Accounting for Business: The Case of Agnew Agricultural Ltd
1. Executive Summary (250)
2. Incremental Budgeting Approach
a) Impact of incremental budgeting
The use of incremental budgeting is crucial since it operates under the premise of making
minor changes in the original budget to arrive at the new budget (Hansen, Mowen, and Guan,
2007). The reliability of the budgeting process is dependent on the consistency of the method
used and the ability to stick to the organizational plan. The incremental budgeting allows for
slight adjustments of the budget to maintain consistency and reliability. The use of the
incremental budgeting approach makes this possible by ensuring the continuity of funding to
various departments without significant analysis or delays (Hansen et al., 2007). The incremental
budgeting is vital and helps incorporate the notion of change and ensures the continuity of the
business operations even when departments or production units exceed their budgeted amounts
(Hansen et al., 2007). Additionally, the approach ensures that there are no significant deviations
in the original budget since it only allows for gradual changes in budgeting.
b) Impact of zero-base budgeting
Zero-based budgeting, as explained by Hansen et al. (2007), is an approach whereby the
budget of the current year is prepared from scratch as opposed to incremental budgeting which
makes adjustments to the previous budget. The old and new business activities are ranked based
on their importance and allocated without taking into account the previous achievements and
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budget. The approach ensures that the organization has a fresh budget, and the allocation of
resources is justified by the current year’s expenses (Hansen et al., 2007). This approach is ideal
as it ensures the efficient and ideal allocation of resources as well as eliminating wasteful
expenses since allocations are made after taking into account the associated risk and the cost
benefit analysis (Hansen et al., 2007). Moreover, this approach encourages innovation, a
necessary feature for the growth and future success of an organization. Moreover, the method
allows an organization to integrate new goals into the budget and set new targets.
c) Recommended budgeting approach
The growing competition demands a management technique that ensures efficiency,
innovation and competitiveness of an organization. However, incremental budgeting approach
does not offer any of this and relies on previous performance and techniques. The zero-base
budgeting is ideal for organization in the current business environment that is characterized by
uncertainties. Globalization, technological innovation, and increased competition has created an
unstable business environment, and organizations are required to adopt agile management
techniques so that they can respond to changing market conditions within the shortest time
possible (Masood and Farooq, 2017). Zero-base budgeting allows for the development of a new
budget each year depending on the prevailing market conditions, thereby incorporating flexibility
and allowing for innovation due to implementation of new methods. As such, the zero-base
budgeting technique should be implemented instead of incremental budgeting.
3. Break-even Analysis
a) Risk and return of manufacturing options
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The concept of operational gearing refers to the impact of fixed costs on the correlation
between the sales and operating profits (Abid and Mseddi, 2010). The fixed costs have a huge
impact on an organization, and it is vital to examine how they affect an organization. The first
option for Agnew Agricultural Ltd is in-house manufacturing. The organization will have to
incur an additional £600,000 in manufacturing overheads when this option is employed.
However, the variable entity will incur lower variable costs for producing its products in-house.
This increases the risk of the organization due to the greater risk associated with in-house
manufacturing, such as machine breakages, substandard materials, and employee inefficiency.
However, the returns can be considerably higher due to the lower variable costs, which increases
the profit margin with every increase in sales.
The second option entails the use of outsourcing manufacturing. The second option has
higher variable costs and lower fixed costs compared to the first option. This means that the
organization is exposed to lesser risks, and the returns are also smaller due to the higher variable
costs, meaning an increase in sales will also result in higher expenditure compared to the in-
house manufacturing option. The option with the high fixed costs tend to increase operational
gearing, and in this case, the in-house manufacturing option (Abid and Mseddi, 2010). Equally
important, the option that generates sales with low variable costs and a high gross margin
generally high operating leverage. The high degree of operating leverage for in-house
manufacturing (since it has low variable costs) underlines a greater danger from forecasting risk
(Abid and Mseddi, 2010).
b) Recommended manufacturing option
Although the outsourced manufacture option will have lesser risk, I recommend the first
option (in-house manufacture due to the expected high returns. Since outsourcing will have
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greater variable costs, then it will ultimately have higher costs compared in-house
manufacturing. Table 1 below indicates the actual return from both options in case sales increase
by 20%.
Table 1 : Profitability of the two options
Increased sales by 20% In-house manufacture (2,659
units)
Outsourced manufacture
(2,874 units)
Sales (for 7,977,000 8,622,000
Variable 6,222,060 7,587,360
Fixed 1,212,000 612,000
Gross profit 542,940 422,640
This indicates that the in-house manufacture is a better option despite the associated risks.
Also, the sales for outsourced manufacture needs to be high to break-even or match profits from
the in-house manufacture.
4. Difference Between Net Cash Flows and Operating Profit
The net income/ operating profit depicts he profit earned by the entity while the net cash flow
indicates the amount of money that go in and out of the organization on a daily basis. The net
income of the entity is computed by factoring in the expenses (amortization, cost of sales,
depreciation, taxes, interest, operational expenses) from the total revenue/ sales of the
organization. The cash flow statement indicates the amount of cash or cash equivalents
transacted each day. Notably, the net income is the first item on the cash flow statement.
Notably, there are certain items that are incorporated differently on the income statement than on
the cash flow statement.
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The income statement and the cash flow statement shows that some items, including non-
cash expenses such as share-based compensation, amortization, and depreciation are included in
the operating profit. However, these transactions/ items do not reduce the amount of cash
generated by an organization for the specified duration. As such, the expenses from these items
are included back into the cash flow statement. This results in a difference in the cash flow
system as a result of the different accounting/ recording methods for the non-cash expenses.
Furthermore, the operating profit statement and cash flow statement differ as a result of the time
gap between actual sales and documentation of sales. The inventory turnover rate significantly
affects the documentation of the actual payments. In case the consumers pay the invoiced
amount before the next period, the situation is under control. However, there tends to be a
significant difference between the operating profit and the cash flow statements when the
payments are postponed further. If the situation persists, the annual financial statements will be
characterized by low net income and cash flow.
5. Original and Proposed Costing Methods
a) Reason for apportionment bases (250)
The allocation and apportionment of expenses to cost centers requires the identification of
production overhead expenses that have diverse service/ production cost centers. This is done
through apportionment and allocation of overheads among the different departments. The choice
of the bases of apportionment is complex since the the expense that is apportioned should be
measurable using the basis used and there should be a correlation between the basis of
apportionment and the expenses. This means that different allocations can be utilized, as is the
case in Document 4. The different use of allocation basis in the manufacturing process have
resulted in the difference in the overhead absorption rate.
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During the original costing method, the cost of labor, machine value, and floor area are
used as the basis for the allocation. These factors, particularly machine and floor area are fixed
costs and do not vary with production capacity. However, the proposed costing method utilizes a
different approach, including the number of workers. This approach is used where the
expenditure is more dependent on the number of workers as opposed to the wage bill in terms of
labor hours. This tends to lower the amount allocated compared to the use of fixed parameters
such as the floor area.
b) Appraisal of sales director’s view
The director’s view is accurate and justified since the absorption rate should be based on the
production levels. Since the Large Machinery profit center has struggled to improve sales, then
the production has been low as a result of the low demand. As such, the utilization of machine,
direct/ indirect labor, human resources, and space is lower than the other profit centers. Equally
important, costs such as machine depreciation, machine insurance, and indirect labor should be
decreased due to the lower performance/ productivity of the profit center.
The costing method adopted should ensure the accurate allocation and apportionment of
costs based on resource utilization. This is to help track the actual expenses incurred by each
production line and determine the appropriate price of the products and expected profits. The
proposed strategy appears to reflect the actual use of resources and factors of production for the
large machinery. The reduction in the overheads means that the organization can lower the cost
of the large machinery, thereby increasing sales and generating more revenue.
6. Capital Investment Appraisal
a) Advantages and disadvantages of capital investment appraisal approach
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The Weldmaster option
The major benefit of the Weldmaster option is that it will increase efficiency through cost
reduction. Furthermore, this option will require lower capital investment as opposed to the
second option. The remaining capital can be directed to other organizational operations to boost
production and efficiency.
The Weldmaster option is a risky approach since it offers a short-term impact. The firm
will generate significant profits during the first year of implementing the new technology.
However, the net profits will decline throughout the next five years, thus indicating the loss of
efficiency and cost-saving ability.
The Solderking method
This approach will have a high rate of return for the organization at 14.6% compared to
the cost of capital. The approach will help improve the production innovation, thereby affecting
quality, sales, and profitability. Likewise, the greater efficiency will stimulate profitability across
the five years. Furthermore, the future cash flow for this option will be considerably higher than
that of the Weldmaster option.
Despite this advantage, the Solderking option will not be fully effective until the
introduction of a number of new product lines in the next few years. The lifetime of both options
is five years, and thus the additional investment in expanding new product lines is not viable
considering the time limitation. Furthermore, Agnew Agricultural Ltd is unlikely to recoup its
investment in case the Solderking is not implemented immediately considering the time
limitation of the investment.
b) Risk and return from the Weldmaster and Solderking Options
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The greatest risk offered by the Weldmaster option is the longevity of the expected cost
saving considering the gradual decline in profitability over the five years. Theoretically, the
accounting rate of return is greater than the cost of capital. However, this may not be the case in
case the option loses its ability to lower the cost of production and enhance efficiency after the
first year. Notably, this approach will have an instant return since it will lower costs immediately
after introduction. On the other hand, the second option offers a greater accounting rate of return
as well as a steady increase in profits over the period under investigation. Also, the net present
value will be considerably higher, thus indicating the viability of the option. However, the
second option is risky since it will not have an immediate impact on the organization. Since both
strategies are short-term decisions, they should have an immediate impact on the entity.
The Solderking option is the better option due to the higher profitability as well as higher
net present value.
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References
Abid, F.,and Mseddi, S. (2010). The impact of operating and financial leverages and intrinsic
business risk on firm value. International Research Journal of Finance and Economics,
44, 129-142.
Hansen, H., Mowen, M., and Guan, L. (2007). Cost Management: Accounting and Control.
Boston: Cengage Learning.
Masood, Z., and Farooq, S. (2017). The Benefits and Key Challenges of Agile Project
Management under Recent Research Opportunities. International Research