decisions are among the most crucial and es b) Present Value Index Method ns on account of the following reasons. { ¢) Internal Rate of Return Method Need and Importance of Capital Budgeting 1) Heavy Investment: penditure projects involve hea investment of funds. These funds are raised by the firm from various 1. PAY BACK PERIOD METHOD external and intemal sources. Hence, it is important for a firm to Pay back method is popularly known as pay off, or plan its capital expenditure, method. It is defined as the number of years required t cash outlay invested in a project. 2) Permanent Commitment of Funds: The funds involved in capital expenditures are not only large but also more or less permanently Computation of Pay Back Period: If the annual cash inflows these are long term investment decisions. The 1e pay back period can be computed by dividing cash ie greater is the risk involved. Hence, careful Sutlay (original investment) by annual cash inflows. For example, = 000 as initial investment that will generate a riod will be 4 fash inflow of Rs. 5,000 for 10 years. The pay back period will be ted as follo Anita nS Sp tes “Annual cash inf Capital budgé have @ long term and significant effect on the profitability of the y can increase the size, scale and Pay back period = growth potential of the concern. Jn most cases, capital budgeting decisions The annual cash inflow i er taxation ersible. Once the decision for acquiring a permanent asset net income before depreciation but is very lows are not uniform, the cal cash infl we period takes a cumulative form. In such 26 can be found out by adding up thestment. For example, a project requires arent af Re, 20,000 and the anual cash inflows fo, R500 Rs. 5,000 Rs. 6,000 and Rs, 4.9 Rs, 8.000 Tk period will be 3 years calculated a the total is equal to initial inv an initial 5 years are sectively. The pay bac Cash inflows Cumulative cash inflosys Year 1 Rs. 6,000 Rs. 8,000 } 7,000 15,000 3 5,000 20.000 4 6,000 26,000 5 4,000 30,000 . If there are two projects, the project which has a shorter pay back period will be chosen. Merits ; ; The pay back method has the following merits. 1. Its easy to calculate and simple to understand. 2. It is preferred by executives who like quick answers for selection of the proposal. 3. Itis useful where the business is funds as quick recovery is essen ffering from shortage of 1 for repayment, 4. Itis useful for industries subject to uncertainity, instability or rapid technological changes. 5. Itis useful where profitability is not important. Demerits The method has the following demerits. 1. This method is delicate and rigid. A slight change in the ‘operation cost will affect the cash inflows and the pay back period. It does not take into account the life of the project, depreciation, scrap value, interest factor etc. It completely ignores cash inflows after the pay back period. The profitability of the project is completely ignored. 5. It gives more imy idi it re importance to liquidity as a goal of capital expenditure decisions which is not justifiable. 6. It ignores time value different years are treqi on ™*Y: ted equall U1, Accounting or Average Rate of p , It is known as accounting rate of account, the accounting concept of profit and tax) and not the cash inflows Th highest rate of return is selected, Cash flows received in leturn Method return because it taki it takes into (ie. Profitatter depreciation '€ Project which yields the ‘The accounting rate of retu: following methods. 1. ARR = Average Annual profit Original investment“ 190 (or) 'm may be calculated by any of the Average Annual profit = ee Atal profit 2. ARR= “Average investment * 100 ‘The term average annual profit refers to average profit depreciation and tax over the life ofthe project. es Pro" after The average investment can be calculated by any of the following methods. Original Investment (or) 2 Original Investment — Scrap value 2 ‘The following are the merits of accounting rate of return method. 1. It is simple to understand and easy to calculate. 2. This method gives due weightage to the profitability of the project. 3. It takes into consideration the total earnings from the project during its life time. 4. Rate of return may be readily calculated wit accounting data. ith the help of Demerits This method suffers from the following weaknesses "1. It uses accounting profits and not the cash inflows in appraising the project.en can be reinvested 1e the fair rate of retum on eitferent methods for ealeuTating the Accounting v omany concepts of NVEStIENts as yl ‘es different restilts. This reducas 6, There are Rate of Return du it. Ea y of the method. piscounted Cash Flow Method of Time Adjusted Technique ‘The discounted cash flow method is an improvement on the pay back method It takes into account both the profitability and the Pay Meslue of money. This method is based on the fact that future atue of money will nat be equal to the present value of money. Fop ample, a sum of Rs. 100 received today is more valuable than Sam of Rs, 100 received after one year because by receiving the ‘mount now and investing it somewhere a firm can get Rs. 110 (say including 10% interest) after one year. Discounted cashflow methods for evaluating capital investment proposals are of three types. 1. Net Present Value method. 2. Excess Present Value Index. 3. Internal Rate of Return, 1. Net Present Value Method (NPV): Under this method, present ‘alu fash inflows is sculted atthe required rat of return and pared with the original investment. Ifthe present value is higher than the original in ji tan he org investment, the project can be selected, otherwise 2. Excess Present Value Index: _the present value method basis of net present value w One of the major disadvantages of i ts not easy to rank projects on the ¥en the costs of the projects differ. To 86 x such projects the present value inde oe inde prepared hea be with the help ofthe following formes excess Present Value index = “Total Present value of cash inflows Total Present value of cash outflows: ao ‘The higher the profitability index.the more desirable is the investment. ternal Rate of Return (IRR): Internal rate of return is the rate of hhich total present value of future cash inflows is equal to ‘stent. This method is used when the amount of ch inflows are known but the rate of return is not found by trial and error method. 3. Int jeturn at jnitial inves Investment and Ca Iino. The rate of retumi generally counted Cashflow Method Merits of Dis ‘method considers the entire economic life of the project 1. 2. Tt gives due weightage to time factor. That is, time value of money is considered. tates comparison between projects. ing time factor, makes sufficient 4. This approach by reco provision for uncertanity and risk It is the best method where cash inflows are uneven. Demerits 1. It involves a great d and complicated. It is very difficult to forecast the economic life of any investment exactly. leal of calculations. Hence it is i 43, ‘The selection of an appropriate rate of interest is also difficult. 40. It does not correspond to accounting conee costs and revenues. ips for recordingCHAPTER 7 BUDGETARY CONTROL Define the term budget. What are the essentials of a pudget? ‘A budget is a plan of action expressed in financial terms or ~ pon financial terms. It is prepared for a definite period of time. Itis a ‘ed estimate of future business conditions such as the sales, and profit. A budget is a tool which helps the management in .d control of business activities. cost planning an ‘According to ICMA, England, a budget is, "a financial and/or / titative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during the period for the V of attaining a given objective". It is also defined as, "a blue print of a projected plan of action of a business for a definite period of time”. ‘According to the definition, the essential features of a budget 1. Itis prepared for a definite period well in advance. 2. It may be stated in terms of money or quantity or both. 3. It is a statement defining the objectives to be attained and the policy to be followed to achieve them in a future period. 2. Define budgetary control and state its advantages and limitations. According to ICMA, England, budgetary control is, "The establishment of budgets relating the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision”. According to J. Batty "budgetary control is a system which uses budgets as a means of planning and controlling all aspects of Producing and/or selling commodities and services”.advantages agement to fix up responsibility in casey. ‘below expectations. : 5. It helps the management to reduce wasteful expen This lvads to reduction in the cost of production, 6. It brings in efficiency and economy by promoting coy | consciousness among the employees. es centralised control with decentralised activiy, 7. Mt fa &. It acts as internal audit by a continuous evaluation of departmental results and costs. 9. It facilitates introduction of standard costing. 10. It aids in obtaining bank credit. "Hence the possssibility of under or over capitalisation is eliminated. 12. It provides a basis for introducing incentive remuneration plans based on performance. 13.It helps in the smooth running of the business unit. There will be no stoppage of production on account of shortage of raw materials or working capital. The reason is that everything is planned and provided in advance. 14. It indicates to the management as to where action is needed to solve problems without delay. * concerns cannot afford. There will be active and pa: control as it points out the ef 6. The success of budgetary control depends upon willing co- raGiOA and team work. This is often Jacking. i‘ ‘What are the main steps in budgetary control? State the main objectives of budgetary control. ‘The main steps in budgetary control are: Establishment of budgets for each section of the ion. organi Recording of actual performance. Continuous comparison of the actual performance with the budget. In case there is a difference between actual and budgeted performance, taking suitable remedial action. Revision of budgets if necessary. Objectives of Budgetary Control: 1. to define the goal of.the enterprise. fe long and short period plans for attaining these ities of different departments.75 lofined organisation chart for and responaibiity ofa jot Contre 2. Budd Or entre is that part of the organisation for which the a budget coms sdget centre may bea department, orasection eng. production department o purchase section), tO Hget centre is essential for covering all parts a pment Ofrre budget centres are also necessary for cost is available forthe ati otye evaluation of performance becomes e25y when 3 tablished. quate working cai of the business. .s to where action is needeg _| committee : ‘companies, the budget is prepared by the cost dget control i sn ot But in big companies, the budget is prepared by the eee ee ne? ccountant. Te pudget committee consists of the chief executive or budget director, jirector, budget officers and the managers of various ‘The managers of various departments prepare their d submit them to this committee. The committee will make idjustments, co-ordinate all the budgets and prepare a 3, Budget In small main funetio risals0 necessary a ter Budget. ‘The main functions of the committee are: 1. to receive and scrutinise all budgets. ing forall the meetings of the budget committee, 1. Arran 2. Issuing instructions to various deen 2. to decide the policy to be followed. 3, Receiving and checking the budget estimates. _ 3. tosuggest revision of functional budgets wherever necessary. 4. Suggesting revisions. 4, to approve the finally revised budgets. 5. Preparing the summary budget and place all bu 5. 16 prepare the Master Budget after functional budgets are approved. the committee. a ‘6. Ensuring that management prepares their budget in time. 6. to co-ordinate the budget programme. to study variations of actual performance from the budget. 8. to recommed corrective action if and when required. 7, Kecordinating all budget work. \ Brey discus thesteps inthe installation ofasye® JA 4, sudgor Manual control. 7 al Budget Manual is a book which contains the procedure to be | followed by the executives concerned with the budget. It guides the It is the responsibility of budgetary contro: ‘The following steps should be taken in a sound system ! ‘ecutives in preparing various budge! s the budget officer to prepare and maintain this manual.M8 Particulay, jectives and princi 6. Ples oy cor, { committee. Proced 5. Budget Period 6 s budget period is the lengh of time for which a budget, get peniot) it may be different in the same industry o¢ period depends upon the following factors: ier it is a sales budget, production |) purchase budget, ‘or capital re budget. A capital budget may be for-a longer to 5 years; purchase and sales budget may be 7. e demand for the product. Jing for the availability of finance. igth of the trade cycle. above factors are taken into account while fixing the budget period. 6. Key Factor A. Classification According to Time: i) 77 what are the requirements of a good bu . Myatem? 'dgetary control wing are the requirements of a good budgetary control budgetary control system should have the support of the top management. — ‘A budget committee should be established consistn t of the budget director and the executives of vari rf of the organisation. itealaa saiereia ‘There should be proper fixation of authori shoul authority an responsibilty: The delegation of authority should be done in a proper way. ‘The budget figures should be realistic and easily attainable. ion between actual figures and budgeted figures should be reported promptly and clearly to the appropriate levels of management. ‘A good accounting system is essential to make budgeting successful. ‘The budget should not cost more to operate than is worth. riefly explain the different types of budgets or what re functional budgets? ‘The budgets are classified according to their nature. The following are the types of budgets which are commonly used. Short period Budget: These budgets are usually fora period of one year. E.g. Cash Budget, Material Budget, etc. Long period Budget: These budgets are for a longer period say 5 to 10 years. E.g. Capital Expenditure Budget, Research & Development Budget. ‘Current Budget: These budgets are for a very short period, say, a month or a quarter and are related to current conditions.78 tH Classification According 1° Function lates to any y ng are the commonly, f the during the bi Gquantity or both, Wee : and area wise tion of © ref, sdgets is dependent on jes manager taking into accoun, wise, product wi prepared as the Pref This budget is prepared by the fi lowing, 2.Salesmen’s estimates 4, Availability of raw materials 6. Availability of finance 8. Orders on hand Past sales figures Plant capaci Seasonal fluctuations 7. Competition Other factors like political condit wns, government policies ete, >. production Budget: The preparation of production budget is dependent on the sales budget. Production budget is an estimate Sr guantty of goods that must be produced during the budget period, Tay be stated in terms of money or quantity (weights, units etc.) or both. Production may be calculated as follows: mits to produced = Budgeted sales + Desired closing stock — Opening stock ‘This budget is prepared by the works manager by taking into account the following: . (2) Sales budget (2) Production capacity (3) Stock of goods to be maintained (4) Decision to make or buy the component parts 6) Availability of raw materials and labour. snare Matsiale Budget: Materials may be direct of indirect. The terials budget deals with only the direct materials. Indirect materials are included in the fact i lory overhead budget. Is budget can be classified into two categories: See Materials Requirement Budget and Materials Purchase Budget. Materials Requirement estimate of total quantities of sired = material required-for Broduction during ths budge period. The Material purchase Budget 4 of raw materials to be purchased for st be taken into account. budget, (1) Raw materials re ired for the budgeted production. \¢ lag, between the placing of order i “gt he placing of order and the receipt of the 9) Storage facilities available. (4) Financial resources availabh (6) Price trends in the market, (6) Opening and closing stocks. 4, Direct Labour Budget: This indicates detailed requirements of direct labour and its cost to achieve the production target. This of get is classified into two categories namely, labour requirement bug fabour recruitment budget. The labour requirement budget gives anformation regarding the different classes of labour required for inf department, theit rates of pay and the hours to be spent. The cacpur recruitment budget states the additional direct workers to be recruited. 5, Factory Overhead Budget: Factory overheads include indirect material, indirect labour and indirect expenses. Factory ingrhead budget indicates the factory overheads to be incurred in Gs budget period. The expenses included in the budget are classified iifo fixed, variable and semi-variable expenses. Fixed expenses are infjmated on the basis of past records. Variable expenses are Estimated on the basis of budgeted output. 6. Administrative Expenses Budget: The budget is an estimate \of administrative expenses to beincurred in the budget period Eg. rent, salaries, insurance etc. 7. Selling and Distribution Overhead Budget: The budget gives an estimate of selling and distribution expenses to be incurred in the budget period. For example, Salesmen’s salary, commission, ‘dvertisement, transportation costs etc. It is prepared by the sales executive. It is closely linked with sales budget. ‘The following points should be considered in the preparation of this budget. (a) The channels of distribution of the“product (b) The advertising and sales promotion policies (¢) The market area to be severed (ch The credit and collection polices (e) The mode of packing and despatch of products to customers.Probable reall tatu, to indicate when additional finance is find out whether surplus funds are natside investment. E Cash budget can be prepared by any of the following methods: (@) Receipts and Payments method (©) The Adjusted Profit and Loss Account method. (©) The Balance Sheet method. 10. Master Budget: incorporating, all functional budgets. It is defined as, budget incorporating the functional budgets which is finallly approved, adopted and employed", The budget may take the form of budgeted profit and loss account and balance sheet. It contains sales, product ion, debtor, fixed assets, payable etc. It also shows the gross and net profits and the important accounting ratios. It has to be approved by eee before itis pul into operation. yy the board of direc hee budget is also called static budget: udget designed to remain unchanged location Sanput. To prepare flexible budget, fixed, practical: ve for cost control purposes. useless performance when the level of eaves >. Flexible Budget: Flexible budget is abo called vas ‘costs and profit at differents levels of output. It fociiszs performance withthe budget st any lve ct cost shouldbe cassis le and semi-varial more elastic, useful and used for the purpose of control: “This budget is used in the following cases: (1) Where sales cannot be accurately predicted because of the nature of business. (2) Where the concern is suffering from shortage of materials, labour, plant capacity ete. (@) Where production during the year varies from period te period, due to the seasonal nature of the industy- (4) Where it is dificult to forest the demand accurately. IERO BASE BUDGETING & What is Zero-Base Budgeting (zBB)? Explain the process of ZBB and its advantages. ero base budgeting is 4 management techs om Cal Fe ae ptm usin of sources TS Ton inteodued by the US. Department of Ae aosvaised ils Phyer designed its basic fame work in 1970 and Pega erssued Pry dest Manse 619 ge for the use 0} jo . a mania bas or ntoling state expenditure Te techniqu gov cies has become quite popula in the US.7.14 PROBLEMS & SOLUTIONS Produétion Budget: Problem 1: Prepare a production budge for three months eng, March 31, 2008 for a factory producing four products, on the bac? is of the following information: Estimated Stock Estimated Sales Desired clog, Type of on January 1, during January- Stock Product 2008 March, 2008 March 31, 2094 Units Units Units A 2,000 10,000 5,000 - B 3,000 15,000 4,000 c 4,000 13,000 3,000 D 5,000 12,000 2,009 ee (B.Com., Bharathidasan, adapted) Solution: Production Budget for 3 months ending 31-3-2008 Particulars A B c D (Units) (Units) (Units) (Units) Estimated Sales 10,000 15,000 13,000 12,000 Add: Desired closing stéck 5,000 4,000 3,000 2,000 15,000 19,000 16,000 14,000 Less: Opening stock 2,000 3,000 4,000. 5,000 a 12,000 9,000 13,000 16,000 product line in the first fiscal quarter, 1,20,000 units in the s€e0 quarter, 1,30,000 units in the third quarter and 1,50,000 units in fourth quarter and 1,49,000 units in the first quarter of the followité Year. At the beginning of the first quarter of the current year, there” 14,000 units of product in stock. At the end of each quartet oe |J com] weohWk §, FrOCRON on 4a§ p Cone JV. “, Coun 4’Y none , l ! bud gee ,» plans to have an invento: pany P Ty equal to one-fift for the next fiscal quarter. th of the sales How many units must be manufactured in each current year? quarter of the (B.Com., Madras, Bharathidasan) Solution: PRODUCTION BUDGET eis see ee First Second Third Fourth | Quarter Quarter Quarter Quarter Units Units’) Units Units To ———— Sales 1,10,000 _ 1,20,000 1,30,000 1,50,000 Add: Desired closing stock 24,000 26,000 30,000 28,000 1,34,000 1,46,000 1,60,000 1,78,000 14,000 24,000 26,000 30,000 —__——_—-- ————— Less: Opening stock Estimated production 1,20,000-_1,22,000 "_1,34,000 1,48,000Manufacturing Overhead Budget Problem 16 : From the following particular, prepare manufacturing overhead budget for the quarter ending 31.12.08 Budgeted output during the quarter 5,000 units Fixed overheads : _ Rs. 30,000 Variable overheads Rs. 15,000 (varying at Rs. 5 p.u) Semi-variable overheads Rs. 15,000 (40% fixed 60% varying at Rs. 3 p.u) Solution: . Manufacturing Overhead Budget for the quarter ending 31.12.08 Fixed overheads Rs. 30,000 Variable overheads (5,000 units x Rs. 5 p-u) Ks. 25,0007.32 @ Semi — variable overheads: Fixed 40% of Rs. 15,000 6000 ~ Nariable (5,000 units x Rs.3 p-u) 15000 21,000 —— Total Manufacturing Overheads Cost 76,000 Prohlem 17 - penne Sena7.33 ion Budget t utilisat ticles A,B & C are produced in a factory. ple® 18: Three ar problem” rough two departments X and Y. From the following fy ee a machine utilization budget in both the departments. data, Pre wa sales pudget + ( ‘Annual Budgeted Opening stock of Closing stock duct Sales in Units finished goods equivalent to _ 2 months sales 6000 600 2 3600 200 ? 4800 600 - 2 ic (p) Production Budget data: Machine Hours per units product Dept. X Dept. Y / 50 25 B 2058 20 c 80 12, () Number of machines: Dept. X 400 Dept. Y 300 (@) Estimated working hours during the year: 3000 Solution: Production Budget (in units ) Product Sales Closing Stock Total Opening Production Budget Stock A 6000, + 1000* 7000 = - 600 6400 B 3600. + 600 4200 — - 200 4000 c 4800 + 800 5600 —-- 600 5000 Working : Calculation of Closing Stock Budgeted sales p.m. = 6,000/12 = 500 Closing Stock is equivalent to 2 months sales = Similar calculations are made for other 2 products 500 x 2 = 10007.34 Machinery Utilization Budget ' artment Y fs per i Department X a reduction $$$ £_—__—$__ Machine. No.o of Budget | Hours Machine | No.of Hows hours —_ Machine, pu. hours machines Ee 4 95 160,000 - 160" A.6400.,,.50) 3,20,000, 160* > 20 80,000 80 B 4000 20 80,000 40 0 Fe 60,000 60 c5000. 80 4,00,000 200 12 \ 3,00,000 400 3,00,000 300 00, Workings: , Calculation of No. of machines in Dept X&Y Product A: i * For 8,00,000 machine hours, number of machines required =400 number of machines required = 3,20,000 x 400 / 8,00,000 = 160 Similar calculations are made for other two products For 3,20,000 machine hours, Product B: * For 3,00,000 machine hours, number ‘of machines required = 300 For 1,60,000 machine hours, number of machines required | 1,60,000 x 300 / 3,00,000 = 160 Similar calculations ar oe ee € made for other 2 products