Budgeting Process. Budgeting process can be described as when an organisation plans all its expendituresfor proper capital utilisation (Pride, Hughes & Kapoor 2011). When a company is preparing a budget, they ensure that all the financial constrains are met in future operation of business. In this case, the organisations creating a budget should ensure that finances are available to fund the budget. In order for a budget to be successful, all expenditures in the budget must be fulfilled (Pride, Hughes & Kapoor 2011). Additionally, the benefits of a budget must exceed the setbacks. In the case of Sainsbury’s Stores, they must ensure that they have met all expenditures of opening a new store in order for the budget and stores to be successful. However, certain benefits and drawbacks might affect the organisation.
Benefits of the Budgeting Process. When Sainsbury’s Stores starts applying the budgeting process, they are going to experience the following benefits. First, a budget tends to link objectives of the company and the available resources (Spiceland 2009). In this case, Sainsbury’s objectives are expanding their business into a new location. This is where they aim at building another branch to increase their cashflows. On the other hand, reaching this objective requires a lot of resources. In this case, a budget tends to link the two together. This is where the resources are allocated to the different expenses attributed to the objectives. The budget aims at making sure that all the expenses of an object are met and fulfilled. This shows that Sainsbury’s will be able to link their available resources to the objectives.
Secondly, the budgeting process will provide Sainsbury’s Store in conducting an extensive research of the objective before even starting the work (Spiceland 2009). In this case, managers are provided with information that will be helpful in making proper decisions. In this case, Sainsbury’s is going to research on the different prices involving the expenses they are going to make. In this situation, the management can make informed decisions concerning how they are going to spend their resources on their objectives. In addition, a budget can help them realise that the objective might not be viable even before they start. Therefore, a budget helps in saving costs. For this reason, a budget benefits both the organisation and management.
Drawbacks of the Budgeting Process. First, a budget does not consider certain activities aligned to the objectives of the company. This is where the budget does not consider improving certain activities like customer care. This is because a budget only caters for those objectives that involve resources. In this case, quality improvement and customer care are not considered in the budget. Secondly, budgets are not flexible (Spiceland 2009). They are extremely rigid making it difficult for them to accommodate any changes that might come on the way. For instance, Sainsbury’s Stores might encounter difficulties when they are expanding their business due to external and internal factors. Finally, budgets are likely to demotivate employees while they are working (Spiceland 2009). This is because employees are not considered in the budget making process. Moreover, the budget is not subject to changes, thus it seems to rule employees. For this reason, Sainsbury’s Stores might find it work with their employees.
Critical Evaluation of Forecast Cashflows. Theory of Forecasting. Forecasting is mainly predicting the future based on experiences. In a business, management tends to use forecasts to make a timely business decision about the future. For instance, the management can be able to make a decision about production based on the amount of sales they have been receiving in the past. In the case of Sainsbury’s Stores, the management is using the forecasts to make the decision of expanding the business. According to the rate of business activities, they have established that expanding the business is the most significant decision for the company. One of the elements they are using is the cashflows. This is where they check cashflows of the business from the past few years to predict the future directions of the business.
In cashflows forecasting, various methods are being used to predicting the future. One of the methods is the use of cashflow statements. In this case, the management tends to use the statements of the different past years as they follow from the latest to the oldest. In this case, they apply the financial ratios to come up with different computations or percentages that will help them predict the future outcome. In this way the management can make conclusive decisions about the future. Secondly, the management might decide to use the different financial statements together with the cashflow statements to make future cashflow forecasts. For instance, Sainsbury’s Stores used their financial statements to come up with the different cost figures they might incur when they are expanding their business. In addition, they used the cashflow statements to make future cashflow forecasts on the amount of sales they might expect from the new branch they are building.
Differences between Forecast and Budget
These two techniques are almost similar in the way they are structured, but they have several differences. First, in their definitions, a forecast is a future prediction of a certain situation based on the experiences of the situation. In this case, the key elements in a forecast are future predictions and experiences of the situations. A forecast depends on past performances of the situation for purposes of coming up with conclusive evidence to oversee future happenings. This means that experiences provide evidence for purposes of predicting the future. In predicting the future, forecasting is easily done by using the experiences. This means that the main aim of a forecast is to predict the future using the experiences. An excellent example to prove this is how Sainsbury’s Stores has given predictions on the amount of cashflows they are going to expect from the new store. This shows all the elements of forecasts showing the difference between a forecast and a budget.
On the other hand, a budget is a plan of how the different resources are going to be utilised in an organisation. The key elements in a budget are resources and its utilisation. Costs, expenditures and other costs related issues are included in resources. This means that a budget aims at planning how much money the company is going to spend on a certain objective. In utilisation, it simply means how this money is going to be shared among the different activities of the business. An excellent example is how Sainsbury’s Stores has created a budget that is going to help them expand their business. In this case, their cost estimates of how they are going to spend in building the new branch. This reveals that they are showing their available resources, and the way they are going to utilise them.
The second difference is that a forecast explains the directions the business is taking while a budget is a goal or a target. In a forecast, the management of an organisation tends to view the direction in which the business is taking. For instance, Sainsbury’s Stores management conducted a forecast based on the performance of the business. In this case, they realised that the business is making tremendous sales. This means that customers are demanding more of their goods and services. For this reason, they have decided to expand their business to increase their sales. In this situation, the forecast shows the management that the business is going to continue performing extremely well due to the information they have tabulated using the forecasts.
On the contrary, a budget is mainly a target the management is aiming to attain in the course of business activities. In a budget, the management tends to provide expenditure of what they are expected to fulfil by the end of time stipulated in a budget. In the example of Sainsbury’s Stores, it can be clearly seen that the management has provided an expenditure they will incur in building the new store. According to the management of the company, they are going to spend six million in order to create a fully functional store that is going to bring profits for the company. In this case, it is their main target to achieve this by the end of fives years as stipulated in the budget. This shows that a budget is goal oriented, while a forecast is concerned with the going concern of the business.
Finally, a forecast works excellently when created in once a month, while a budget is only prepared once. Forecasts are occasionally made to predict the changes that are occurring with time. For example, a forecast that was done more than three months ago is extremely different from a forecast that is going to be made presently. This is because forecasts base their facts on experiences that are happening as time passes. In this case, many activities can change within three months due to external and internal factors affecting the organisation. Not only does this proves that forecasts are prepared often, but it also proves that a forecast made after every month works perfectly. For this reason, the management is going to experience different tabulations as compared to the past producing new future predictions.
When this is compared to a budget, it is only created once. A budget can also be referred to as a target the management is trying to attain. In this case, targets are unique and different from each other. For these facts, a budget is created once for each objective. For example, Sainsbury’s Stores is going to create a budget for building the new store only once. This is because their target is to create a new store. In case they are going to build another store, they are going to create a different budget. This is because a different budget has new costs. This shows that a budget is only prepared once because it is different from each other, while forecasts are prepared often, since they are similar but subject to change.
Specific Factors that Influence the Forecast Cashflows. Forecast cashflows are exclusively predications and not actual figures or statements of what is going to happen. For this reason, forecast cashflows are subjected to the influence. In this case, the specific factors can be categorised into two groups. These groups include internal and external specific factors. Specific external factors are those outside activities affecting the organisation. The first specific external factor is change in the market environment. Globally, there have been many changes taking place affecting the market environment. Therefore, when the market conditions change, they affect the forecasts of the company. For example, if there is a change in tastes and preferences by the customers, the sales will decrease significantly affecting the forecasts. It can be noted that this change does not take place in the past, it is current.
Secondly, introduction of a new competitor in the market will affect the forecasts. This is a specific external factor because it affects the company indirectly. In this case, the new competitor is likely to lure customers to buying their products. As a result, sales are going to decrease significantly. This will affect the forecasts of the company significantly. Finally, change in technology is another specific external factor affecting forecasts. A company using the old technology is likely to have obsolete products causing a reduction in sales. Therefore, these will immensely affect forecasts.
The specific internal factors are those affecting the organisation internally. It should be noted that these factors are controllable as compared to the external factors. The first factor is a change in technology within the organisation. In this case, the new technology is expected to improve the quality of services and products provided by the organisation. In this situation, the company will predict a reduction in cashflows due to the expenses made in initiating the new technology. However, after introduction, they are going to expect an increase in cashflows. This shows that technology affects forecasts significantly as an internal factor.
Secondly, the methods used to make these forecasts are going to affect forecasts significantly. In this case, different methods result to different conclusions. For instance, the forecasts obtained from using net present value are different from the forecasts obtained from using internal rate of return. In this case, different forecasts will be made by the management. This proves that methods used by management to forecast have an immense effect to the overall prediction. Finally, a change in management will affect the forecasts. This is where a new management comes with new policies. These policies might affect the organisation positively or negatively. For this fact, they are going to impact the forecasts significantly.
Issues Surrounding the Forecast Cashflows. Since forecasts are estimates making them susceptible to changes, they constantly face criticism. One of the issues is the management outlook. In most cases, people tend to judge the forecasts based on management. For instance, if the management is constantly faced with allegations, nobody is going to believe the forecasts even if they are true. This is because parties of the company might think that the management is manipulating the information for their own personal gains. Secondly, there is the fear of the unknown. Many investors are afraid of the future when they are making decisions based on the cashflows of the organisation. They believe that forecasts do not give an actual happening of events in the future. For this reason, they fail to approve the forecasts.
Calculation of Payback Period and Net Present Value
Sainsbury’s Payback Period
Payback period = total costs divided by annual net cashflows.
Total costs – 6,000,000
Annual net cashflows – 3,000,000
6,000,000 divided by 3,000,000 = 2
Therefore, the Sainsbury’s Stores payback period is 2 years.
Sainsbury’s Stores Net Present Value
Net present value = total collections of a given period – total costs
Totals costs = 6,000,000
Total collections = 5 multiplied by 3,000,000 = 15,000,000
15,000,000 – 6,000,000 = 9,000,000
Evaluation of Investment Appraisal Technique. Payback Period. Payback period is a simple investment calculations technique of forecasting where the time to repay the investment is taken into consideration (Cavusgil, Knight & Riesenberger 2012). For example, the management of the company might be having a project they would like to pursue. In this case, a sum of money is required to fund the project. This sum of money is often referred to as an investment. For this reason, the management would like to know the time the project would take to repay the investment. Therefore, this time is referred to as the payback period.
Net Present Value. The net present value is a time series of cashflows both the inflows and outflows of a single entity. The net present cashflow is a standard tool for calculating future long-term forecasts. In most cases, the net present value is used in capital budgeting for the purposes of measuring the excess and shortfalls of cash after eliminating the expenses (Marx 2004). This method is extremely complicated for small companies, but it is highly advisable for large corporations.
Internal Rate of Return. Internal rate of return is used for the purposes of measuring and comparing profitability of different investments. In this technique, different projects are calculated assuming all other factors are constant to estimate the desirable project. The project that has a high internal rate of return would be the most desirable project for the management. Since it involves quality, the management can also use it to measure efficiency, quantity and the yield of an investment.
Appreciation of the Time Value Money Concept. Time value of money can simply be described as the present value of money. This means that having a dollar now is more worth than having a dollar in the future despite the forces of inflation and deflation (Barrow & Barrow 2008). This is because the present dollar is likely to earn more money than a dollar in the future. For instance, a person may decide to invest on the dollar, and after four or five years, the dollar might realise ten dollars. On the other hand, the future dollar is not going to earn any investments since it is not available. In this case, it is expected to remain a dollar, since it is not earning anything (Keir Educational Resources 2003). When this two are compared in the future, the present dollar has become ten dollars whereas the future dollar remains one. This short explanation shows the appreciation of the time value of money.
Therefore, it is desirable for a company to invest the money they currently have than to save and wait to invest in the future. This is because they are going to earn more than what they are going to save. In this case, the management can invest the money in the way they intended to use and at the same time, they can use the excess money for investing in another project. This will earn them a lot of money. It is worth noting that time value of money takes into account the present value of money (Barrow & Barrow 2008). In this case, appreciation of time value of money is when the present value of money increases over successive years through investments as compared to a similar amount in future. Therefore, the present cash has appreciated.
In Depth Analysis of each Technique. Payback Period. Payback period as discussed above is the time taken to repay an investment. This is a simple calculation commonly used by small companies (Cavusgil, Knight & Riesenberger 2012). However, this does not mean that large corporations do not use it; they still use it with other techniques. The example of Sainsbury’s Stores will clearly explain this techniques. According to the management of Sainsbury’s Stores, they require a total cost of six million dollars to complete the new stores. Based on their forecasts, the store is expected to realise net cashflows of three million annually. Using the formulae, the payback period is two years. However, this does not mean that irregular net cashflows cannot be calculated, they can be calculated with ease.
Payback period technique can also be used to measure two different projects or investments the management is trying to pursue. In this case, the investment that has the least payback period is desirable holding other factors constantly. The problem of the time value of money is that it ignores the present value of money. Secondly, it does not measure profitability, since it does not consider what happens after the payback period. Therefore, payback period method is not desirable to be used in comparing two projects solely without other techniques.
Net Present Value. The main aim of net present value is to compare the value of a dollar today to the value of a dollar in the future, considering the forces of inflations and returns (Cavusgil, Knight & Riesenberger 2012). In this situation, the project that will result into a positive figure is desirable than the project that has a negative figure. This is because the positive value reflects profits of the project in the future, while the negative results represent the losses of the project in the future. For this fact, the management should reject projects with a negative figure and take those projects that have positive figures. In this case, it can be noted that the net present value includes many valuables for the purposes of coming up with the results for making a conclusive decision.
Internal Rate of Return. The internal rate of return is commonly used by management to evaluate the growth of a project (Ps%u030CUnder 2002). This is where the management can identify directions the project is likely to take as the years progress. However, the actual internal rate of return is more true representation of what is likely to happen than internal rate of return. In this case, the project that has the highest values is likely to have a tremendous growth as compared to a project that has low internal rate of return. On the other hand, this method does not consider many variables to come up with the results (Ps%u030CUnder 2002). For this reason, the management should try to consider other techniques together to come up with a conclusive decision.
Which Technique is Consideredto be Superior to the Two. According to business analysts and scholars, net present value is considered the best appraisal technique as compared to the other techniques. This is because the disadvantages of other techniques are an advantage to the net present value. To show this, the advantages of net present value over the payback period are going to be discussed. The first advantage is that net present value considers time value of money while payback period does not. When calculating payback period, the only useful element is time (Qatar Financial Centre 2009). For instance, a project might have a shorter payback period but has a negative result in net present value showing that it is not desirable yet payback period technique is proving it to be desirable.
Secondly, net present value considers cashflows rather than the economic life of a project. According to net present values, the inflows and outflows of money are considered through out the entire life of a project. In this case, the management will be able to know the amount of money generated by the project. On the other hand, payback period only considers the payment period. In this case, the payment period of a project might be less, and the overall cashflows are low. Therefore, this shows that the net present value is more superior to payback period.
Finally, the payback period does not show the shareholders wealth is going to increase as compared to the net present value. Payback period technique only shows the repayment time of an investment. This means that the shareholders do not have an idea whether their value is going to be increased by a certain project or not. On the contrary, net present value shows whether shareholders wealth is going to increase. This is because of the inflows and outflows of cash being calculated. Additionally, since net present value considers time value of money, it is easy for shareholders to find out whether their wealth is going to increase in future. Therefore, net present value is superior to payback period technique.
In order to show that net present value method is superior to the other techniques, an analysis of the advantages of net present value over internal rate of return is being done. First, it is extremely difficult for internal rate of return to measure those projects that have uneven net cashflows. However, net present value does not encounter difficulties while measuring different projects despite the fact that there might be uneven net cashflows. In this case, the management will tend to use net present value method over internal rate of return method. For this reason, net present value method is superior to internal rate of return method.
In areas where net present value and internal rate of return have conflict results about projects, net present value method always prevails because it tends to produce convincing results. In net present value, the profitability rates are shown meaning that when there are high profitability rates, the shareholders wealth is going to increase. In the case of internal rate of return, it is extremely difficult to determine whether the shareholders wealth is going to increase or not. This is because internal rate of return is subjected to changes when they are compared to the actual internal rate of return. Therefore, net present value is superior to internal rate of return.
Finally, net present value method incorporates many elements into one to come up with the appraisal results as compared to the internal rate of return. Net present value method incorporates all the elements of time, cashflows and time value of money in its calculations. In this case, this method is extremely easy to calculate using all this elements. On the contrary, internal rate of return method has difficulties in incorporating all these elements to its calculations making it difficult for the management to use. However, internal rate of return method can use all this elements, but it is susceptible to errors. Therefore, based on the above analysis of the two techniques with net present value, it is clear that the net present value method is superior to the two techniques.
Example of their Use in the Real World. Payback Period. A real world example of the way payback period strategy is used by a company can be derived from the Sainsbury’s Stores case scenario (Cavusgil, Knight & Riesenberger 2012). In this case, Sainsbury’s Stores has a project of building a new store as a process of expanding their business. In order for them to know the time, the investment is going to repay their costs they have to spend on the payback period technique. Additionally, in a real world situation, management of organisations use payback period to evaluate the time different projects are going to take to repay the costs of their investments.
Net Present Value. In the net present value, investors and management use net present value to know whether they are growing to increase their wealth (Cavusgil, Knight & Riesenberger 2012). An excellent example is the Sainsbury’s Stores situation. In this case, management can know that they are growing to increase their wealth in the future, since net present value results are a positive figure after the end of the five years. Additionally, the investors also know that they are going to increase their wealth, since the new branch is expected to bring more value to the company in the future.
Internal Rate of Return. Internal rate of return is mostly used in the banking sector by the different account holders when they want to know how much money they are earning when they put a certain amount of money in their account (Crean 2008). For instance, an investment having a five per cent simple interest is expected to give a return of five per cent of the amount of investment placed in the investment.
Non Financial Factors to be Considered. The non-financial factors that Sainsbury’s Stores should take into consideration relating to the creation of the new store. The first factor to be considered is the location of the new stores (Cavusgil, Knight & Riesenberger 2012). Location of a business means a lot when a company is making a strategic decision. In this case, if Sainsbury’s Stores build the new stores in a location where it is difficult for customers to access their services and products, they are not going to make the expected net cashflows. On the other hand, if they build the new store where access of goods and services will be easier for their customers, they are going to make predicted cashflows. Therefore, the location of the new stores is one of the non-financial factors Sainsbury’s Stores should consider.
Secondly, customer tastes and preferences is another non-financial factor affecting the new store (Cleary & Malleret 2007). In the case of Sainsbury’s Stores, they should consider the tastes and preferences of the customers residing in the new area where they are going to set up a new store. This is because of the fact that their services and products are not in line with the tastes and preferences, they are going to make the expected cashflows. On the other hand, if their services and products are compatible with the tastes and preferences of customers in that area, they are going to make the expected cashflows. For this reason, Sainsbury’s Stores should consider this as a non-financial factor.
Thirdly, existing competitors in the new area where they are intending to open a new stores is another non-financial factors Sainsbury’s Stores should consider (Cleary & Malleret 2007). This is because of the fact that if a competitor has already established a store, the competitor is likely to command the market in that region. Additionally, competitors might be more sophisticated by having high quality goods and services. In this situation, it would be extremely difficult to attract customers to the stores. As a result, it will lead to low cashflows. On the other hand, if the competitors are not well established or they do not have proper resources, Sainsbury’s Stores is going to attract new customers quickly leading to improving cashflows.
Finally, political factors are another non-financial factor that should be taken into consideration (Cleary & Malleret, 2007). The new location where Sainsbury’s Stores intend to create a new store might have new laws and regulations of conducting business. If there are many restrictions, it would be extremely difficult for the Sainsbury’s Stores to build their new stores. This is because they are going to incur numerous costs for purposes of fulfilling the market laws and regulations. On the contrary, if the laws and regulations are conducive for the business environment, it will be easier for them to build the new stores. As a result, they are going to make the intended net cashflows.