1.0 Introduction
The real estate industry comprises the buying and selling of rental land, housing, and buildings. It is one of the industries that are significantly affected by macroeconomic factors and involves a lot of projects. The project and finance managers need to plan for the future uncertainties in the industry by making budgets under uncertainty. Budgeting under uncertainty identifies the potential risks, accounts for the risks and ensure adequate funding for the projects and deal with the challenges related to future uncertainties in cash flow. Master budgeting is very important in each and every business as it has certain issues, which accrues if it was not taken in consideration.
1.1 Importance of Budgeting under uncertainty
Budgeting under uncertainty is important since it helps the project manager identify most of the potential risks that may arise in the course of completing it. An identification of the uncertainties helps to account for them so that they have little impact on the financial needs of the project (Beraldi et al., 2013). Sometimes, it is challenging to accurately identify the technical changes, obsolescence, and other economic events. Budgeting under uncertainty enables a manager to propose an improved technique to address the uncertainties of a project and consider the interdependency between the life of a project and cash flows.
Budgeting under uncertainties helps to account for potential risks that may arise in the future. Many risk analysis techniques could assist to address the uncertainties in budgeting. The commonly used techniques include sensitivity analysis, simulation and risk premiums in discount rates amongst others (Ahmed, 2013). The net present value is also a considerable technique although some analysts have argued that majority of its variants often result in incorrect conclusions particularly when exposed to a risk that was incorrectly incorporated (Žižlavský, 2014). However, proper accounting of risk ensures that a project is viable and sensitive to the risks identified.
Budgeting under uncertainties helps to address issues related to the lack of constant cash flows. In reality, cash flows of many projects tend to differ from the initially expected cash flows. Therefore, it is important to establish flexibility in management to respond to potential changes underlying the assumptions of the project value and application of reliable valuation tools (Konstantelos & Strbac, 2015). Correct evaluation of the uncertainty entails the determination of the real values of the options and optimal investment decisions especially when an organization considers investment as a major source of cash flow. The decision of investing in a project should be undertaken in case the value that can be achieved by failure to run the project is less than the value realized from the implementation of the project.
1.2 The main issue to budgeting under uncertainty
The biggest issue related to budgeting under uncertainty is that the manager doesn’t know about the certainty of future events. The manager has to rely on possibilities necessitating the use of diverse probabilistic models to address various situations of uncertainties (Konstantelos & Strbac, 2015). Consequently, it becomes challenging to make true financial decisions since he doesn’t know the exact future cash flows. Moreover, since the manager has to rely on various evaluation tools such as the probability models, it becomes difficult to choose one that would incorporate all the risks.
Managers have to develop a budget that includes uncertainties since it is the roadmap for meeting all the planned activities of a project after an agreed period. Budgeting under uncertainty is important since it helps the manager to identify potential risks, account for them and ensure there are sufficient funds to address future uncertainties in case, they arise. Each risk is approximated and its impact determined. Moreover, it helps address the challenge of constant cash flows which many projects face.
1.3 Master Budget Definition
The total of all the lower level budgets produced by company’s different functional areas, and also includes budgeted financial statements, cash forecast, and financing plan. It explains the company’s strategic direction of growth and how the master budget will assist in accomplishing certain goals, and the needed management actions in order to achieve the target (Steven, 2017). Master budgeting is considered to be the main planning tool used by the management to direct the activities of a corporation, as well as to judge the performance of its various responsibilities centers. Usually senior management team goes through a number of iterations of the master budget to review it (Steven, 2017).
1.4 Master Budget issues
There are set of key performance metrics that are calculated based on the information in the budget such as, accounts receivable turnover, or inventory turnover, or earnings per share. These metrics are useful in order to test the validity of the budget model against actual results in the past. For instance, if the accounts receivable turnover metric is much lower than historical results, that mean the company is over-estimating its ability to collect accounts receivable promptly, which means the amount of accounts receivable shown in the balance sheet may be understated and the amount of cash may be overstated (Steven, 2017).
1.5 Master budget problems
Senior management forces the organization to closely adhere the master budget implementation by covering the goals in employee compensation plans, as in doing so three main factors get effected:
• When compiling the budget, employees tend to estimate low revenues and high expenses, so that they can easily meet the budget and achieve their compensation plans.
• Forcing the organization to follow the budget requires a group of financial analysts who track down and report on variances from the plan. This adds unnecessary overhead expense to the business.
• Managers tend to ignore new business opportunities, because all resources are already allocated toward attaining the budget, and their personal incentives are tied to the budget.
This means by applying a master budget, one can tie down the operational performance of a business. Because of this problem, it may be better to employ the master budget as just a rough guideline for management's near-term expectations for the business (Steven, 2017).
2.0 Literature review
Budgeting is broadly discussed among researchers and has been identified as an essential part of management accounting for a plenty of companies. According to Anthony and Govindarajan (2007) the budgeting is a process of communication between management and representatives from other departments, which helps to determine future revenues and costs. The budgeting can be made under three stages – creation, follow up and analysis (Jonsson and Akerlund, 2012). The first stage refers to the development plan; the second implies comparison the actual figures with planned ones, the analysis allows to use to make some alterations to gather benefits in future.
These days traditional budgeting has been a topic of arguing. Some economists criticize its role and offer new approaches to resolve problems (Sandalgaard, 2012). The main critique of the traditional budgeting concerns the costs of producing budgets as the management needs to spend its priceless time on generating that of those. Others believe that the traditional budgeting is not appropriate in a current existing environment that has been extremely changeable and competitive (Bunce et al, 1995). Hope and Fraser (2003) determine traditional budgeting as not effective tool to survive in such unstable and uncertain economic conditions.
According to Hansen et al. (2003) there are two ways to deal with arising difficulties – either substantially enhance budgeting or withdraw it. The first approach is called the activity based budgeting (AAB), which implies the usage of costing information. In other words, the opportunity to convert expected number of products or services into needed quantity of resources comes to the presence. The second approach is more revolutionary as it is considered that the unique management model that is based on the performance evaluation, subjective views, forecasts and some major non-financial indicators should substitute the budgeting.
The two main drivers for applying AAB approach were established such as uncertainty on the market and highly competitive environment. The paradox comes to reality when on the one hand, it is believed that such present conditions provoke for making even stronger emphasis on budgeting within corporate world (Chenhall, 2007), on the other hand, it is thought the uncertainty is more designed for open and concentrated management control system. Ekholm and Wallin (2011) made a conclusion regarding the budgeting based on the survey among Sweddish companies. They indicated the existence of negative relationship between the uncertainty and anticipated usefulness from traditional budgeting.
The survey, which was provided by Sandalgaard, (2012) showed that the annual budget is still strongly used by companies. According to empirical findings only 4% companies (out of 246) abandoned annual budgeting and 2% have come with a decision to do so; 11% of companies think about it.
Therefore, although the perceived usefulness of annual budgeting is under discussion, it is till widely applied and considered as an effective tool of setting up and monitoring costs and revenues for organizations. Ekholm and Wallin (2011) traditional annual budgeting and new approaches should be complimentary.
In order to provide the reliable tool to control the budget, the master budget was designed. The master budget is the system of integrated budgets of sales, production, costs, income, purchases etc. In addition, it implies the presence of financial statements (Saeed et al., 2016). The master budget allows managers to plan business activities based on existing figures. The result of each period can be evaluated by the applying comparison with the master budget; after this all needed adjustments can be taken. The procedure of generating master budget is beneficial for company itself and for its management.
On one hand, the first and the most obvious advantage is the opportunity to follow the overall earnings and spending as a whole, as it integrates small budgets from all departments of the company. It allows managers to identify the current financial standing, which is essential for the further planning (Jane, 2018). As the master budget can be used as an effective tool for planning we can highlight this feature as a separate advantage. It implies that by looking at the master budget it can easily be determined the overspending of any department within the company, leading to less generated earnings. When the department with excessive spending is identified, managers can either cut expanses or come up with ideas to cut costs in other department to generate new additional financial resources.
On the other hand, there are a few disadvantages from using the master budget. Firstly, it is the lack of specificity, implying the written figures in master budget are collective sum of all earnings and expenses. It is very hard to identify how much each department spends on monthly basis, as the amount will be included to the overall sum of spending for all departments. Secondly, the master budget is hard to use practically as it has lots of information and numbers, which are included to the budget. The difficulties also arise when it comes to budget reading and understanding as the master budget has a plenty of charts and descriptions.
Therefore, the master budget plays an essential role in the control and planning procedures within any organization. However, it should always be updated to produce effective and outstanding outcomes.
3.0 Discussion
As defined earlier, master budget is a tool that combines all lower-level budgets together in order for management to make decisions for the upcoming uncertain future and have an overview on budgets of all departments and measure overall performance. It brings together two major aspects of budgeting under uncertainty, operational budget and financial budget (Sandu, 2009).
The scheme below demonstrates all divisions of operational and financial budgets.
Operational budget gives an insight on company divisions’ budgeting and budgeted Income Statement, whereas financial budget provides capital, cash, Balance Sheet and Cash flow budgeting. Master budgets allow companies to add budgets such as sales budget, COGS budget, production, S&G&A expenses budgets, and even desired ending inventory budget.
Personal example: one of the group members is working in a company that is developing a new cost charging system for employee salaries and different allowances that company has to pay. The person is not allowed to disclose specific information on that budgeting project, but it can be explained and described in general terms. The company has codes for each employee as well as the grading system for salaries; it ranges from 4 to 20. As well as each grade has its own range: Min, Mid, Max. Previously, the company was charging expenses individually to each employee according to his or her needs, but now management is trying to make the cost charging to be more systematic. They will apply same costs such as airplane tickets, mobile allowances and car/vehicle allowances according to each employee’s salary grade. This will allow them to budget expenses ahead of time and predict future expenses the company will be facing in the near future. Also, margin of actual and accrued budget will allow the company be more flexible with allocating different costs. This example briefly describes how master budgeting can help big organizations to plan ahead.
Even though Master Budget is known to be effective, it has its own strong and weak sides as any other decision-making tool. Descriptions of strengths and weaknesses mentioned previously will be discussed in more details below.
Advantages:
• Combination of all budgets. Since lower-level budgets just cover the costs and income for each department, there would be a need to analyze all of them separately. The master budget uncovers how much your organization is procuring and spending all in all, and shows whether the business is in great or negative money related standing.
• According to Mary Jane (2018), master budget gives the ability to allocate problems and plan accordingly ahead of time. When looking at all budgets at once, management can clearly see which department is spending in excess and then to solve such issue management could cut that department’s expenses or cut another department’s expenses to fund the one that needs more funding.
• Helps to identify potential risks from a completely different perspective: overall perspective. Best to combine with sensitivity analysis or simulations.
• Allows creating a link between future budgets, projects and cash flows.
• Since the budget can be allocated to every division and then summer together, small miscalculations can be adjusted.
Disadvantages:
• Master Budget does not take time value of money into account. Dollar today is not equal to dollar tomorrow. Financially speaking, it is not correct to plan future budgets without discounting the cash flows.
• If over budgeted, might be a waste of working capital that could be invested in other project instead of hanging. Since working capital is an vital for company’s operations, taking a big chunk from it could affect the outcome.
• Master budget is difficult to update because it contains a large amount of data. Also since it has multiple reports, tables, charts, it can be difficult to read and understand. This could require extra training for employees so they could learn how to assess the master budget effectively.
3.0 Conclusion
Budgeting under uncertainty identifies the potential risks and deals with the challenges related to future uncertainties in terms of cash flows. One of the major issues in budgeting under uncertainty is that the manager doesn’t know about the certainty of future events and how to market will be fluctuating in terms of taxes, duties, and government regulations.
This article along with the potential uncertainties also elaborates how to control these uncertainties from a financial aspect. The solution to control all these budgeting problems explained in this report is applying Master budgeting process. Master budgeting is considered to be the most efficient and effective planning and budgeting tool used by the management to direct the activities of a corporation, as well as to judge the performance of its various responsibilities centers. The main advantages of doing master budgeting are explained as following:
• Combination of all the lower level budgets, which cover the costs and income for each department.
• Master budget gives the ability to allocate problems and plan accordingly ahead of time.
• Helps to identify potential risks from a completely different perspective.
• Allows creating a link between future budgets, projects and cash flows.
This means that the all the lower level budgets should be combined for all the financial heads and departments of the organization so that all the management should be on the same page while allocating the budgets keeping in view the contingencies, risk factors and unforeseen events of the future. Once the management will sit together and it will be easier for the organization to identify the problems and the potential business associated risks at a single forum.
There are pros and cons of everything therefore along with the advantages the disadvantages of master budgeting are Fluctuating financial market, over budgeting and large amount of data.
Thus the management needs to be focused on the negative factors and should incorporate the financial market trends in the budgeting i.e. FOREX rate, stock market. Secondly the budgeting should be done with detailed research of previous forecasting data so that optimal result should be achieved.
This concludes that master budgeting is a management tool which aligned with the organizational budget planning, by doing this the organization can achieve economies of scales for optimal / lean financial spending and higher profits.
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