Tag: Cost Control and Management AccountingOsmania University b.com Notes

It is a budget known as constant budget, never registers the changes in the preparation of a budget, being prepared for irrespective level of output or production. This budget is mainly meant for the fixed overheads of the firm which are constant in volume irrespective level of production. The ultimate utility of the budget is to control the cost as a cost controlling measure, but the fixed budget is meaningless in having comparison with the actual performance.

A fixed budget is a financial plan that is not modified for variations in actual activity. Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:

• The industry is not subject to much change, so that revenues are reasonably predictable.
• Costs are largely fixed, so that expenses do not change as revenues fluctuate.
• The company is in a monopoly situation, where customers must accept its pricing.

Mitigate

A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where a new budget period is added onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, the most recent projections are incorporated into the budget, while also maintaining a full-year budget at all times.

Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.

The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected – the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavourable variances, even though they are simply doing what is needed to keep up with customer demand.

Features of Fixed budget

• The performance report does not contain useful information and misleading one.
• Fixed budget is rarely prepared and used. The reason is that the actual output is differing from the budgeted output. Hence, the management cannot exercise cost control.
• If units are overlooked in the cost-to-cost comparison, accurate result is not available.
• Fixed budget is limited by the costs and expenses which are affected by fluctuations in volume. This is a well known accepted fact.
• The performance report gives merely whether the actual costs are higher or lower than budgeted costs.
• There is no meaning of comparing one activity level with some other activity level. A fixed budget can be usefully employed when budgeted output is close to the actual output.

Example

let’s assume that a company pays a 5% sales commission on all of its sales. If the company prepares a fixed budget and it is projecting sales of Rs.1 million, the budget for sales commissions will be fixed at Rs.50,000. If the actual sales end up being only Rs.900,000 the budget for sales commissions will remain unchanged at the fixed amount of Rs.50,000. If the actual sales are Rs.1,100,000 the budget for sales commissions will also be Rs.50,000.

Had the company prepared a flexible budget, the budget for sales commissions would be expressed as 5% of sales. This means that the budget for sales commissions will be Rs.50,000 only when sales are Rs.1 million. If the company has actual sales of Rs.900,000, the budget for sales commissions will flex and will be Rs.45,000 (5% of Rs.900,000). If the actual sales are Rs.1,100,000 the budget for sales commissions will be Rs.55,000.

The term “financial analysis”, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

Objectives and Importance of Financial Statement Analysis:

The primary objective of financial statement analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object.

However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such analysis:

• To assess the operational efficiency and managerial effectiveness.
• To assess the earning capacity or profitability of the firm.
• To assess the short term as well as long term solvency position of the firm.
• To make inter-firm comparison.
• To identify the reasons for change in profitability and financial position of the firm.
• To make forecasts about future prospects of the firm.
• To assess the progress of the firm over a period of time.
• To guide or determine the dividend action.
• To help in decision making and control.
• To provide important information for granting credit.

Users Objectives

Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both managers and investors can take preventive measures to avoid/minimise losses.

Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return.

The decision makers are futuristic and are always concerned with the future. Financial statements which contain information on past performances are analysed and interpreted as a basis for forecasting future rates of return and for assessing risk.

Assessment of Past Performance and Current Position:

Past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance.

Loan Decision by Financial Institutions and Banks:

Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can make proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.