The various cost management systems that small businesses employ for a financial year have their own independent merits and demerits. But when it comes to ensuring the success of any business, the most mandatory aspect to analysed is the budgeting systems. Smaller firms may have their own reason for not relying on discounted cash flow to finance projects and instead go for mostly unsophisticated evaluation tools. But with increasing competition at both global and local levels, it is imperative that even small-scale businesses understand the actual scope of their decisions. Along with cost control risk analysis, cost estimation and value analysis, small scale business must study their past year performances to make a rational capital budgeting decision that will impact the future of their company. In this report, we will study relevant pieces of literature to critically analyse the effect of capital budgeting decisions on small scale businesses.
Table of contents
Brief Discussion on the budgeting process
How budgeting process satisfies the purpose of “planning, controlling and evaluating performance
Top down Budgeting and Bottom up Budgeting
Traditional Budgeting Versus Beyond Budgeting
Small Scale businesses have played an extremely significant role in the history of the Indian economy since the beginning of time. In the past 50 years, their contribution to employment generation, GDP and foreign exchange etc, has been immense. There certain working financial models that small-scale businesses must follow to not hinder their growth. Capital budgeting provides businesses with a financial measurement mechanism for its bigger capital expenditures. When it comes to small scale businesses, this is extremely crucial as capital budgeting systems help them accurately assess value and predict investment returns. Even in the presence of financial and resource constraints coupled with limitations of time, an effective cost management process can be the real decision driver. This is where capital budgeting and its sound predictions can help a small-scale business grow in the future. In this report, we will be understanding the various ways in which small scale businesses deploy this method to their advantage and its effects.
It is extremely important to remember that when it comes to a small scale or a large-scale industry, the system of capital budgeting decision is not just a financial commitment but an investment decision that could really affect the company. This is why it becomes crucial to understand the repercussions of any decision that a firm takes. And here the choice of evaluation tool plays a very big role (Al-Mutairi et al., 2018).
The financial planning of any business involves scrutiny of its current existing systems and the previous decisions. While preparing for profitable financial outcome companies need to consider their investment returns and then deploy suitable budgeting systems to get maximum profits. From studying budget assumptions to devising ways that will incur the best results the budgeting process must suit the nature of the company.
Small scale business owners must rely on comprehensive data analysis to make informed decisions to aid project management. Capital budgeting helps them in doing so as its decisions are the ones that the owners make about long term allocation of resources.
While many may argue that industry is dominated by service orient firms, the 1997 Economic Census said that more than half of them are in agriculture, construction, transportation wholesale markets construction and retail companies. All of these companies require a substantial amount of capital investment. Therefore, to succeed and help the economy thrive small scale businesses need capital investment.
The budgeting method requires a thorough analysis of the company needs. This research is done to enhance company performance and discover the drivers of the business. Accordingly, the company then utilizes the capital budgeting methods to systematically rank and then assess company expenditures on pricier investments.
Some of the most well-known measurement tools are future capital accounting profit by period, future cash flows by period, the present value of company cash flows, i.e. discounting those cash flows with a specific interest rate. When thinking about investing on a larger scale it is imperative that the small-scale firm recognizes its yearly needs to asses it expenditure pattern. They have to do this in order to ensure that they are able to pay back the original capital investment.
Capital budgeting systems are an extremely important tool for any small-scale company as given the amount of money they have at stake in a financial year they cannot take a risk and not thoroughly evaluate their pricier ventures (Mendes-Da-Silva & Saito, 2019). Smaller firms lack the personnel resources to analyse data that comprehensively at every stage which is why they might often lean towards balancing wealth maximization when making investment decisions. Capital constraints and liquidity concerns may be another reason why smaller firm may often not opt for capital budgeting.
Some of the tools that these firms may use to budget payback period method, accounting rate of return method, discounted cash flow method and net present value method.
The reason why a small-scale business should consider capital budgeting is that once any large-scale investments are made, they cannot be reversed. With limited funds, it becomes extremely important that companies analyse and plan properly. There is a reason why purchase of permanent assets requires so much analysis as there is always a possibility that when it comes its disposal the firm will have to incur a substantial loss (Su et al., 2018). In a situation like this, it can be noticed why small-scale firms will go for capital budgeting systems as this allows them to increase their returns of profits while still reducing costs. This is extremely beneficial in the long run as the collected date and analysis helps the company invest in an adequate, sustainable manner.
Accurately enough when it comes to decision making in the arena of cost management, capital budgets require extra scrutiny. This is because an undertaking of this size has to be profitable. How does a small-scale firm determine that a decision is right for the future of the company through financial tools like payback period, internal rate of return and net present value.
In the ideal scenario, all of these tools would lead to the same decision but more often than not they all produce completely different results. After this it all depends on the opinion and preferences of the project management team.
The article in question concentrates on the capital budgeting techniques and cost management processes used by small scale businesses. It emphasizes on the framework designed to incur profits whilst practising the concepts of effective management in small scale businesses.
Proper risk analysis whilst utilizing the financial tools is the standard way of approaching a decision. The more sophisticated the tool of analysis the more favourable is the outcome.
Mun (2020) had come up with a pretty basic rule to guarantee the success of business for managers it said that investing in projects that all positive net value was an extremely good idea. This according to them was the perfect way to maximize the wealth of shareholders while rejecting all projects that had even a little bit of negative net value. Net present value is considered the ultimate measure of a projects’ worth or contribution to company profits, so it seems only fair that all the other capital budgeting tools would be dismissed. For instance, payback period or accounting rate of return were not required anymore.
But another important thing to be considered in this scenario is the fact that these assumption-based decisions are not always correct. More importantly small-scale firms cannot always operate according to the most ideal assumption for them. Whether its financial constraints or limitations on time or the mere lack of required capital, there are times when ideas and plans fall through. Also, there is no guarantee of cash flow that might be necessary for use in discounted cash flow.
For this thorough analysis, attention to detail is of utmost importance. Each and every employee in a small-scale company must actively seek out information so as to make for the lack of sophisticated decision-making tools that large-scale companies can deploy. From estimates of sales, to previous year data, production levels or prediction of output, employee assessment, to future plans of the firm, availability of resources and risk management are some of the factors that are to be considered when collecting primary data (Kengatharan, 2016). Tax implications and multivariate analysis are some of the other factors that help managers make a firm decision when it comes to cost management.
the distinguishing factor of capital budgeting systems is the assumption of a perfect market system. It believes that in order to maximise the shareholders profit which is the primary goal of the firm one must only invest in value enhancing projects. But the market conditions must be perfect for all this (Jha & Arora, 2019). When all these assumptions are met, firms can invest in high scale projects and their financing decisions will be in tandem with the project management teams aspirations for the company.
If the discounted cash flow analysis is really the financial management tool of choice for a firm then they must decide their trajectory or course of journey in coming years. A wonderful way of illustrating this can be the choice between existing product lines and new product lines (Hall and Sibanda, 2017). When it comes to coefficients of expansion of an existing product line, the results are mostly positive so the use of discounted cash flow in this arena makes sense. This is because, a study of past years performances can actually tell us how the product line will perform. But when it comes to new product lines there is no reference point and neither is it possible to predict future cash flows. In a situation like this using discounted cash flow will not maximise the wealth of the shareholders.
But the impediment of imperfect capital markets cannot be ignored when it comes to decision making. The whole affair can be rather tricky for small scale businesses due to the lack of strong banking relationships or unavailability of desired loans (Michelon et al., 2020). In this scenario, the idea of managers and shareholders helping the firm increase its value will lose all merit due to the financial constraints.
When it comes to ensuring maximum output while minimizing risks in a small-scale business, there are two ways of preparing budgets are “top-down” budgeting and “bottom-up “budgeting.
The Top-down approach is focused on general to specific approach and the latter is based on the exact opposite, that is moving from specific to general. Top-down utilizes a divergent mechanism or flow of order as per the company's hierarchy (Barthelemy et al. 2013). For example, when a company plans a strategical journey and then decides to follow it. in this process, it will first consider the big plan and then, subsequently break it into smaller plans. These plans will then have their smaller targets distributed among various sectors and departments of the same company to produce the maximum outcome.
When it comes to small scale industries this does not apply as a particular firm may not have as many departments. Lack of personnel resources is a very important factor that disables small scale firms from performing comprehensive research for astute decision making.
The problem with top-down budgeting is that it does not take into consideration the subjectivity and complexities of all the problems (Aneja, 2019). Another factor that makes it less desirable is the unreliability of communication and the pressure it puts on time constraints. The emphasis on hierarchy and its divergent nature may not always give maximum outcome.
On the other hand, the “bottom down” approach is convergent and completely decentralized. The reason why this approach often works is that it involves the absolute and direct engagement of its employees (Britzelmaier et al., 2020). For a small-scale firm, this approach might work because it engages all the employees and shareholders equally.
Planning, scheduling, monitoring resource utilization, tracking progress, administering the budget, performing quality reviews and maintaining documentation are the standard parts of the capital budgeting process.
Lack of expertise and unreliable cash flows is another reason why a bottom-down approach works for small scale businesses. For instance, when investing in a new product, future cash flows are pretty unpredictable (Gupta & Pradhan, 2017). Just an analysis of past performances cannot dictate the turnover of the firm’s current situation. Besides, deciding what is cost effective cannot always rely market prediction of future demands.
Capital budgeting system helps the businesses to effectively manage huge expenditures which can crop up suddenly in the global market. Facing the challenges hidden in the big expenditures, these firms require a sound base which would provide certain financial stability to the company. In relation to project management, assessment of the organization’s financial strength company can only be feasible if it deploys tools of capital budgeting system in its decision-making process (Hall and Sibanda 2016). Along with this forming a unique perception of the company along with reallocating resources to reduce operational risks are some of the major factors why capital budgeting system works for small scale businesses. Capital budgeting provides businesses with a financial measurement mechanism for its bigger capital expenditures. It is useful in assessing the value and to predict investment returns. Even though there are financial limitation as well as limitation of resources, an effective process of cost management can provide assistance in decision making in the company (Dearman et al., 2018).
On the other hand, traditional budgeting is a non-flexible and the traditional budget which does not exhibit coping during difficult situations, where there are rampant changes in the system or the organization. The other reason which was seen as a drawback was that the older budgeting process created a false perception for the managers, as they considered everything was possible (Aneja, 2019). Furthermore, it is noteworthy that the traditional budgeting process was a slow and time taking one, and expensive as well as an ineffective process. The goals formed with the process were ambiguous and conflicting as they were arising from various other divisions. It does not work on the concept of reallocation of resources effectively. Traditional budgeting approach is based on merely more reduction of cost instead of value creation (Becker 2014). It also resolute issues of cash flow analysis. There were limited resources of budgeting, for example social marketing was not a part of the earlier organizational budgets. But with change of time need of the organization to include the newer marketing strategies which would include the same in the budget. Capital Budgeting offers solution and flexibility for such new strategies. (Hayward et al. 2017)
The significance of studying the budgeting processes in multinational organization is to adapt itself as per the changing demands of the time and the market. Many small, as well as big companies, can be promoted by the application of principles of Capital budgeting (Hayward et al., 2017). The benefits are seen in asset development, turnover ratio, revenue generation, profitability in sales profitability and an increase in the average rate of return on assets of the organization. The primary focus of the “Capital budgeting theory”, is to significantly improve the value shareholders in order to maximize the value of the firm.
As per Kengatharan 2016, “In addition, the firm is expected to have access to perfect financial markets, which permits it to finance all value-enhancing projects.” When these expectations have been met, firms can be isolated decisions based on investments as well as finances and should invest in all positive net present value projects (Brealey and Myers, 2003). Along with this forming a unique perception of the company along with reallocating resources to reduce operational risks are some of the major factors why capital budgeting system works for small scale businesses. According to the research conducted by Brealy and Myers 2003 “Second, many small firms have limited management resources, and lack expertise in finance and accounting. Because of these deficiencies, they may not evaluate projects using discounted cash flows. Providing some support for this conjecture, find that small-firm managers are more likely to use less sophisticated methods of analysis, such as the payback period.”
In most of the situations, ideally, small scale businesses go with a capital budgeting system in hand as it helps them get a grip over their big expenditures in a continuously changing, unpredictable global market. When it comes to big expenditures, these firms need a measuring stick to measure how their investment is faring. Concerning project management, proper assessment of the financial strength of a company can only come when all the tools of the modern capital budgeting system are employed in the decision-making process. Along with this forming a unique perception of the company along with reallocating resources to reduce operational risks are some of the major factors why capital budgeting system works for small scale businesses.
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