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In fact； far from having a real payback in year 4 and generating a cash
surplus of ￡5；000； this project will make us ￡4；358 worse off than we had
hoped to be if we required to make a return of 15 per cent。 The project； in
other words； fails to meet our criteria using DCF but might well have been
pursued using payback。
Internal rate of return （IRR）
DCF is a useful starting point but does not give us any definitive information。
For example； all we know about the above project is that it doesn’t
make a return of 15 per cent。 In order to know the actual rate of return we
need to choose a discount rate that produces a net present value of the entire
cash flow of zero； known as the internal rate of return。 The maths is time
consuming but Solutions Matrix website （solutionmatrix） has a
tool for working out payback； discounted cash flow； internal rate of return；
and a whole lot more calculations relating to capital budgeting。 You have
to register on the site first before downloading their free capital budgeting
spreadsheet suite and tutorial。 From the home page you should click on
‘Download Center’ and ‘Download Financial Metrics Lite for Microso。。
Excel’。
Using this spreadsheet you will see that the IRR for the project in question
is slightly under 7 per cent； not much be。。er than bank interest and certainly
insufficient to warrant taking any risks for。
BUDGETS AND VARIANCES
Budgeting is the principal interface between the operating business units
and the finance department。 As a staff function （see Chapter 4 for more
on line and staff functions）； the finance department will assist managers
in preparing a detailed budget for the year ahead for every area of the
organization and is in effect the first year of the business plan。 MBAs are
invariably expected to play a role in facilitating the process within their
78 The Thirty…Day MBA
departments。 Budgets are usually reviewed at least halfway through the
year and o。。en quarterly。 At that review a further quarter or half year can be
added to the budget to maintain a one…year budget horizon。 This is known
as a ‘rolling quarterly （half yearly） budget’。
Budget guidelines
Budgets should adhere to the following general principles：
。 The budget must be based on realistic but challenging goals。 Those goals
are arrived at by both a top…down ‘aspiration’ of senior management
and a bo。。om…up forecast of what the department concerned sees as
possible。
。 The budget should be prepared by those responsible for delivering the
results – the salespeople should prepare the sales budget and the production
people the production budget。 Senior managers must maintain
the munication process so that everyone knows what other parties
are planning for。
。 Agreement to the budget should be explicit。 During the budgeting
process； several versions of a particular budget should be discussed。
For example； the boss may want a sales figure of ￡2 million； but the
sales team’s initial forecast is for ￡1。75 million。
。 A。。er some debate； ￡1。9 million may be the figure agreed upon。 Once
a figure is agreed； a virtual contract exists that declares a mitment
from employees to achieve the target and mitments from the
employer to be satisfied with the target and to supply resources in
order to achieve it。 It makes sense for this contract to be in writing。
。 The budget needs to be finalized at least a month before the start of the
year and not weeks or months into the year。
。 The budget should undergo fundamental reviews periodically throughout
the year to make sure all the basic assumptions that underpin it still
hold good。
。 Accurate information to review performance against budgets should
be available 7 to 10 working days before the month’s end。
Variance analysis
Explaining variances is also an MBA…type task so performance needs to be
carefully monitored and pared against the budget as the year proceeds；
and corrective action must be taken where necessary。 This has to be done on
a monthly basis （or using shorter time intervals if required）； showing both
the pany’s performance during the month in question and throughout
the year so far。
Finance 79
Looking at Table 2。4； we can see at a glance that the business is behind
on sales for this month； but ahead on the yearly target。 The convention is to
put all unfavourable variations in brackets。 Hence； a higher…than…budgeted
sales figure does not have brackets； while a higher materials cost does。 We
can also see that； while profit is running ahead of budget； the profit margin
is slightly behind （–0。30 per cent）。
Table 2。4 The fixed budget
Heading Month Year to date
Budget Actual Variance Budget Actual Variance
Sales 805* 753 （52） 6；358 7；314 956
Materials 627 567 60 4；942 5；704 （762）
Materials
margin
178 186 8 1；416 1；610 194
Direct costs 74 79 （5） 595 689 （94）
Gross profit 104 107 3 820 921 101
Percentage 12。92 14。21 1。29 12。90 12。60 （0。30）
* Figures indicate thousands of pounds
This is partly because other direct costs； such as labour and distribution in
this example； are running well ahead of budget。
Flexing the budget
A budget is based on a particular set of sales goals； few of which are likely
to be exactly met in practice。 Table 2。4 shows a pany that has used
￡762；000 more materials than budgeted。 As more has been sold； this is
hardly surprising。 The way to manage this situation is to flex the budget
to show what； given the sales that actually occurred； would be expected
to happen to expenses。 Applying the budget ratios to the actual data does
this。 For example； materials were planned to be 22。11 per cent of sales in
the budget。 By applying that to the actual month’s sales； a materials cost of
￡587；000 is arrived at。
Looking at the flexed budget in Table 2。5； we can see that the pany
has spent ￡19；000 more than expected on the material given the level of
sales actually achieved； rather than the ￡762；000 overspend shown in the
fixed budget。
The same principle holds for other direct costs； which appear to be running
￡94；000 over budget for the year。 When