Barney Bakes profitability is at risk and must therefore improve its profitability through increasing sales, as a result, this will increase the earnings attributable to equity shareholders and more earnings will be available to pay the investors as dividends. This also puts the company’s liquidity at stake; the management should undertake some measures to improve the firm’s liquidity. This can be done through improving the credit policy thus increasing the total debtors, maintaining more cash in hand and bank; all of these increase the current assets available to the firm.
All three budgeting approaches that are the Traditional Incremental Budgeting approach and Hybrid budgeting approach do not provide ideal means for planning, harmonization and control (Irons, 2010). But they all offer an advantage to advocate each alternative; thus, it may be perceived that the optimal solution lies in the midst of the three approaches, meaning that there is no best approach as the best approach will depend on how the Barney Bakes utilizes any of the approaches it chooses to use.
In a decision-making exercise concerning closing down one of the product lines through the use of a decision-relevant approach, Barney Bakes should not close down any of its product lines as the division contribution margin is positive and therefore the products line is not a problem to the Barney Bakes ltd. Barney Bakes ltd should employ an economy of scale in the production of Cakes and Biscuits since through economy of scale the firm will be able to cover all the costs of production and expenses both fixed and variable costs (Irons, 2010).
Ratio analysis and commentary
Ratios for Barney Bakes Ltd
|Return on Shareholders’ Funds||20.93%||21.03%||23.46%||20.37%|
|Return on Capital Employed||24.46%||25.10%||29.63%||26.10%|
|Gross profit margin||61.67%||61.49%||62.33%||61.98%|
|Net profit margin||5.22%||4.95%||5.83%||5.36%|
|Stock Turnover (days) (average)||25.99||16.64||15.15||14.06|
|Trade Debtor (days)||0.39||0.22||0.13||0.13|
|Trade Creditor (days)||50.93||40.07||48.88||43.13|
|Sales to Capital Employed (asset turnover)||3.32||3.56||3.64||3.4|
|Sales per Employee (£)||34561.33||32,357.99||£31,141.61||£ 29,032|
|Earnings per share (pence)||317.70||303.51||322.12||263.00|
Financial ratios Interpretation and recommendation
The above is the summary of Barney Bakes Ltd four year ratios from 2007 to 2010; they consist of profitability ratios, efficiency ratios, liquidity ratios, gearing ratios and investment ratios as this are most commonly used ratios (GoldmanSachs.com, 2011). Profitability ratio measures the management effectiveness as shown by the turnover generated on sales and investment (GoldmanSachs.com, 2011). This means that if a firm can be able to make a profit it will be able to meet its short term obligations and also pay dividends to its owners. The major ratios in this category include: Net profit margin, Gross profit margin, return on capital employed, operating profit margin, and return on shareholders’ fund. Return on shareholders’ for the year 2010 has decreased as a result of increase in the shareholders’ equity, while return on capital employed decrease is as a result of increase in leverage and the shareholders’ equity. Gross profit, operating profit and net profit margins have increased when compared to the previous periods, this shows that the company was efficient in controlling its cost of sales, operating expenses and financing cost thus yielding a higher ratio which is better for the company.
The efficiency ratio measures the efficiency with which a firm uses its assets to generate turnover and are also known as activity ratios/ turnover ratio since they indicate the rate at which assets are converted into sales (GoldmanSachs.com, 2011). A balance of sales and the assets reflects that the assets are well managed. These ratios show how efficiently a company has managed its short-term asset and long-term liabilities (Drake, 2009). It takes approximately 26 days for the firm to convert stock into revenue which is higher than the previous years; it means that in the year 2010 the firm takes more days to sell its stock.
In addition, the average collection days for the company is longer in the current year when compared to the previous years, this means that the company credit policy is not efficient. It takes more days for the firm to settle their dues, implying that in the year 2010 the company had more cash to meet its short-term obligation and the suppliers were more confident in the firm in that they were willing to wait for long to be paid the amount owed. Over the years the number of times that capital employed can be covered by sales has decreased as a result of an increase in the capital employed. The number of employees in the year 2010 has been reduced leading to an increase in sales per worker.
Liquidity ratios measure the firm’s ability to meet its short-term maturity obligation as and when they fall due; they measure liquidity risk of the firm, whereby the lower the liquidity ratio the higher the liquidity risk and vice versa (Meir, 2008). The firm is more liquid in 2010 compared to 2007, 2008 and 2009; its current and quick ratio are high which is not safe for the company as the required margin of safety is 1 for both current and quick ratio (Meir, 2008). This means that the firm is not able to meet its short-term obligation as and when they fall due, thus the liquidity is not satisfactory for the firm.
Gearing ratios, on the other hand, measure the extent to which a firm uses the assets which have been financed by non-owners supplied funds i.e. they measure the financial risk of the company. The higher the ratio, the higher the financial risk of the firm. A firm should then have an appropriate mix of debt and equity (Atrill and McLaney, 2006). In 2010, 2009, 2008 and 2007 the company raised 17.05%, 16.17%, 9.58% and 10.49% of capital employed as debt respectively.
The gearing level is satisfactory since the ratio in four years is less than 50%, it increase in 2010 due to increase in defined benefit pension liability, deferred tax and other long term provisions, by 18.29% when compared to year 2009.
The investment ratios are used to calculate the overall performance of the company. They are also used to determine the company’s dividend policy, the effect of a proposed financing option on the company and also to predict the effect of right issue (Microstrategy.com, 2011). The investors can use investment ratio to determine the theoretical value of company’s securities and ascertain whether the securities are overvalued or undervalued (Microstrategy.com, 2011). The firm paid 49.74%, 48.42%, 52.56%, and 30.32% of earnings attributable to equity shareholders as dividend and retained 50.26%, 51.58%, 47.44%, and 69.68% as retained earnings in 2010, 2009, 2008, and 2007 respectively.
In 2010 the firm paid more dividends compared to 2009 and 2007; implying that less was retained in the company to fund future needs. In 2010 the number of times earnings attributable to equity shareholders can cover dividend is less compared to previous years except 2008, it shows that the company is not safe in its ability to pay dividends to its shareholders, implying that it will not maintain or increase future dividends. In 2010 the shareholders will receive cash dividends of 45.03% for every share purchased in the company at the current market price per share compared to the previous years, which have a lower yield. This shows that investors are expecting to receive more dividends in 2010 for every share purchased in the firm. Every share invested in Barney Bakes limited generates 317.70 pence of the company earnings which is higher than 2009, and 2007 which generated 303.51, and 263 pence respectively. While in 2008 the shareholders expected to generate 322.12 pence inform of earnings for every share invested in the company.
Thus the company was more profitable in 2010 on a per share basis compared to 2009. The investor in 2010 will take 1.23 years to recover his initial investment in the shares from the earnings generated by the company compared to 2009, 2008 and 2008 which have a higher payback period of 1.26, 1.52, and 1.69 respectively. The company can improve its profitability through increasing sales, as a result this will increase the earnings attributable to equity shareholders and more earnings will be available to pay the investors as dividends. The company liquidity is at stake and the management should undertake some measures in order to improve the firm liquidity; this can be done through improving the credit policy as this enables a company to sell more goods on credit thus increasing the total debtors and maintaining more cash in hand and bank. All of these increase the current assets available to the firm.
Corporate Governance and Budgeting
The shareholders appointed a Board of Directors to manage the company on their behalf. Therefore, the board is the agent while the shareholders are the principals; this establishes an agency relationship (Brough, 2008). An agency relationship exist where one party, the agent is hired or contracted by another party that is the principal and given authority to transact business on behalf of the principal (Brough, 2008). In this regard, the board becomes responsible to the shareholders and directors must make available annual reports to the owners on the company performance at the AGM (Annual General Meeting) (Brough, 2008). At the AGM the board must present the company strategic plans and surrender for re-election according to the law (Brough, 2008).
The company’s objective is laid out in the Memorandum of Association and all regulations concerning any internal relationship can be found in the Articles of Association. The BOD main function is to make sure that the firm is successful by controlling the firm’s businesses, at the same time accomplishing shareholders and stakeholders vested interests (Brough, 2008). Besides, in order to carry out financial and operational issues, the BOD must face up to the issues concerning CSR (Corporate Social responsibility) corporate governance and ethics (Brough, 2008).
The roles of the BOD includes; establishing the company’s mission, vision and corporate values, setting strategic plans and chain of command, delegating authority to management and being responsible to shareholders and stakeholders (Kavanagh, Johnson and Fabian, 2010). The BOD are elected and dismissed by the shareholders since they are the owners of the company and are comprised of two types of directors; the executive directors and non-executive directors (Kavanagh et al, 2010). There is no legal distinction between the non-executive and executive directors. But the non-executive function is perceived as balancing the executive directors’ role; this guarantees the management of the BOD effectively (Kavanagh et al, 2010). The executive directors are expected to have the company’s information close at hand while the non-executive is expected to possess wide point of view concerning the world (Kavanagh et al, 2010).
Reasons for having Non-executive directors on the board
The firm gets some benefit for having executive’s non-directors on the board since it gains from the experience possessed by the director, they also participate in company decision making in addition to contributing to strategy formulation and guidance of achievement of goals and resource allocation (Pricewaterhousecoopers.com, 2009). Their objectivity, independence and company intelligence match the exhaustive know-how and experience (Pricewaterhousecoopers.com, 2009).
Benefits of appointing Non-executive directors
Executives have managerial duties to fulfill in a company; therefore they are not capable of giving solutions to contradictory matter in the BOD, as such, non-executive directors play their role as they have a wide perception of things (Pricewaterhousecoopers.com, 2009). Non-executive directors are not involved full time in the company businesses and therefore they can convey a wider external view on matters before the board especially when formulating strategic plans. They also provide specialist skills into the firm for example accounting, marketing, and analyst as they assess the board performance by monitoring and controlling the company’s operation (Pricewaterhousecoopers.com, 2009).
Non-executive directors act independently and therefore are able to give an independent point of view concerning any divergence of interest between various stakeholders. Non-executive directors do networking on behalf of the company and identifying sources of resources, they also give advice to the public concerning the annual reports (Pricewaterhousecoopers.com, 2009). Finally, non-executive directors make sure that the interest of the minority group is not ignored; in private companies Non-executive directors adds value to the BOD through their individual skills and know-how (Pricewaterhousecoopers.com, 2009).
Roles and responsibilities of non-executive directors
In law the responsibility of both the Executive and Non-executive directors are the same; a legal definition of executive according to Baginsky Cohen Chartered accountant (2010) is that “An ‘Executive Director’ is a director who has separate responsibilities within the company as an Executive”. The non-executive directors ensure that the BOD accomplishes its main objectives as they bring experiences gained from other disciplines and positively influence the company (Lloydstsbbusiness.com, 2011). The directors responsibility are owed to the entire Barney Bakes Ltd, these responsibilities come up from Common law and Statutes and are grouped as follows; “First, Fiduciary duty to act honestly and in good faith, second, duty to exercise skill and care and lastly Statutory duty” (Baginskycohen.com, 2010). Breach of these responsibilities may lead to judgment of being unfit to run the company businesses and as a consequence lead to disqualification from the board.
As board members, directors have the duty to exercise their authority only for the reasons they were contracted to perform; they must act in utmost good faith at the interest of the firm and not to their own interest (conflict of interest) (Baginskycohen.com, 2010). This means that directors should not gang up by assenting with each other or third parties on how they will vote at the upcoming BOD meetings (Baginskycohen.com, 2010).
Duty of skill and care
The Board of Director should warrant proper control of the firm’s asset, keep them in safe custody, insure them, utilize them to earn income by investing in low risk portfolio, and keep accurate documentation of all transactions (Baginskycohen.com, 2010. The board should demonstrate high level of skills as may be expected of them as individuals with know-how and familiarity; they should also take care of the company just like any common person in their capacity would, in application of these principles no distinction should be drawn between executive directors and non-executive directors (Baginskycohen.com, 2010). Non-executive directors should not for instance give incessant concentration on company businesses as they are only required to familiarize themselves with the firm’s businesses by taking account of financial position and attending BOD meeting when they are sensibly able to attend (Baginskycohen.com, 2010). The directors, both executive on Non-executive should make known of their skills in which they are specialist in a particular discipline for example qualified marketer, finance analyst or accountant and act in reasonable manner as expected of him/her in that occupation (Baginskycohen.com, 2010).
Company law enforces various responsibilities on the directors for instance preparation of annual reports, and they should also conform to Employment Law when recruiting employees (Baginskycohen.com, 2010).
Remuneration of Non- Executive Directors
The board should be sufficiently compensated for spending their time on the firm’s business, however, non-executive directors should not rely heavily on the income they get from the firm or else they will endanger their independence (Baginskycohen.com, 2010). A non-executive director may be appointed elsewhere as an executive director and if that happens he/she is expected to pay fees received to the employing firm (Baginskycohen.com, 2010). There exists an insinuation that, if a director is betrothed full time in another company is not supposed to sit part time on the BOD of another firm and be independently rewarded (Baginskycohen.com, 2010). It does not matter if the employment contract with principal owner permits him/her to be flexible as this is an issue of fact and not law (Baginskycohen.com, 2010). There is no harm in the appointment of competent non-executives provided there is proper balance between the non-executive and Executive directors and that their role and responsibilities are sufficiently spelt out (Pricewaterhousecoopers.com, 2009).
Budgeting process is an important part of organization control systems; this is because it provides system of planning, harmonization and control for running the company which is a difficult process (Irons, 2010). Traditional incremental budgeting involves the use of current’s budget or the company’s actual performance as a baseline with addition amount being added to the budget being prepared; these addition amounts consist of inflation, sales price and costs increase (Irons, 2010).
Drawbacks of Traditional Incremental Budgeting
It presumes that the existing cost and activities in the current budget will still be incurred without assessing them exclusively and management would not need to justify the existence of particular costs in the budgets (Irons, 2010). The management is not induced in reducing the cost for current year, thus they end up having more expenditures in order for them to be allocated cash the next period because if they do not spend, it will be perceived that they do not need cash in the next budgeting period (Irons, 2010). The use of traditional incremental budgeting approach makes the managers demoralized as it does not challenge them to think harder, this result to past inefficiency being carried forward to the next budgeting year (Irons, 2010).
Alternatives to Traditional Incremental Budgeting
Zero based budgeting
This kind of budgeting process starts from zero which means that there is no baseline; this implies that the inefficiencies of prior years cannot be transmitted to the future periods (Financialweb.com, 2010). Each and every division role are evaluated in detail, all the expenditures must be approved for them to be financed as it attempts to attain the best possible distribution of resources to other section or departments (Financialweb.com, 2010).
Zero based budgeting process
First the management identifies course of action, then they establish alternatives on how the activities will be performed; the activities are then broken down in form of a decision package (Irons, 2010). The decision package analysis the activity cost, its purpose, alternatives ways of attaining the purpose, performance measures are then established and a sensitivity analysis is performed (Irons, 2010).
Secondly, the decision packages are ranked by the management in order of benefit that the company get from them; the management through the use of rank packages determines where to put the money and how much (Irons, 2010). Thirdly, the management allocates resources in order of priority (Irons, 2010).
Benefits of Zero based budgeting
It does not make a presumption that this year’s budget activities are suitable for the next period as all the firm’s activities are evaluated each time a budget is being prepared (Irons, 2010).It therefore motivates the management as everyone in the organization is involved in the budget preparation that is a bottom-up approach; it is also very challenging as it act in response to changes in the environment and results in an efficient distribution of resources (Iron, 2010).
Zero-based budgeting drawbacks
Division managers may lack the required knowledge on decision package construction; this necessitates training which requires time and cash in addition to a lot of paperwork and may be difficult to rank the activity packages because some activities may be qualitative in nature (Irons, 2010). Managers may be unable to respond to changes that will occur as the year progresses, given that decisions are completed at budget period; this will have a negative effect on the business because of the failure to respond especially of the MIS (Management Information System) fail to supply required information (Financialweb.com, 2010).
Most firm uses hybrid method to budget their future activities, this method uses part of past performances of the industry trends and economic factors and considerations when preparing the budget (Irons, 2010).
Since Zero-based necessitate costs justification, it would appear unsuitable to be used for the whole process of budgeting in a commercial sectors.
There is no need of taking more time and spending more cash by justifying cost of various activities. Generally, traditional incremental budgeting is faster compared to hybrid and zero-based budgeting; however, it use gives rise to inertia, inefficiency and budgetary deficiency (Irons, 2010). In conclusion therefore, all the budgeting methods do not provide an ideal means for planning, harmonization and control, but they all offer an advantage to advocate it. Thus it may be perceived that the optimal solution lies in the midst of the three approaches.
Decision making exercise
Decision relevant approach
The decision relevant approach considers only the relevant costs and ignores the irrelevant costs (Atrill and McLaney, 2007). When making future decision irrelevant costs are not considered because these costs will be incurred despite the company undertaking the decision or failing to go on with the decision. While relevant costs will be affected by present or future decision (Atrill and McLaney, 2007).
If Barney Bakes ltd uses the information as it is in appendix 2 with the inclusion of the irrelevant cost such as; Advertising, Sales director office expenses and Warehousing expense, 40% of the Finance director office expenses, 50% of Drivers wages and 50% of Drivers expenses, Motor vehicle expenses, Head office expenses and Accounting & audit costs, and 30% of Salesman wages and 80% of Salesman expenses are all fixed within the segments; these fixed costs are unavoidable; meaning that the Barney Bakes Ltd cannot by any circumstances claim that they are going to save these cost by adopting a given alternative (Atrill and McLaney. 2007).
Making financial decision based on the accounting information means the company will end up with wrong decision; thus losing on opportunities. According to the accounting information in appendix 2 the company will make profit/ (loss) of £1,478,000, (£1,018,000), (£591,000) and £2,621,000 on Breads, Cakes, Biscuits and Savouries respectively, this include the irrelevant costs/ fixed costs (Atrill and McLaney. 2007). Thus Barney Bakes will end up closing Cakes and Biscuits production lines as they will generate losses.
The profit of Barney Bakes Ltd Aberdeen bakery in total and for each product line
|Cost of sales||1,650||800||1,000||1,300||4,750|
The above table represents the Barney Bakes Ltd contribution margin (sales minus variable costs). Barney Bakes Ltd is considering a decision on whether to close one or more of production lines in Aberdeen in order to maintain profit levels in a difficult economic environment. Using the decision relevant approach Barney Bakes ltd seems to make profit since the contribution margin is positive. The common rule of continuing or discontinuing a decision is that the firm should keep the division or product line if variable costs are covered by the contribution margin and also taking into consideration some qualitative factors (Eldenburg and Wolcott’s, 2008).
This implies that Barney Bakes ltd should not close any of the production lines as they have a positive contribution margin. Therefore, from the original accounting information two products line (Cakes and Biscuits) had a loss amount, considering their contribution to the company earning they are actually not a problem to Barney Bakes ltd. Barney Bakes ltd should employ economy of scale in the production of Cakes and Biscuits; through economy of scale the firm will be able to cover all the cost of production and expenses both fixed and variable cost thereby making a profit (Kinney and Raiborn, 2009).
Other factors that should be considered before recommending cessation of a product line
If one of the production line is discontinued let take for example Cakes and Biscuits product lines are being considered for discontinuation, the management should consider the effect on the total profit of the firm, the impact on Breads and Savouries production costs and the opportunity cost of eliminating Cakes and Biscuits product line. If the two product lines are closed the contribution margin will drop by 22.94% as shown by appendix 4 while the production cost will increase assuming that all raw materials are supplied by only one supplier which means that the firm will not be given volume discounts on purchases of raw materials.
Strategic planning team should also consider the resource requirement before closing a production line; that is resources that would turn the division around and think about the long term effects of division closure. For example, closure of production line will reduce the market diversification and this would cause clients to buy products from other dealers who have a wide product diversification (Primeconsultinggroupinc.com, 2001), as a consequence the firm market share will decline.
The company management should also consider the effect of the product line closure on the work force turnover. If a division is closed, some of the existing employees will have to be laid off in order to minimize cost of doing business. This will cause panic to the rest of the employees leading to stress, demoralization which in turn will affect the production of the employees by lowering the total number of units produced (Weygandt, Kimmel and Kieso, 2009). The strategic planning team decision on closing down one of the division may lead to a across-the-board consequences on the firm, shareholder and/ stakeholders perception regarding the company management. Suppliers may also lack confident in the firm and this will reduce credit granted by the suppliers to the firm thus resulting to a higher cost of doing business (Principleofaccounting.com, 2011).
The decision to close down a production line will influence the supply chain in various ways. At the manufacturer level, the firm should close the division if it has a new product it wants to introduce into the market, if it wants to change the product package, its size or if they are reformulating the product. Other reasons are if the product is slow moving this can be done through undertaking a demand-driven evaluation in a particular region and if the product fails that is if it attains the closing stages of its product life cycles. The product failure may be as a result of poor promotion techniques, bad product formulation and inadequate marketing research and development (Principleofaccounting.com, 2011). The management should consider closing the product line if revenue falls below what is expected since the company is changing the brand ownership, the product season expires, and also change of sales agent (Principleofaccounting.com, 2011).
Baginskycohen.com. 2010. Duties of Executive and Non-executive Directors. Web.
Financialweb.com. 2010. Pros and cons of Zero-based budgeting. Web.
GoldmanSachs.com. 2011. BRICs. Web.
Irons, A. 2010. Comparing budgeting techniques. Web.
Leslie G. Eldenburg & Susan K. Wolcott’s. 2008. Cost Management: Measuring, Monitoring, and Motivating Performance. Web.
Lloydstsbbusiness.com, 2011. Becoming a company director and your responsibilities. Web.
Meir, L. 2008. Financial ratio analysis.
Microstrategy.com. 2011. Financial Analysis. Web.
Michael R. Kinney and Cecily A. Raiborn. 2009. Relevant information for decision making. Web.
Pamela P. Drake.2009. Financial ratio analysis. Web.
Primeconsultinggroupinc.com. 2001. Improving Efficiencies in Product Discontinuation: A Grocery Industry White Paper. Web.
Pricewaterhousecoopers.com. 2009. Non-executive directors: the role and responsibility. Web.
Appendix 1: Ratios for the year 2010
|Barney Bakes Ltd|
|1||Return on Shareholders Funds||20.93%|
|profit after tax/total equity|
|2||Return on Capital Employed||24.46%|
|operating profit/capital employed|
|(Assume Capital Employed equals Total Equity|
|plus Total Non-Current Liabilities)|
|total equity + total non-current liabilities∞||197993|
|3||Gross profit margin||61.67%|
|5||Net profit margin||5.22%|
|profit after Tax/sales|
|1||Stock Turnover (days) (average)||25.99|
|[(closing stock + opening stock/2)/Cost of sales]*365|
|2||Trade Debtor (days)||0.39|
|3||Trade Creditor (days)||50.93|
|4||Sales to Capital Employed (asset turnover)||3.32|
|sales/(equity + non-current liabilities)|
|5||Sales per Employee (£)||34561.33|
|(sales/no. of employees)*1,000|
|total current assets/total current liabilities|
|(total current assets-stock)/total current liabilities|
|total non-current liabilities/capital employed|
|Dividend/ Profit for year *100|
|Profit for year/Dividend|
|Dividend per share/(1-t) /share price|
|Dividend per share = Dividend/number of share||1.5802|
|4||Earnings per share (pence)||317.70|
|Profit for year/number of shares|
|share price/total basic EPS|
Appendix 2: Barney Bakes Ltd Production line profit and loss
|Cost of sales||1,650||800||1,000||1,300|
|Sales director office||80||80||80||80|
Motor vehicle expenses
|Accounting & audit||144||216||252||108|
|Finance director office||240||120||190||150|
Appendix 3: Workings on the proportion of variable cost on the total cost
Appendix 4-5: Discontinuing product line
|Cost of sales||1,650||1,300||2,950|
|Cost of sales||1,650||1,300||2,950|
Appendix 6: The profit of Barney Bakes Ltd Aberdeen bakery in total and for each product line
|Cost of sales||1,650||800||1,000||1,300||4,750|