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Baumols Model of Cash Management by omd17505


Baumols Model of Cash Management document sample

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									  Budgeting and

         Prepared for

      Dr. Ghassan Tarakji


   Engineering Management


       Joo Young Byun
       M. Endarsyahreza
          Naiwei Jin
          Yuhua Bai
          Yun Chang

     School of Engineering
 San Francisco State University

                                  March 22, 2003

1      Introduction of Financial Management .................................................................. 1
    1.1     Basic components of financial management ................................................... 1
    1.2     Budgeting, Planning and Control .................................................................... 3
2      Business Plan and Fiscal Management ................................................................... 3
    2.1     The main reasons you should write a business plan ...................................... 3
    2.2     Business plan outline......................................................................................... 4
    2.3     Example of a business plan .............................................................................. 5
    2.4     Financial aspect & sources in an organization/corporation. ........................ 8
3      Budgeting Concept and Theory ............................................................................. 12
    3.1     What is a budget?............................................................................................ 12
    3.2     When & who do budgeting?........................................................................... 12
    3.3     Types of budgeting .......................................................................................... 12
    3.4     Budgeting theory ............................................................................................. 13
4      Capital Budgeting ................................................................................................... 14
    4.1     Importance of capital investment .................................................................. 15
    4.2     Non-discounted capital budgeting techniques .............................................. 15
    4.3     Discounted capital budgeting techniques ..................................................... 16
5      Operating Budget .................................................................................................... 17
    5.1     Purposes ........................................................................................................... 17
    5.2     Budgeting steps................................................................................................ 17
    5.3     Summary of operation budgeting .................................................................. 21
6      Cash Management .................................................................................................. 22
    6.1     Why cash management? ................................................................................. 22
    6.2     The reasons for holding cash ......................................................................... 22
    6.3     Cash management ways ................................................................................. 23
    6.4     Summary and conclusions .............................................................................. 28
7      Responsibility Accounting ...................................................................................... 29
    7.1     Controllability concept ................................................................................... 29
    7.2     Advantages and disadvantages ...................................................................... 29
    7.3     Summary and controversial question ........................................................... 30
8      Reference List .......................................................................................................... 30

1    Introduction of Financial Management
     Financial management involves the acquisition and allocation of organizational
resources and the tracking of performance resulting from such allocations. The objectives
of financial planning and management are quite simple in theory, but they are much
difficult in practice.
     In theory, one merely has to decide what is wanted (specify goals and objectives),
measure these wants (quantify the benefits sought), and then apply the means available to
achieve the greatest possible value of the identified wants (maximize benefits). The
means are the resources of complex organizations. Therefore, the primary objective of
financial planning and management is to maximize benefits for any given set of resource

1.1   Basic components of financial management
    The essential tools for managing financial resources include techniques for assessing
the long-term fiscal needs of the organization and for acquiring these resources, rational
procedures for allocating resources and managing costs, and appropriate mechanisms for
recording and disseminating relevant financial information.

                   Figure. Linkages Among the Financial Management Cycles

    Financial management involves the acquisition and allocation of organizational
resources and the tracking of performance resulting from such allocations. In a profit-
oriented enterprise, financial statements form the basis for the stockholders' assessment
of performance of management. In not-for-profit organizations, management seeks to
satisfy the needs and desires of its constituents within a set of financial (budgetary)
constraints. In either case, financial resources are the focal point for managerial decision
make, action, and accountability. Methods and techniques utilized in the performance of
these financial functions are relevant to managers in all types of organizations.

     The allocation of existing resources and the management of costs to derive future
benefits are key responsibilities of financial managers. The relationship between current
resource allocations and future benefits is asymmetrical, however. Whereas existing
resources are expended with certainty, the anticipated stream of benefits often is
uncertain. This stream may fall considerably short of the expected results or may exceed
initial estimates. In financial management, this deviation from expected returns provides
an important definition of uncertainty and risk.

    To determining the financial feasibility and desirability of resource commitments, an
analysis of future costs and benefits must be undertaken rather than the mere
reconciliation of past expenditures. In the allocation of resources, the following question
must continually be examined: Are anticipated long-run benefits (adjusted for risk) of a
given project commensurate with the long-run costs that may be incurred?

    Financial managers must also be concerned with the long-term asset requirements of
the organization. A prime function of financial management is to identify the resources
required to attain the overall objectives of the organization. A financial plan is a key
ingredient in the long-term strategies of any organization. The main purpose of financial
planning is to project resource requirements for specific time periods and to identify the
likely sources of the funds needed.

    A view of the future is required before any plan can be formulated. This forecast lays
out explicitly and implicitly the political, economic, and environmental conditions that
are likely to affect the programs and activities of the organization. Sound professional
judgment is an essential ingredient in the development of forecasts because of the
difficulty in predicting future conditions and events.

    Financial management must identify the magnitude of future needs, determine the
timing, and negotiate with potential sources of external capital. Decisions of whether to
engage in short-term bank borrowing or long-term bond issues are dependent on cash
flow expectations, capital structure determination, and cost-of-capital considerations. To
discharge these functions effectively, financial managers must be sensitive to macro-
economic developments that may influence the availability and cost of the capital to be

1.2    Budgeting, Planning and Control
    In long-term (strategic) and short-term planning processes are core management tasks
that are critically important to the future survival and success of the business. The budget
prepared for planning purposes, as part of the strategic planning process, is the
quantitative plan of management’s belief of what the business’s costs and revenues will
be over a specific future period. The budget prepared for control purposes, which may
have been based on standards that may not be reached, is used for motivational purposes
to influence improved departmental performance. Monitoring the actual performance
against the budget is used to provide feedback in order to take the appropriate action
necessary to reach planned performance, and to revise plans in the light of changes.

2   Business Plan and Fiscal Management
    Business plan is a document prepared by a company's management, detailing the past,
present, and future of the company, usually designed to attract capital investment. Sound
financial management is one of the best ways for your business to remain profitable and
solvent. How well you manage the finances of your business is the cornerstone of every
successful business venture. Each year thousands of potentially successful businesses fail
because of poor financial management. As a business owner, you will need to identify
and implement policies that will lead to and ensure that you will meet your financial

    To effectively manage your finances, plan a sound, realistic budget by determining
the actual amount of money needed to open your business (start-up costs) and the amount
needed to keep it open (operating costs).

     The important step to building a sound financial plan is to devise a start-up budget.
Your start-up budget will usually include such one-time-only costs as major equipment,
utility deposits, down payments, etc. The financial section of your business plan should
include any loan applications you've filed, capital equipment and supply list, balance
sheet, breakeven analysis, pro-forma income projections (profit and loss statement) and
pro-forma cash flow. The income statement and cash flow projections should include a
three-year summary, detail by month for the first year, and detail by quarter for the
second and third years. The accounting system and the inventory control system that you
will be using are generally addressed in this section of the business plan also. If a
franchise, the franchiser may stipulate in the franchise contract the type of accounting and
inventory systems you may use. If this is the case, he or she should have a system already
intact and you will be required to adopt this system. Your plan should include an
explanation of all projections. Unless you are thoroughly familiar with financial
statements, get help in preparing your cash flow and income statements and your balance

2.1   The main reasons you should write a business plan

    To test the feasibility of your business idea. Writing a business plan is the best way
to test whether or not an idea for starting a business is feasible, other than going out and
doing it.

    In this sense, the business plan is your safety net; writing a business plan can save
you a great deal of time and money if working through the business plan reveals that your
business idea is untenable. Often, an idea for starting a business is discarded at the
marketing analysis or competitive analysis stage, freeing you to move on to a new (and
better) idea.

    To give your new business the best possible chance of success. Writing a business
plan will ensure that you pay attention to both the broad operational and financial
objectives of your new business and the details, such as budgeting and market planning.
Taking the time to work through the process of writing a business plan will make for a
smoother startup period and fewer unforeseen problems as your business becomes

    To secure funding, such as bank loans. You're going to need both operating and
startup capital to start a new business and you have no hope of getting any money from
established financial institutions such as banks without a well developed business plan.
And established businesses often need money, too, to do things such as buy new
equipment or property, or because of market downturns. Having a business plan gives
you a much better chance of getting the money you need to keep operating or to expand.

    To make business planning manageable and effective.A business plan is essential
if you're thinking of starting a business, but it's also an important tool for established
businesses. Viable businesses are dynamic; they change and grow. The company's
original business plan needs to be revised as new goals are set. Reviewing the business
plan can also help you see what goals have been accomplished, what changes need to be
made, or what new directions your company's growth should take.

    To attract investors. Whether you want to shop your business to venture capitalists,
or attract angel investors, you need to have a solid business plan. A presentation may
pique their interest, but they'll need a well-written document they can take away and
study before they'll be prepared to make any investment commitment.

   Be prepared for your business plan to be scrutinized; both venture capitalists and
angel investors will want to conduct extensive background checks and competitive
analysis to be certain that what's written in your business plan is indeed the case.

   Writing a business plan is time-consuming, but it's essential if you want to have a
successful business that's going to survive the startup phase. If your business doesn't have
one, maybe it's time to start working on one. The process of writing a business plan can
do wonders to clarify where you've been and where you're going.

2.2   Business plan outline

    The Executive Summary While appearing first, this section of the business plan is
written last. It summarizes the key elements of the entire business plan.

    The Industry An overview of the industry sector that your business will be a part of,
including industry trends, major players in the industry, and estimated industry sales.
This section of the business plan will also include a summary of your business' place
within the industry.

    Market Analysis An examination of the primary target market for your product or
service, including geographic location, demographics, your target market's needs and
how these needs are being met currently.

    Competitive Analysis An investigation of your direct and indirect competitors, with
an assessment of their competitive advantage and an analysis of how you will overcome
any entry barriers to your chosen market.

   Marketing Plan A detailed explanation of your sales strategy, pricing plan, proposed
advertising and promotion activities, and product or service's benefits.

   Management And Ownership An outline of your business' legal structure and
management team's organization.

   Operating Plan A description of your business' physical location, facilities and
equipment, kinds of employees needed, inventory requirements and suppliers, and any
other applicable operating details, such as a description of the manufacturing process.

    Financial Plan A description of your funding requirements, your detailed financial
statements, and a financial statement analysis.

    Appendices And Exhibits Any additional information that will help establish the
credibility of your business idea, such as marketing studies, photographs of your product,
and/or contracts or other legal agreements pertinent to your business.

      In this presentation, we will be focusing on the Financial plan aspect.

2.3     Example of a business plan
      The below is an actual business plan from a company called In The Pipeline

                                 The company and its products

        The background of company In late 1996, Maarten Byl, Nick Raschella and
Nicholas Love were introduced to John McMahon, an electrician and inventor. One of
John's many ideas was for a novel poly vinyl chloride (PVC) pipe repair system. He was
resolute in his conviction that all enormous market existed for a product, which would
make broken PVC pipe a snap to fix. Since ITP(in The Pipeline)'s formation in
November 1996, John's concept has undergone a rapid evolution. A prototype of a split
conduit repair solution was manufactured and test marketed in Australia in early 1997.
Responses from this showed a substantial demand for a product that could do more than
repair straight PVC pipe.

    ITP has arranged for the production of Snapfix by Marley Plastics for supply to
Australia's two telecommunications companies and Ideal Electrical. Ideal Electrical is
Australia's largest independent electrical wholesaler and will be marketing Snapfix in
their upcoming June catalog.

    The product of the company. Snapfix is the first total repair, redesign and
installation system for PVC pipe. Snapfix solves the problems inherent in the existing
piecemeal approaches; specifically the costly and time consuming process of relaying
large sections of pipe, the severing, removal and re-threading of encased electrical and
telecommunications cables, and the use of toxic resins.

                                    Executive Summary

    Executive Summary In the Pipeline is a company whose strengths lie in
identification, development and promotion of innovative products. The management team
has proven their ability to rapidly evolve a new product from the conception of the idea to

    The company's launch product is Snapfix, a long awaited solution to the often
difficult repair, redesign and installation of PVC pipe. Snapfix provides both cost savings
and increased efficiency.

    In the Pipeline's competitive advantages lie in the identification and marketing of
commercially viable new products. For commercialization of Snapfix, In the Pipeline
requires access to an established manufacturing base and distribution network. An
incorporated joint venture will allow In the Pipeline to merge these competitive
advantages with a company whose complementary strengths lie in plastics manufacturing
and distribution.

    Market Analysis A survey of selected firms in the telecommunications and electrical
industries revealed a large unanswered demand for a repair, redesign and installation
system such as Snapfix. This demand has been long standing, as evidenced by the 40
patented pipe repair, redesign and installation systems dating back to 1975. None of these
systems have been able to adequately fill this need. The demand for a total system such
as Snapfix is driven by the:

      Cost of current repair, redesign and installation approaches
      Time that other approaches take to apply in the field
      Aging nature of the existing electrical cable networks
      Telecommunications industry demand for fiber optic cable encased in PVC pipe.

    Competitor Analysis As Snapfix faces few direct competitors, the pricing structure
is of reduced importance. The pricing strategy for Snapfix is to emphasize the total cost
of repair, redesign and installation solution, rather than the specific product cost. In

broader terms, the PVC pipe industry is one which is characterized by decreasing pricing
scales, based on customer buying power.

    Market Opportunity The market potential for Snapfix is enormous. Modern
Plastics, a leading trade journal, reports that U.S. sales of PVC pipe in 1996 were in
excess of 5.36 billion pounds, an increase of 10% over 1995. Furthermore, there has been
an estimated 45 billion pounds of PVC pipe installed since 1980, a Substantial amount is
buried underground, encasing telecommunications and electrical cables. On average 0.1%
of the total installed pipe network fails and needs repair or replacement annually. This is
an average of 45 million pounds per year.

    Launch Market – California According to the Pacific Bell Engineering Department,
there are very few sections of California's pipe network which have not sustained
earthquake damage. For this reason, it has been selected as the geographic launch market
for Snapfix. The region has an installed base of 6.2 billion pounds of PVC pipe, 700
million pounds of it installed in 1996.

    Business Strategy ITP's competitive advantages lie in the identification and
marketing of new products. The commercialization of Snapfix also requires access to an
established manufacturing base and distribution network.

    Establishing a manufacturing operation and distribution network is not cost effective
for ITP. Therefore, ITP's strategy is to merge its competitive advantages with a company
that has complementary strengths in plastics manufacturing and distribution, and an
existing customer base At present, the PVC pipe industry is characterized by an excess
production capacity of 10%. It is also growing at a rate of 10% per annum.

    Marketing Plan The major consumers of PVC pipe can be divided into two distinct
market segments. The first one is the Telecommunications and power utility firms with
installed pipe networks, and the second one is the electrical wholesalers and contractors.
Snapfix provides the product benefits and advantages which meet these key purchasing
criteria. One of Snapfix's most significant product benefits is the total installed cost
savings it provides. A second is that Snapfix is made of impact resistant PVC and sold
with a lifetime replacement warranty.

                                    Operational Plan

    Business Structure ITP is an incorporated Delaware company. Its shareholders
consist of the three members of the management team (25% each) and the inventor's
Australian company (25%). Currently all four shareholders are directors. ITP will appoint
an independent chairman with relevant industry experience. The convertible note to be
issued to the venture capitalist may convert into 25% equity in ITP between January 1
and June 30, 2000. A seat on the board will be offered upon conversion.

   Future Products ITP has a further three ranges of products, Volsnaps and Ezifix
Anchors to launch on the US construction market. Also to be launched is an irrigation

variation of Snapfix. ITP's business risk will be diversified by having these products on
the market simultaneously.

    Development Activities ITP will not conduct scientific research but rather locate and
commercialize at least two additional product lines from outside of the company by the
end of 2001. It will be the task of ITP's New Venture Manager to identify and advised
management of these new product opportunities for ITP. Expenditure has been provided
for in the financials to assist in the purchase of intellectual property rights to new
products identified by the New Venture Manager. In addition, the inventors of the
products secured by ITP will continue to refine and further develop their inventions on a
consulting basis.

    Expansion Plans In keeping with its strategic objectives, ITP aims to enter into
follow up joint ventures with companies whose strengths he in the manufacturing and
distribution of plastics products. ITP will have finalized joint venture arrangements in the
South by 2000, and the Midwest by 2002, utilizing a similar structure to the joint venture
in California. Figure 4 illustrates the sequential expansion schedule for ITP.

   Managerial Personnel ITP's managerial structure facilitates the achievement of the
company's aims and objectives by efficiently dividing and delegating responsibilities in
order to utilize each manager's distinctive skills and experience

    Non-Managerial Personnel ITP is to employ three office support and administration
staff in its California office, over the first two years. It is expected that numbers of these
non-managerial personnel will increase as the company grows. The costs associated with
employing these support staff are reflected in the financial statements.

    Worst Case Scenario – Summary In the Worst Case Scenario an IRR of 94% and
NPV of $3.1 million are achieved, As debt holders do not convert their debt to equity,
their IRR remains at the coupon rate of 32%. The Worst Case Scenario outcomes are
summarized in the table below and a detailed Income Statements, Cash-flow Statements
and In the Worst Case Scenario ITP will use its line of credit to meet a shortfall of cash in

2.4   Financial aspect & sources in an organization/corporation.

    Long Term Debt/Loan Long Term Debt, Loans and financial obligations lasting
over one year on which interest is paid. A long term loan is arranged when the scheduled
repayment of the loan and the estimated useful life of the assets purchased (e.g. building,
land, machinery, computers, equipment, shelving, etc.) is expected to exceed one year.
Long term loans are normally secured, first, by the new asset (s) purchased (up to 65%)
and then by other unencumbered physical assets of the business (for the remaining 35%) ,
or failing that, from additional funds from shareholders or personal guarantees from the
principals. On the balance sheet, the equipment purchased shows up in the long term
assets section, while the counterpart loan information is shown in the current and long

term liabilities portions. The useful life of the assets is directly reflected in their
depreciation schedules.

    Debt lenders (creditors) make loans to businesses that exhibit strong management
ability and steady growth potential. A written business plan, including a cash flow
demonstrating the business ability to repay the loan principal and interest over the term of
the repayment schedule, is mandatory. The lender will expect you to have appropriate
insurance to protect the assets.

    Characteristics of long term debt Principal repaid over a period of time directly
related to the useful life of the asset(s) (e.g. land and buildings - up to 30 years,
computers - 3 years).

       Loan carries both interest and principal repayment provisions in a set repayment
        schedule. Early repayment may entail a penalty because the lender had not
        planned an alternate investment for that money.
       The percentage interest rate normally remains constant for the term of the loan.
        Each payment of principal reduces the balance of principal remaining and the
        subsequent interest is calculated on this reducing balance.
       Different lenders make different types of term loans. Term loans often carry lower
        interest rates than operating loans because the term is fixed and the loans are
        secured by assets (asset-backed)

    Short Term Debt Short term refers to the time for which a loan is required and the
period over which its repayment is expected to take place. Short Term Loans usually take
the form of operating term loans (less than one year) and revolving lines of credit. These
finance the day-to-day operations of the business, including wages of employees and
purchases of inventory and supplies. Supplies are used up quickly and inventory is sold
resulting in stock-turns. Also bridge financing (interim loans with a short, fixed term) can
be used to finance accounts receivable contracts, which are relatively risk-free, but
delayed for one to three months.

    Short term operations money may be secured against first, any unencumbered
physical assets of the business; second, additional funds from shareholders or personal
guarantees from principals. On occasion, inventories can be used as temporary security
for operations loans. Bridge financing is normally secured by assignment of all the
receivables and personal guarantees. On the balance sheet the accounts receivable,
inventory and supplies stocks show up in the current assets section, while the counterpart
loan information is displayed in the current liabilities section.

    Lenders normally charge a higher base rate of interest for operating loans reflecting
this relatively weaker security position. The amount of the operating line of credits will
be determined from the projected cash flow information in the business plan. Lenders
favor businesses that exhibit strong management, steady growth potential and reliable
projected cash flow (demonstrating the business ability to pay the monthly interest
payments on this line of credit from its projected revenues in a written business plan).

    Assets List anything of value that is owned or legally due the business. Total assets
include all net values. These are the amounts derived when you subtract depreciation and
amortization from the original costs of acquiring the assets.

    Short-term investments Also called temporary investments or marketable securities,
these include interest- or dividend-yielding holdings expected to be converted into cash
within a year. List stocks and bonds, certificates of deposit and time-deposit savings
accounts at either their cost or market value, whichever is less.

    Long-term Investments Also called long-term assets, these are holdings the business
intends to keep for at least a year and that typically yield interest or dividends. Included
are stocks, bonds and savings account for special purposes.

    Debt ratio Debt capital is divided by total assets. This will tell you how much the
company relies on debt to finance assets. When calculating this ratio, it is conventional to
consider both current and non-current debt and assets. In general, the lower the
company's reliance on debt for asset formation, the less risky the company is since
excessive debt can lead to a very heavy interest and principal repayment burden.
However, when a company chooses to forgo debt and rely largely on equity, they are also
giving up the tax reduction effect of interest payments. Thus, a company will have to
consider both risk and tax issues when deciding on an optimal debt ratio.

     Cash is an asset to the business and is usually considered to be one of the current
assets. The other current assets are stocks and debtors. Under the heading cash on the
balance sheet may be included a number of items of varying liquidity. A small amount
may actually be cash (or readies) held in tills or as petty cash, but the majority is likely to
be held in various bank accounts. However, since money in current accounts rarely earns
interest, if a business has a surplus of cash it may invest it in various ways. Some will
have to be in very liquid accounts so that if necessary they can get at it very quickly, but
some may be tied up for longer periods of time. As with the debtors, the amount of cash
required will vary according to the line of business the firm is in. Retail firms may have
higher levels of liquid cash than businesses that operate mostly on a credit basis and
therefore rarely handle notes and coins. It is often said that in business "Cash is King",
this is said because cash is all important to businesses. Without cash employees cannot be
paid, suppliers cannot be paid, and therefore the business will grind to a halt. Cash is the
oil in the machine of business, and a Cash Flow Statement tells us how much cash is or
will be available within the business or how much cash will be needed to keep the
business running.

   There are various aspects to the firms cash management.
    Liquidity
    Investment
   Stocks are often also known as inventories. They are anything which a firm has
which is not currently being used for one of the firm's functions. Most departments in the
company will have stocks of something. The factory may have stocks of raw materials

ready to produce, the office may have stocks of stationery and the warehouse may have
stocks of finished goods.

    Stocks are vital to a company to help it function smoothly. If production had to be
stopped every time the firm ran out of raw materials, the time wasted would cost the firm
a fortune. If a shop had no stock on the shelves, customers would soon desert them. The
same is true of most areas the firm operates in - I am sure you can appreciate the
importance of planning ahead and having suitable levels of stocks.

    Stocks are considered to be current assets because many types of stocks can be
converted into cash reasonably readily - particularly stocks of finished goods. However,
they are generally the least liquid of the current assets. At times of recession or similar it
may be very difficult for the firm to sell stocks, and so although they may be listed as a
certain value their true value may be lower.

     Liquidity The firm has to ensure that it has sufficient cash for all its day-to-day
activities. It needs to be able to pay its bills when they are due and pay its staff and so on.
It therefore needs to have sufficient of its cash in a liquid form to cope with all
contingencies. However, the more liquid a form the cash is in the less it will be earning
for the firm. You could check this by trying to compare the rates that a bank or building
society offer for money that is tied up for different time periods.

    Investment This is linked in with the notion of liquidity. If the firm has surplus cash
for its day-to-day needs it should perhaps think about investing it. This investment could
be a financial one (portfolio investment), or it could perhaps be investment in fixed assets
(productive / direct investment). Either of these will make the money work harder than it
will in a more liquid form. The firm does, however, need to plan carefully to ensure that
it has planned as necessary for its future cash needs. Because the firm is constantly
receiving cash (from sales, debtors and perhaps even from interest), and constantly using
cash (paying bills, paying staff and so on) it needs to ensure that the two balance out. The
consequences of a mismatch of the two should be obvious. Think of it in terms of your
own bank account and you will see what I mean. More money going out than coming in
quickly leads to bouncing check and 'persuasive letters' from the bank manager. The
same will happen to a firm and it will run into cash flow problems.

    Revenue The income received by a business for goods sold or services provided. It is
the cash flowing into a business.

    Expenses Under expenses or expenditure you will find all of the money spent by a
business within a time period. This is the money flowing out of the business. There are
many different types of expenditure; some of the more common are shown in the cash
flow statement. All of these are examples of money flowing out of a business.

3     Budgeting Concept and Theory

3.1   What is a budget?
    There is a lot of definitions could be found by search the Internet. But it is basically a
plan which to…
     ensure that there are money for future activity,
     to control finance,
     to make confident financial decisions by relying on solid figures that would
       otherwise have been based around guesswork and instincts.

    So a budget indicates where your money will be going and how this money will be
raised if your business does not have the cash flow to compensate. The main objective of
a budget is to make your business profitable or at lease as improving profitability. (there
are some differences between government and business budget, Based on our
engineering background and the course focus, here we only discuss the business

3.2       When & who do budgeting?

   When: There are no fixed time periods that a budget must compensate for. But
commonly, a business will prepare a budget to coincide with their financial year. This
should be the maximum budgeting period. Often when the budget covers such a large
time scale, it is common to split the budget into monthly statements to make the process
more manageable and feasible to follow. Many businesses also budget on a 1-4 week
cycle. but to be truly effective, they should cover a period that will give your business
some footing to go forward.
   Who: Management, Financial stuff.
   Engineer: provide the date and requirement to let management make best decision.

3.3       Types of budgeting

   For the small businesses the budget could be sample. But for most of business, their
budget will be separated into different portion, for example, manpower expenses,
material cost, etc. The below is the list of some budget types were often used in business

          The sale budget
              This particular budget is to forecast the sale revenue.
          The production budget or operational budget.
              This particular budget is the budget for company to run the business. For the
           production business, this budget will be production budget. For the service
           business, this budget will be operation budget.
          The material purchase budget
              This budget is mainly for the manufacturing businesses
          The manpower budget

               In this budget, the manpower (or stuff) costs will be computed during the
           budget period.
          Overhead budget
          The capital Expenditure budget
               After compiling the production budget and sales budget, it may be necessary
           to purchase or hire machinery due to the lack of resources to meet demand at a
           particular time. In which case, it is vital that you budget for purchasing/hiring
           such equipment so that you can arrange finance in good time if need be.
          The cash budget
               The cash budget is the link between all the individual budgets and the master
          The master budget
               In this budget, it will summarize the projected Profit & Loss balance sheet.
          Project budget
               It is a small and simple business budget. It could involve the material budget,
           manpower budget,

3.4       Budgeting theory

    Modern theories of budgeting: Activity based budgeting, Zero-Base Budgeting. There
are other budget theory for example, programme based budget and performance
budgeting. (not discussed here).

Zero-Based Budgeting

    Zero-Base Budgeting (ZBB) was first developed and introduced for business by Peter
A. Pyhrr. During the development of ZBB Mr. Pyhrr was the Manager, Staff Control, at
Texas Instruments, Inc. Dallas. From this beginning ZBB has been explored and adopted
by many other businesses.
    It approached budgeting in which each year’s activities are judged a new, with no
reference to dollar amounts of past years

    The objective of Zero Based Budgeting is to "reset the clock" each year. While a
traditional budgeting process allows managers to start with last year's expenditures and
make a adjustment to come up with next year's budget. Zero Based Budgeting implies
that managers need to build a budget from the ground up, building a case for their
spending as if no baseline existed -- to start at zero.

      The pros and cons of ZBB

          Can eliminate a sense of "entitlement" to costs increases.
          Improved cost containment.
          Increased discipline in developing budgets.
          More meaningful budget discussions during plan review sessions.


       May be overkill in some situations to request that managers justify every existing
        expenditure. Can meet with significant active and passive resistance.

Activity based budgeting (ABB)

    ABB is distinct from Activity-based Cost Accounting (ABC). Activity-based
Budgeting (ABB) means presenting a budget in terms of the cost of an organization's
products and services, it captures and analyzes how workers spend their time. By given
projections of volume, ABB provides projected cost.

    For cost minded companies, Activity Based Budgeting, supported by an Activity
Based Costing system can appear to be very attractive. If implemented well, it will help
to control costs and help a management team tighten their grasp on the business.

    The advantage of ABB

       Detailed understanding of an organizations cost
       Increased control over expenditures
       Improved understanding of the linkages between a company's processes &
        activities and their related costs
       Increases the level of the dialog during departmental budget review sessions,
        encourages a healthy discussion of issues and cost drivers.

    Limitation of ABB

    Success of ABB depends heavily on two factors:

        Management's commitment to act on the data,
        Worker's commitment to accurately record their time.

   If management team does not understand how the budgets and allocations were
developed, and fails to support the results, then the entire process can be undermined.

   Likewise, if individual workers fail to accurately account for their time, or if their
superiors take too many shortcuts in estimating their time, then the resulting allocations
and budgets will not prove very useful.

4   Capital Budgeting

    Capital Budget is a budget that deals with large expenditures for capital items
normally financed by borrowing. Usually, Capital items have long-range returns and
useful life spans, are relatively expensive, and have physical presence (for example,
buildings, roads, and sewage systems).

   Engineer in capital budgeting. What can we do in the capital budgeting as an
engineer? As a technology specialist in certain field, we can provide the technical view

and the future development in that area to the top management. Let the investment
project has more clear view of the future.

4.1   Importance of capital investment
    The capital investment decision are critical to long run profitability, it is because
     The large initial outlay.
     Potential long-term impact on earning,
     Difficult to reverse course.
    Clearly, we can know all the long-term investment decisions are important. The larger
the investment, the more critical is the budget for that expenditure. And the longer the
time period, the more difficult to access future outcome and to plan accordingly.

4.2     Non-discounted capital budgeting techniques
      The two commonly used methods under non-discounted techniques are:
       The payback method
       The unadjusted rate of return method.

    Payback Method is widely used in business because it is simply to apply and provide
the preliminary screening of investment opportunities.

      Payback period = Investment cost / annual net cash inflows

      Example: Build a production line costs $500K,
               The new production line will bring 20K annual net income,
               Payback period = 500/20 = 25 months.

   The strength of the payback method is for management to determine whether an
investment fits within an acceptable time frame fro use of the fund.

      There are several weaknesses in the payback method
       Did not reflect the profitability of the investment.
       Did not reflect the life span of the goods you invested.
       Did not take a count of time value of the money.

   The unadjusted rate of return method (also refer as simple rate return or
accounting rate of return)

      Unadjusted rate of return =
        Increase in future average annual net income/ initial investment cost

      Example: Use the example in the payback method.
      Unadjusted rate of return = 20/500=10%

    Unlike the payback method, the unadjusted rate of return method attempts to measure
the profitability of an investment. But, the main weakness of this method is that does not

consider the time value of money. It brings the future income to present without

   To summarize, the both methods are do not consider the time value of money. The
payback method measure the time required to recover the initial cost of the investment. It
could useful as a preliminary screen of investment projects. And unadjusted rate of return
method provides a measure of the profitability of an investment.

4.3   Discounted capital budgeting techniques
    Discounted capital budgeting techniques are recognized the time value of money,
which non-discounted capital budgeting techniques do not take care of it. There are two
widely used methods, Net present value method and Internal rate of return method. The
below we only discuss the net present value method.

    Net Present Value Method compares all the expected inflow cash associated with an
investment with the current and future cash outflow. All the cash flows are discounted to
their present values, so it gives recognition to the time value of money.

      In general, the net present value method involves three steps:

          Compute the discount factor,
          Calculate the total present value of each cash outflow and the total present value
           of cash inflow
          Evaluate the result, if the net present value is great than zero, It means the project
           (or investment) is acceptable in financial point of view.

      Example: Replace a exist production line with high efficient new production line,
                Cost: $10,000, salvage value of old line: $1,000,
                Every year net income increase by using new line $1,000 with first 4
                years. After 4 years, the production line will be have $7000 value if

          Step1: Compute the discount factor,
                    based on where the money comes from, e.g loan from bank with 10%
                  interest rate.
          Step 2: Subtract the present value of cash inflow from cash outflow

                  Cash inflow               Value($)       Discount factor     Present value($)
                  Net income increase       1,000          3.1699              3,169.9
                  Value after 4 years       7,000          0.6830              4,781
                  Total present value                                          7,950.9
                  Cash outflow              9,000          1.000               9,000

          Step 3: Evaluate the result get the net present value, in this example, the value is
                  negative which means not worth to investment in financial point of view.

5   Operating Budget
   Operating (master) budget, sometimes known as profit plan, details the immediate
goals for revenues, production, expenses, and cash for the next period. It is used by
managers to establish and communicate daily, weekly, and monthly goals for the
organization, and is the most heavily used budget in an organization.

5.1   Purposes
    The overall purpose of an operating budget is to quantify a general plan so that
performance in relation to a goal can be carefully monitored. Its purposes are as
     Provide the basis for revenue measures and adjustments to fiscal plan.
     Allow ongoing comparison between actual results and the plan in order to control
       operations or activities.

    Behavioral Considerations Research has shown that several behavioral factors
determine how successful the budgeting process will be. First, the process must have the
support of top management. Without a clear indication from top management that the
budgeting process is important to the organization, managers will not be motivated to
devote the time necessary to formulate an effective and efficient budget.

   Second, all managers and most employees should participate in the budgeting
process. Mangers will be more motivated to achieve budget goals that they understand
and help design.

    Third, deviations from the budget must be addressed by managers in a positive and
constructive manner. Identifying deviations from the plan is simply a way to focus
management’s attention on areas needing improvement. Unfortunately, some mangers
treat these deviations as an opportunity to find fault and assign blame to lower-level
mangers. The result is usually a loss of motivation, accompanied by such dysfunctional
behavior as interdepartmental bickering, defensive attitudes, and attempts to “build slack”
into the budget.

5.2   Budgeting steps
    In a manufacturing firm, the master budget begins with a forecast of sales; is followed
by detailed budgets for the production, selling, administrative, and financial activities;
and culminates in a set of budgeted financial statements. The flow of the preparation of
the individual budgets within this master network is shown as in Figure



                                                                              Selling and
                                      Production                         Administrative Expense
                                        Budget                                  Budget

             Direct Materials         Direct Labor                 Manufacturing
                 Budget                 Budget                    Overhead Budget


           Budgeted Income          Budgeted Balance             Budgeted Statement
              Statement                  Sheet                     of Cash Flows

                   The Master Budget for a Manufacturing Firm
                                          Figure 1

     Sales Budget The first step in developing an operating/master budget is to prepare a
sales budget. The sales budget is the most important element in the operating budget as
all other budget assumptions flow from the sales forecasts in the budget. As shown in
Figure 1, all the other budgets are developed from this budget. However, forecasting
accurate sales is very difficult because sales are a function of both external variables
(customer tastes and economic conditions) and internal variables (such as price, sales
effort, and advertising expenditures). Therefore the factors needed to be considered when
forecasting sales budget:

          The state of the overall economy
          Competitors’ actions
          Advertising and sales promotion plans
          Changes in the products’ prices

   The cost of raw materials and direct labor are directly related to the level of sales, it
might not be so obvious how other budget elements relate. Here are some relationships:

          The level of capital expenditure will depend on the level of sales. If a
           company is showing rapid sales and therefore production growth, there may
           not be sufficient manufacturing capacity and the company will need to buy
           more capacity. This will require capital expenditure.

          The level of sales which are on credit will influence the Balance Sheet
           because it drives the level of Accounts Receivable
          The level of sales will drive selling and marketing expenses because extra
           sales means extra distribution costs and may relate to bonuses paid to the sales
          The mix of sales can relate to the level of selling and marketing expenses. If a
           company is introducing a new product there may be a high level of sales
           expenses as new advertising campaigns are ramped up

    Production Budget The second detailed budget covers production, the number of
units to be produced during the period. Factors to be considered in preparing this
production budget are estimated future sales for the period, the required ending inventory,
and the amount of time needed to obtain materials and then to make a unit of product.

   Ending inventory is an important figure because management wants enough units on
hand to meet customer demands, but not so many that unnecessary costs will be incurred
because of excessive inventory. Usually, the desired ending inventory for any period is
expressed as a percentage of this period’s expected sales volume.

    The production budget has probably been most affected by recent developments in
our product costing and inventories. The production budget supplies information for all
manufacturing cost budgets. Only after production quantities are known can management
determine the amount of direct materials, direct labor, and manufacturing overhead
during the period.

    The level of production in a period will be determined by using the output from the
sales budget and will incorporate some assumptions on the desired level of closing

   Direct Material Budget The next detailed budget to be prepared is the direct
materials budgets. Based on the engineering department’s estimates of the materials
required to make product, this budget helps management schedule purchases from

    Like the production budget, the direct material budget depends on the desired level of
ending inventory. If management does not maintain sufficient materials inventory levels,
costly work stoppages can occur; if inventories are excessive, inventory investment and
storage costs may be unduly high.

    Similar factors as apply to the calculation of the quantity of units produced in the
production budget will also apply for the raw materials. It will be necessary to be aware
of at least the dollar value of raw materials on hand at the end of each period and for

some businesses it may well be appropriate to know about the physical quantities of the
raw materials that make up each item of manufactured product.

   The calculation of raw materials usage and purchases and inventory balances in
physical quantities would be as follows:

     Direct Labor Budget The fourth detailed budget is the direct labor budget. Because
labor is costly, the direct labor budget is often revised on a monthly or even weekly basis.
Management must plan so that sufficient (but not excessive) labor is always available.
Otherwise, the company is likely to suffer the high cost of frequent hiring, firing, layoff,
and overtime work. Probably even more important than the high cost of employee
turnover, however, is the feeling of demoralization among employees that such events
can cause.
It is normal to see the direct labor budget as responding directly to production levels. The
direct labor budget for a particular item in the product range will usually be calculated as

    Manufacturing Overhead Budget This budget includes all production costs other
than those for direct materials and direct labor. It is now a major element of total
manufacturing costs in many organizations.
    In preparing this budget, company must first estimates the annual variable costs, like
indirect materials and labor costs, utilities expense, other payroll costs, and fixed costs,
like property taxes expense, insurance expense, depreciation expense—plant and
supervisors’ salaries. This budget serves two important purposes:
     Provide management with a basis for controlling costs and evaluating the
        performance of the managers responsible for those costs.
     It is used in product costing.
    Selling and Administrative Expense Budget It includes planned expenditures for all
areas other than production. The costs of supplies used by the office staff, the salaries of
the sales manager and company president, and the depreciation of office buildings all
belong in this category. Because this budget covers several areas, it is usually quite large
and may be supported by individual budgets for specific departments within the selling
and administrative functions.

    Cash Budget It shows expected cash receipts and disbursements during a period,
summarizes much of the information. A detailed cash budget will point out when a
company has excess cash to invest and when it has to borrow funds. This allows a firm to
earn maximum interest on excess funds and to avoid the costs of unnecessary borrowing.
Most firms prepare a month-by-month, or even week-by-week, cash budget. Typically, a
cash budget is divided into four sections:
     Cash receipts
     Cash disbursements
     Cash excess or deficiency
     Financing

    The cash receipts section summarizes all cash expected to flow into the business
during the budget period. Because companies generally extend credit to their customers,
most of their sales are originally recorded as accounts receivable. The collection of
accounts receivable is thus a major source of cash, and its timing is an important
consideration in preparing a cash budget.

    Budgeted Statement, Balance Sheet and Cash Flows Budgeted income statement
projects income for the coming period and therefore, is valuable to management in
making key decisions. Such questions as how high a dividend to pay, whether to invest in
a new plant, and how strenuously to bargain with unions are usually decided on the basis
of projected and actual profits.

    The final two items to be projected are the balance sheet and the statement of cash
flow. The budgeted balance sheet shows company’s assets and liabilities and
stockholder’s equity. The budgeted cash flow has following elements: cash flows from
operating activities, net income, cash flows from investing activities and cash flows from
financing activities.

5.3   Summary of operation budgeting
    The operating budget consists of detailed budgets for sales, production, selling and
administrative expenses, and financing activities. Both the sales forecasting process and
the development of the operating budget may need to be repeated until the results are
consistent with the company’s business plan.

   The detailed budgets that make up the operating budgets are prepared in a logical
sequence, as shown in Figure 1. The budgets related to sales, production, and other
expenses allow the company to prepare a detailed cash budget. The cash budget shows
expected cash receipts and disbursements; it also signals when the company can expect a
cash shortage requiring outside financing, or a cash overage, which should be temporarily
invested in income-producing assets.

6     Cash Management

6.1    Why cash management?
    Cash Management is the strategy by which a company administers and invests its
cash; it is also the control of cash collections. Why do the corporations need cash
    The reason is obviously-- cash is a company business's lifeblood. Manages well, the
company remains healthy and strong. Managed poorly, the company goes into cardiac
arrest. If you haven't considered cash management an important issue, then you are
probably undermining your business's short-term stability and its long-term survival. The
basic objective in cash management is to keep the investment in cash as low as possible
while still operating the firm’s activities efficiently and effectively. However, what is a
good cash management and how to manage cash well? First of all, we should understand
the reasons for holding cash.

6.2   The reasons for holding cash
    There are two primary reasons for holding cash. First, cash is needed to satisfy the
transaction motive. Transactions-related needs come from normal disbursement and
collection actives of the firm. The disbursement of cash includes the payment of wages
and salaries, trade debts, taxes, and dividends. Cash is collected from sales from
operations, sales of assets, and new financing. The cash inflows (collections) and
outflows (disbursements) are not perfectly synchronized, and some level of cash holdings
is necessary to serve as a buffer. If the firm maintains too small a cash balance, it may run
out of cash. If so, it must sell marketable securities or borrow. Selling marketable
securities and borrowing involve trading costs.

    Another reason to hold cash is for compensating balances. Cash balances are kept at
commercial banks to compensate for banking services rendered to firm. A minimum
required compensating balance at banks providing credit services to the firm may impose
a lower limit on the level of cash a firm holds.

    The cash balance for most firms can be thought of as consisting of transaction
balances and compensating balances. However, it would not be correct for a firm to add
the amount of cash required to satisfy its transactions needs to the amount of cash needed
to satisfy its compensatory balances to produce a target cash balance. The same cash can
be used to satisfy both requirements.

    The cost of holding cash is, of course, the opportunity cost of lost interest. To
determine the target cash balance, the firm must weight the benefits of holding cash
against the costs. It is generally a good idea for firms to figure out first how much cash to
hold to satisfy the transactions needs. Next, the firm must consider compensating-balance
requirements, which will impose a lower limit on the level of the firm’s cash holdings.
Because compensating balances merely provide a lower limit, we shall ignore
compensating balances for the following discussion of the target cash balance.

6.3 Cash management ways
   There are many ways in analyzing cash management. Here I separate cash
management into three steps:
 Determining the appropriate target cash balance
 Managing the Collection and Disbursement of Cash
 Investing idle cash

    Determining the appropriate target cash balance The target cash balance involves
a trade-off between the opportunity cost of holding too much cash and the trading costs
of holding too little. But what rules should the firms follow when they determine the
appropriate target cash balance? In general, many firms will apply the Baumol Model,
which is regarded as the most efficient method nowadays.

Baumol Model
     Figuring out how the Baumol Model work is the best way to understand how to
determining the appropriate target cash balance.
     The key (formula) of the Baumol Model in determining the appropriate target cash
balance is:

       To understand how it work, please see the following explanation,

A typical example of applying Baumol Model: Suppose there is a company, name X,
began week 0 with a cash balance of C=$1.2 million, and outflows exceed inflows by
$600,000 per week. Its cash balance will drop to 0 in week 2 end, and its average cash
balance will be C/2, that is, $1.2 million / 2 = $600,000 over the two-week period. At the
end of week 2, company X has to replace its cash either by borrowing or by selling
marketable securities. In the condition C was set higher, say, at $2.4 million, cash would
last four weeks before company X would need to sell marketable securities, but the firm’s
average cash balance would increase to $1.2 million (from $600,000 to $300,000). If C
was set at $600,000, cash would run out in one week and the company would need to
replenish cash more frequently, but its average cash balance would fall from $600, 000 to

    Because transactions costs must be incurred whenever cash is replenished (e.g.
example, the brokerage costs of selling marketable securities), establishing large initial
cash balances will lower the trading costs connected with cash management. However,
the larger the average cash balance, the greater the opportunity cost (the return that could
have been earned on marketable securities). Assume you are the finical manager, to help
the company figure out the problem, you should know:

              C = The size of cash balance
              F= The Fixed cost of selling securities to replenish cash
              T= The total amount of new cash needed for transactions purposes over
                 the relevant planning period ,say, one year
              K= The opportunity cost of holding cash; this is the interest rate on
                 marketable securities

If above information has been known, you should determine the total costs of any
particular cash-balance policy.

    The Opportunity Cost Usually, the opportunity cost can be thought of the return that
could have been earned on marketable securities. The total opportunity costs of cash
balances, in dollars, must be equal to the average cash balance multiplied by the interest
rate, or
               Opportunity costs ($)=(C/2)*K

Suppose we have various data of the opportunity costs as listed in table below (table A):

       Table A:
     Initial Cash Balance         Average Cash Balance           Opportunity Costs(0.1)
                C                          C/2                         (C/2)*K
           $4,800,000                  $2,400,000                      $240,000
            2,400,000                   1,200,000                       120,000
            1,200,000                    600,000                         60,000
             600,000                     300,000                         30,000
             300,000                     150,000                         15,000

     The Trading Cost Total trading costs can be determined by calculating the number
of times that the company must sell marketable securities during the year. The total
amount of cash disbursement during the year is $600,000 * 52weeks =$31.2 million. If
the initial cash balance is set at $1.2 million, company X will sell $1.2 million of
marketable securities every two weeks. Therefore, we can get the trading costs:
                 ($31.2 million / $1.2 million)*F = 26F

In general, the formula is:
                Trading cost ($) = (T/C)*F

We would have a schedule of various trading costs in table B below:
      Table B
    Total Disbursements         Initial Cash Balance               Trading Costs
  during Relevant Period                                            (F=$1,000)
             T                             C                         (T/C)*F
        $31,200,000                   $4,800,000                       $6,500
         31,200,000                    2,400,000                       13,000
         31,200,000                    1,200,000                       26,000
         31,200,000                     600,000                        52,000
         31,200,000                     300,000                       104,000

    Therefore, the total cost of the cash balances consists of the opportunity costs plus the
trading costs:
               Total cost = Opportunity costs + Trading costs = (C/2)*K + (T/C)*F

Table C
   Cash Balance               Total Cost      = Opportunity Costs +       Trading Costs
     $4,800,000               $246,500              $240,000                   $6,500
      2,400,000                133,000               120,000                   13,000
      1,200,000                 86,000                60,000                   26,000
       600,000                  82,000                30,000                   52,000
       300,000                 119,000                15,000                  104,000

The Solution
    From Table C, we can address that a $600,000 cash balance results in the lowest total
cost of the possibilities presented: $82,000. However, someone might question: what is
about $700,000 or $500,000 or other possibilities?
    To figure out the precisely minimum total costs, we have to work with deeper math.
In order word, the company must equate the marginal reduction in trading costs as
balances rise with the marginal increase in opportunity costs associated with cash balance
increases. The target cash balance should be the point where the two offset each other.
This can be calculated by using either numerical iteration or differential equation. Here,
suppose we use differential equation:

Since: Total cost (TC)= Opportunity costs + Trading cost = (C/2)*K + (T/C)*F

   dTC/dC = K/2-TF/C^2=0
   K/2=TF/C^2
    C= square root of (2TF/K) = (2TF/K)^0.5

If F=1,000, T=$31,200,000, and K=0.1, we get C = $789,936.71. Given the value of C,
Opportunity costs are
        (C/2)*K= ($789,936.71 / 2) * 0.10=$39,496.84

We also know the Trading costs are

        (T/C)*F = ($31,200,000/$789,936.71)*$1,000 = $39,496.84

Therefore, the Total cost is $39,496.84 + $39,496.84 = $78,993.68

    Managing the Collection and Disbursement of Cash There are two important
factors in this part. The first one is book cash or ledger cash, or says, a firm’s cash
balance as reported in its financial statements. Another factor is bank cash or collected
bank cash, or says, a firm’s balance shown in its bank account. The essential issue here is
that book cash (or ledger cash) is not the same thing as bank cash (or collected bank
cash). The difference between bank cash and book cash is called float and represents the
net effect of checks in the process of collection. The following examples show why the
issue is important when firms manage the collection and disbursement of cash.

Example 1:
Suppose that company X currently has $1 million on deposit with its bank. It purchases
some raw materials, paying its vendors with a check written on July 8 for $1millon. The
company’s books (ledger balances) are changed to show the $1million reduction in the
cash balance. But the firm’s bank will not find out about this check until it has been
deposited at vendor’s bank and has been presented to the firm’s bank for payment on, say
July 15. Until the check’s presentation, the firm’s bank cash greater than its book cash,
and it has positive float.

                             Position prior to July 8:

                  Float = Firm’s bank cash - Firm’s book cash
                       = $1million        - $1million

                 Position from July 8 through July 14:

     Disbursement float = Firm’s bank cash – Firm’s book cash
                       = $1million        -0
                      = $1million

    We can see that during the period of time that the check is clearing, Company X has a
balance with the bank of $1 million. It can obtain the benefit of this cash while the check
is clearing. The most common way is, the bank cash could be invested in marketable
securities. Checks written by the firm generate disbursement float, causing an immediate
decrease in book cash but no immediate change in bank cash. Usually, there is a certain
period delay from the change of book cash to the change of bank cash. The delay, may be
a couple days, a week, or more. Depending on what business the firm runs or the firm’s
finical condition.

Example 2:
    Imagine company X receives a check from a customer for $1million. Assume, as
before, the company has $1 million deposited at its bank and has a neutral float position.
It deposits the check and increases it book cash by $1 million on November 8. However,
the cash is not available to company X until its bank has presented the check to the
customer’s bank and received $ 1million on, say, November 15. In the meantime, the
cash position at company X will reflect a collection float of $1 million.

                              Position prior to November 8:

                      Float = Firm’s bank cash - Firm’s book cash
                           = $1million        - $1million

                   Position from November 8 through November 14:

                   Collection float = Firm’s bank cash – Firm’s book cash
                                       = $1million        - $2 million
                                       = -$1million

    In this example, check received by the firm represents collection float, which
increases book cash immediately but does not immediately change bank cash.

     From examples above, it is easy to see that the firm is helped by disbursement float
and is hurt by collection float. The sum of disbursement float and collection float is net

     A firm should be more concerned with net float and bank cash than with book cash.
This is the basic knowledge for the financial people-----if a financial manger knows that a
check will not clear for several days, he or she will be able to keep lower cash balance at
the bank than might be true otherwise. An appropriate float management can generate a
great deal of profits, especially for large companies. Let’s see an example: assumes the
average daily sales of Sears are about $248 million. If Sears speeds up the collection
process or slows down the disbursement process by one day, it frees up $248 million,
which can be invested in marketable securities. With an interest rate of 10 percent, this
represents overnight interest of approximately $68,000 [($248 million/365) *0.10]. This
amount is only for one day delay. If the company slows down the disbursement process
longer, it will generate more profits obviously.

    Therefore, management of the collection and disbursement of cash is very important
in cash management. The objective in cash disbursement is to slow down payments,
thereby increasing the time between when checks are written and when checks are
presented. The objective in cash collection is to reduce the lag between the time
customers pay their bills and the time the checks are collected. In other words, collect
early and pay late. Of course, to the extent that the firm succeeds in doing this, the
customers and suppliers lose money, and the trade-off is the effect on the firm’s
relationship with them. However, experienced financial managers should handle the
trade-off well.

    Investing idle cash Investment is also a key issue in the cash management of
corporations. If a firm has a temporary cash surplus, it can invest in short-term
marketable securities. The market for short-term financial is called the money market.
The maturity of short-term financial assets that trade in the money market is one year or
less. Actually, investing in money market is many firms’ business behavior nowadays.

   Most large firms manage their own short-term financial assets, transacting through
banks and dealers. Some large firms and many small firms use money-market funds.
These are funds that invest in short-term financial assets for a management fee. The
management fee is compensation for the professional expertise and diversification
provided by the fund manager. Among the many money-market mutual funds, some

specialize in corporate customers. Banks also offers sweep accounts, where the bank
takes all excess available funds at the close of each business day and invests them for the

   The reasons for firms have temporary cash surpluses are: to help finance seasonal or
cyclical activities of the firm, to help finance planned expenditures of the firm, and to
provide for unanticipated contingencies. For different firms, each of these reasons may
more or less benefit themselves—it depends on different businesses of different firms.

Seasonal or Cyclical Activities
    Some firms have a predictable cash flow pattern. They have surplus cash flows during
part of the year and deficit cash flows the rest of the year. For example, many retail
companies have seasonal cash flow pattern influenced by Christmas. Such companies
may buy marketable securities when surplus cash flows occur and sell marketable
securities when deficits occur. Of course, bank loans are another short-term financing

Planned Expenditures
    Firms frequently accumulate temporary investments in marketable securities to
provide the cash for a plant-construction program, dividend payment, and other large
expenditures. Thus, firms may issue bonds and stocks before the cash is needed, investing
the proceeds in short-term marketable securities, and then selling the securities to finance
the expenditures. The important characteristics of short-term marketable securities are
their maturity, default risk, marketability, and taxability.

6.4   Summary and conclusions

   Cash Management is one of the most important issues in Corporate Finance. It can be
summary in
    A firm holds cash to conduct transactions and to compensate banks for the various
      services they render.
    The optimal amount of cash for a firm to hold depends on the opportunity cost of
      holding cash and the uncertainty of future cash inflows and outflows. The Baumol
      model is a typical transaction model that provides rough guidelines for
      determining the optimal cash position.
    The purpose of the firm manages the collection and disbursement of cash is to
      speed up the collection of cash and slow down payments. The financial manager
      must always work with collected company cash balances and not with the
      company’s book balance.
    Because of seasonal or cyclical activities, to help finance planned expenditures, or
      as a reserve for unanticipated needs, firms temporarily find themselves with cash
      surpluses. The money market offers many short-term financial assets for firms to
      achieve this purpose.

7    Responsibility Accounting
    Responsibility accounting is an underlying concept of accounting performance
measurement systems. The basic idea is that large diversified organizations are difficult,
if not impossible to manage as a single segment; therefore, they must be decentralized or
separated into manageable parts. These parts or segments are referred to as responsibility
centers which include:
     Revenue Centers
     Cost Centers
     Profit Centers
     Investment Centers

   This segmented approach allows responsibility to be assigned to the segment
managers that have the greatest amount of influence over the key elements to be
managed. These elements include:
    Revenue for revenue center
      A segment that mainly generates revenue with relatively little costs
    Costs for cost center
      A segment that generates costs, but no revenue
    A measure of profitability for profit center
      A segment that generates both revenue and costs
    Return on investment (ROI) for investment center
      A segment such as a division of a company where the manager controls the
      acquisition and utilization of assets, as well as revenue and costs

7.1   Controllability concept

    An underlying concept of responsibility accounting is referred to as controllability.
Conceptually, a manager should only be held responsible for those aspects of
performance that he or she can control. However, this concept is rarely applied
successfully in practice because of the system variation present in all systems. Attempts
to apply the controllability concept produce responsibility reports where each layer of
management is held responsible for all subordinate management layers as illustrated
below as Figure1.

7.2   Advantages and disadvantages

     Responsibility accounting has been an accepted part of traditional accounting control
systems for many years because it provides an organization with a number of advantages.
Perhaps the most compelling argument for the responsibility accounting approach is that
it provides a way to manage an organization that would otherwise be unmanageable. In
addition, assigning responsibility to lower level managers allows higher level managers
to pursue other activities such as long term planning and policy making. It also provides a
way to motivate lower level managers and workers. Managers and workers in an
individualistic system tend to be motivated by measurements that emphasize their
individual performances.

        However, this emphasis on the performance of individuals and individual
segments creates what comes critics refer to as the “stovepipe organization.” Others have
used the term “functional silos” to describe the same idea. Consider the Figure 2 below.
Information flows vertically, rather than horizontally. Individuals in the various segments
and functional areas are separated and tend to ignore the interdependencies within the
organization. Segment mangers and individual workers within segments tend to compete
to optimize their own performance measurements rather than working together to
optimize the performance of the system.

7.3       Summary and controversial question

    An implicit assumption of responsibility accounting is that separating a company into
responsibility centers that are controlled in a top down manner is the way to optimize the
system. However, this separating inevitably fails to consider many of the
interdependencies within the organization. Ignoring the interdependencies prevents
teamwork and creates the need for buffers such as additional inventory, workers,
managers and capacity. Of course, a system that prevents teamwork and creates excess is
inconsistent with the lean enterprise concepts of just-in-time and the theory of
constraints. For this reason, critics of traditional accounting control systems advocate
managing the system as a whole to eliminate the need for buffers and excess. They also
argue that companies need to develop process oriented learning support systems, not
financial results, fear oriented control systems. The information system needs to reveal
the company’s problems and constraints in a timely manner and at a disaggregated level
so that empowered users can identify how to correct problems, remove constraints and
improve the process. According to these critics, accounting control information does not
qualify in any of these categories because it is not timely, disaggregated, or user friendly.
    This harsh criticism of accounting control information leads to a very important
controversial question. Can a company successfully implement just-in-time and other
continuous improvement concepts while retaining a traditional responsibility accounting
control system? A number of field research studies indicate that accounting based
controls are playing a decreasing role in companies that adopt the lean enterprise

8     Reference List

      1    “Report On Cash Management And Economic OutLook For The State of
           California” (by Kathleen Connell, November 2001)

      2    "Managing Your Cash Flow" (by Keith Lowe, December 2001)

      3    “Financial Planning and Management in Public Organization” (By Nwagwu,
           Chukwvemeka O'C., Steiss, Alan Walter, 2001)

   4   “Accounting Concept and Applications” (by W. Steve Albrecht, James D. Stice,
       Earl K. Stice, K. Fred Skousen,Monte R. Swain)

   5. “Management” (by Bovee. Courtland, Wood. Marian, Thill. John, 1993)

   6. “Fundamental of Financial Management”,(by Brigham. Eugene, 1995)

   7. “Project Management” (by Harold Kerzner, 2001)

   8. “Productivity and American leadership.Cambridge” (by Baumol, W. J., Batey
      Blackman, S. A. and Wolff, E. N.1989)

   9. Deindustrialisation: causes and implications. Staff Studies for the World
      Economic Outlook (by Rowthorn, R. and Ramaswamy, R. 1997).

   10. “Business Studies”

   11. “Business Plan”.

   13 “The Long-Term Budget Outlook”

   14. “Fiscal Management”

    15. “The Master Budget”

   16. “The World Of The Manane Mentor: Baumol’s Model”


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