Budgets (targets) should be set at a level which are stringent and challenging but attainable. If set too high to be unattainable the staff may be demoralised and may not try to achieve the targets.

2 Departmental managers in consultation with their staff should be permitted to participate in the setting of their budgets by so doing they will have ownership of them and will strive to attain them. Participation clarifies responsibilities, increases communication throughout the organisation and can help to promote line-staff relations. However, it is well to acknowledge possible dysfunctional behaviour as a consequence of participation in budget-setting such as ‘budgetary padding’ or ‘budgetary slack’. It may serve the manager to build ‘slack into the budget ie. to have a ‘pad’ between the formal plan and the expected actual results so that they have a cushion in case unanticipated events cause their performance to decline.

Since budgets tend to be used as a management performance criteria there should be a reward system in place. Too often budgets are used as a mechanism to focus on poor performance so is it any wonder that the staff have negative feeling about them.

4 Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. Hopwood referred to the ‘budget constrained’ style of management with performance in meeting the budget as the main criteria.

The organisation should be concerned with other management performance criteria such as concern with quality, good industrial relations, cooperation with colleagues etc.

There are significant benefits for organisations which engage in budgeting.

Budgeting forces management to focus on the future, to consider the dynamics of the external environment and identify the potential opportunities and threats.

2 In the process of preparing the budgets managers are compelled to co-ordinate the various activities of the organisation and to be less ‘departmental minded’ and to be more ‘company minded’.

It tends to encourage communication throughout the organisation. Staff are aware of what they are expected to achieve and regular budget reports and budget meetings keep them informed.

By assigning managerial responsibility for the attainment of the budgets and the regular comparison of actual results and expected outcomes individual managerial performance can be ascertained.

Research has indicated the role budgets have in motivating managers to achieve the company’s objectives. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company.

INVESTMENT APPRAISAL

METHODS

Lesson 4

Most of the decisions management have to deal with are tactical and short-run but on occasion they may have to consider a decision that relates to a long period of time. Once the decision is taken the business has to live with it and may find it difficult to disinvest or reverse so a great deal of care has to be taken in these decisions.. In the planning process the company may have decided to persue a growth strategy so there may have to be investment in capital projects to sustain the growth in sales and productive capacity. Capital expenditure on new buildings, plant and machinery may be needed from time to time. Again the company may decide rather than grow organically a strategy of merger or takeover is best. Whatever the stategy the various investment projects have to be properly appraised. Capital projects have to chosen and decisions as to the financing of them has to be determined.

Definition:

Capital investment appraisal is the process of evaluating the cost and benefits of a proposed investment in operating assets.

The appraisal process consists of measuring the inflows of cash against the outflows of cash which arise as a consequence of the decision.

There are five main appraisal techniques:

Payback

This technique considers the length of time it takes to recover the initial invesment outlay and the project starts to pay for itself. If a company invests £100,000 on a capital project the question is how long does it take to get back £100,000 cash from the project. Cash flow does not include any non-cash items such as depreciation. Therefore, if the investment returns are given in profit after depreciation terms the annual depreciation is added back. Net cash flow is the difference between cash received and cash paid during a defined period of time.

Example:

A company is considering investing in a new machine which costs £100,000.

The following information is available:

	£	£
Initial outlay		100,000
Net cash flow
Year 1	20,000
Year 2	30,000
Year 3	40,000
Year 5	20,000	110,000
	--------	--------
Net profitability		10,000
		-------

Required: