Management accounting is one of the most important processes in a business. It is the process of creating statements, reports, and documents that are used to make important business decisions. According to Ojra et al. (2021), management accounting uses both financial and non-financial information to generate and communicate to the management and guide them to make decisions that would improve business performance. Considering its critical role in business decision-making, choosing an efficient management accounting is important for a business. Efficient management accounting happens when accounting professionals can use the available time, resources, and money to achieve the set goals and objectives for the company. This implies that the technique is efficient if it can facilitate effective decision-making within the business (Ojra et al., 2021). Therefore, accounting professionals should choose a management accounting technique based on its efficacy. Different management accounting techniques exist, including budgeting and investment appraisal. This report investigates the efficacy of budgeting and investment appraisal as some of the common management accounting techniques used by businesses to guide their decision-making process.
Budgeting
Budgeting is the most important and widely used management accounting technique in business. Cote (2022) defines it as the process of preparing and overseeing financial estimates of the income and expenses of a business over a particular period. Business managers and executives create budgets to ensure that they have the necessary resources to execute their operations and achieve their business goals. Budgeting is important in business for a number of reasons.
One of the key roles of budgeting is to ensure that there are available resources within an organization. According to Conte (2022), the process enables an organization to plan its finances on time and determine which resources that the team requires. As a result, the organization will identify areas where there is a shortage and also prevent overspending, thus securing finances to be used to finance other important projects within the organization. Secondly, budgeting enables an organization to set and report its internal goals. For each coming year, an organization should know the amount of revenue it requires to meet its set goals and objectives. Through budgeting, the organization will set its goals and objectives and ensure that they align with the company’s resource availability. This enables the organization to set SMART and stay within manageable goals. Conte (2022) notes that a company’s financial goals should always be attainable enough, and the expenses required to reach them should be disclosed. In addition, budgeting enables a company to set priorities for projects. The organization uses the return on investment of each project identified from the budget estimates and makes investment decisions based on this return. In this case, the company will prioritize projects that have better potential and whose performance aligns with the company’s financial goals.
Lastly, budgets serve as a pivotal financial plan for an organization. According to Conte (2022), it serves as a financial roadmap for the upcoming period as it breaks down the expected revenue, expenses, and revenue for the company over the period. It also enables the company to balance the needs and available resources while making all the activities, roles, and deadlines clear for all the stakeholders (Anna et al., 2013). Therefore, it is an important process that is very basic for strategic planning and the success of an organization.
Different studies have been conducted to assess the efficacy of budgeting as a management accounting technique. Xolmirzaev et al. (2021) indicate that continuous budgeting is effective in planning and running a business. In this case, it provides an organization with critical information that will enable them to make informed business decisions. In addition, Petera and Šoljaková (2020) note that the budgeting process is the cornerstone of management accounting, and without it, organizations cannot develop their strategic plans.
The efficacy of budgeting is evaluated with reference to the attainment of the organizational goals and objectives. According to the National Center for Education Statistics (2023), budgets are used to control and evaluate sources of resources and their utilization. A budget is, therefore, considered effective when an organization meets its set goals and objectives. Abongo (2018) conducted a study to investigate the effects of the budgeting process on the financial performance of a company. The study revealed a strong correlation between the budgeting process and a company’s financial performance. This means that an effective budget improves financial performance. This is because the budgeting process enables the management to plan, coordinate, and monitor all the activities and processes of the company effectively throughout the period (Harelimana, 2017). From the analysis, it is evident that budgeting is crucial and basic and one of the most important management accounting techniques that every business needs for informed decision-making.
Despite its efficacy in management accounting, budgeting has some areas for improvement which undermine its effectiveness. The major weakness is that budgets are sometimes not flexible and do not allow for unexpected circumstances. In addition, budgets consume time to create and monitor. This makes the budgeting process expensive for a business.
Investment Appraisal
Investment appraisal is another management accounting technique used to assess the attractiveness of an investment before making a decision. It is used in line with capital budgeting and financial techniques to arrive at the best investment decision for a business. Waluyo (2011) notes that the technique specifically focuses on management decisions on which assets or projects the organization should engage in that will enable it to meet its set goals and objectives. The three major investment appraisal techniques are payback period, net present value, and accounting rate of return.
The payback period is the time that an investment takes to generate a profit. It is the time that investment returns all the initial invested amount and breaks even to start earning positive returns. The payback period is calculated by dividing the investment cost by the annual cash flow. In this case, investors consider investments with shorter payback periods to be more desirable as they will start earning profits earlier (Lefley, 1996). According to Saylor (2023), the payback period is effective when measuring an investment risk. Investors use this technique to appraise an investment when the main criterion for choosing them is liquidity. However, Saylor (2023) further notes that it is only suitable for appraising projects or assets whose investment is small and can take little time and effort to analyze. The major weakness of the payback period technique is that it needs to consider the time value of money during the appraisal. This means that it ignores the cashflows and profitability of the company.
The second technique is the net present value (NPV). Ross et al. (2022) consider NPV the basic principle of corporate finance and investment appraisal. It is the difference between inflows and outflows in the current time evaluated over some time. A positive NPV implies that the investment will be profitable, while a negative one shows that the investment is not profitable. In addition, when comparing two assets or projects, the one with a higher net present value is considered more desirable than the others. Using the principle of the time value of money, all cash flows are adjusted to the present time using a discounted rate. Research shows that NPV is the most effective and preferable technique of investment appraisal (Arnold and Arnold, 2014). In this case, NPV is appealing because it directly compares discounted cash inflows and discounted cash outflows, enabling an investor to make an investment decision within a short period. In addition, the study of Kengatharan and Clamenthu (2017) notes that there is a strong relationship between effective decision-making and the use of NPV as an appraisal technique. Despite its usefulness and intuitively appealing nature, NPV has some disadvantages. First, the technique does not account for opportunity cost. Secondly, the approach does not account for any uncertainties that may befall the business in the future.
The third technique is the accounting rate of return (ARR). ARR plays a crucial role when appraising a particular investment as it calculates the expected return of an investment relative to its cost (Murphy, 2023). An investment is considered profitable when the ARR is higher than the expected rate of return.
The analysis of the three investment appraisal techniques shows that they are used to value an investment. However, the most effective of the three is NPV, as it appreciates the time value of money and uses both positive and negative cashflows transacted within the business.
Conclusion
This report investigated the efficacy of budgeting and investment appraisal as some of the common management accounting techniques used by businesses to guide their decision-making process. The analysis shows that budgeting is crucial in establishing resource availability and allocation, as well as planning and coordinating all activities of the business. One major area for improvement is that it cannot foresee unexpected circumstances and is therefore not 100% reliable. Investment appraisal is used to analyze the viability and suitability of a project among many projects. An investment with a short payback period, higher ARR, and positive and higher NPV is considered more suitable than the others.
References
Abongo, S., 2018. The Effect of Budgeting Process on The Financial Performance of Top 100
Small And Medium Firms in Kenya (Doctoral dissertation, University of Nairobi).
Anna, L., Ana, P.L.F., Maria, T.S., Israel, V., Claudia, J., Marcelino, L., Patricia, N., Sarah, G.
and Teonildes, N., 2013. Planning and budgeting. In Plant Identification (pp. 23-60). Routledge.
Arnold, T. and Arnold, T., 2014. How net present value is implemented. A Pragmatic Guide to
Real Options, pp.1-13.
Cote, C. July 06, 2022. Why Is Budgeting Important in Business?
https://online.hbs.edu/blog/post/importance-of-budgeting-in-business
Harelimana, J.B., 2017. The effect of budgetary control on financial performance of Kigali Serena
Hotel in Rwanda.
Kengatharan, L. and Clamenthu, D.P., 2017. Use of capital investment appraisal practices and
effectiveness of investment decisions: a study on listed manufacturing companies in Sri Lanka. Asian Journal of Finance & Accounting, 9(2), pp.287-306.
Lefley, F., 1996. The payback method of investment appraisal: A review and synthesis.
International Journal of Production Economics, 44(3), pp.207-224.
Murphy, C. B. October 15, 2023. Accounting Rate of Return (ARR).
https://www.investopedia.com/terms/a/arr.asp
National Center for Education Statistics. 2023. Financial Accounting for Local and State School
Systems. https://nces.ed.gov/pubs2004/h2r2/ch_3.asp
Ojra, J., Opute, A.P. and Alsolmi, M.M., 2021. Strategic management accounting and performance
implications: a literature review and research agenda. Future Business Journal, 7(1), p.64.
Petera, P. and Šoljaková, L., 2020. Use of strategic management accounting techniques by
companies in the Czech Republic. Economic research-ekonomska istraživanja, 33(1), pp.46-67.
Ross, S.A., Westerfield, R.W. and Jordan, B.D., 2022. Fundamentals of corporate finance.
McGraw-Hill.
Saylor, A. 2023. The Payback Method.
https://learn.saylor.org/mod/book/view.php?id=53751&chapterid=37885
Waluyo, B. 2011. The Illusion of Financial Performance: Lesson from Public Sector
Agencification in Indonesia.
Xolmirzaev, U., Juraev, E. and Axmadjonova, M., 2021. THE ROLE OF ACCOUNTING IN
SMALL BUSINESS MANAGEMENT. Интернаука, (21-5), pp.20-22.
write