The most commonly used techniques to evaluate the profit and costs are Net Present Value (NPV), accounting rate of return (ARR), Internal Rate of Return (IRR) and Payback Period.
Net Present Value (NPV)
Net present value is a popular project selection technique. Net present value calculates the current value of a prospective investment. It can be calculated by subtracting the initial investment from the future cash flows. The projects with a net present value that is positive or more than zero are considered worthy to invest. If not the project should not be adopted. Net present value is based on time value of money. It provides an evaluation of the value of money today with the value of money in the forthcoming time. While comparing it also considers the rate of inflation. A negative net present value implies that the cash flows for this project will be negative. It provides an account of the risk associated with the cash flows and the effect of time value of money. The net present value considers all the initial costs like purchasing costs etc.
It considers the time value of money that is the value of money that will be received in future is lesser than the value of money in hand today. Net present value takes into account the risks related to the prospective cash flows. The issue with net present values is that it is highly responsive to discount rate. Even a slight change in the discount rate will result in a huge change in net present value. Also there is a lot of uncertainty involved in calculating the correct discount rate. The calculations are very simple because of which it is hard to determine the estimated time for generation of a positive net present value. Another issue is that net present value is dependent on cash flows in future that are undecided. Net present value presumes that there is a plentiful inflow of money. If the resources are limited, this becomes tricky. Net present value is not enough to decide in such case. Other things like the amount f investment need to be considered. It also does not do adjustments for flexibility. Still it is a popularly used method for deciding an investment.
Internal Rate of Return (IRR)
Internal rate of return provides a method of evaluating the rate of return on an investment. It is also known as discounted cash flow rate of return. If the net present value is zero for a particular discount rate it is called as internal arte of return. It is a popular technique of project selection. It is best calculated by trial and error. The discount rate is changed till the value of net present value becomes zero. A project is preferred or considered suitable if its internal arte of return is high. The condition to accept project is that internal arte of return should always be more than the opportunity capital costs.
For calculating internal rate of return the net present value is calculated using discount rate. If the result is zero the discount rate is considered as internal arte of return. If it is greater than zero discount rate is increased till a net present value of zero is achieved. IF it is lesser than zero discount rate is decreased till an net present value of zero is achieved.
Internal rate of return considers time value of money as it is based on discount rate. It is commonly used in financial business and is an exceptional technique to find out the value of a project and calculate its risks. The problem with internal rate of return is that if the cash flow is not stable and fluctuates between negative cash flow and positive cash flow, the calculations will either show no rate or return or numerous rate of returns. Internal arte of return uses discount rate, so if the discount rate varies each year, internal rate of return can not be sued fr comparison. Internal rate of return does not support any additions to the project unlike net present value.
payback period can be defined as the time required recuperating the original amount that was invested. It is av ery simple method and does not involve complex calculations. Usually the investments or projects that have shorter payback period are selected or preferred. In real life companiesâ€™ set a specific payback period of time to use as a criterion for selecting projects. It is a simple method. The biggest advantage of payback period is that the time line for recovering the initial investment can be identified. It is also widely use because of its conservativeness. The problem with payback period is that there is no reserve for unknown situations or risk. When the pay back period finishes, the cash flows after that hold no value in this technique. It gives no consideration to time value of money. Because of these reasons pay back period is not considered as an excellent technique for project selection.
Accounting rate of return:
Accounting rate of return is used to evaluate the performance and decide in selection inside an organization. Accounting rate of return uses non-cash items along with the cash items. It is used for internal decisions to select a project. External investors do not use ARR to evaluate the selection of a project because of reasons like ARR includes non cash items which re of no consequence to the investor. Also ARR is not describes or portrays time value of money. ARR does no consider the risks involved for long term. Theoretically accounting rate of return and payback period is based on same concepts. But it is more adventurous than payback period in the sense that it supports greater risk choices.
The benefit of using accounting rate of return is that it involves simple calculations. The biggest problem with accounting rate of return is that it does not considers the time value of money while making decisions and as it is based on non cash item.
The financial plan of a company is known as budget. Most companies have yearly budget but it can be of more or less time period. Another way of defining budget is that they are official and well structured proclamation of expectations of the management of the company a propos to expenses, sales, production and other related transactions for the future. Budgets are not only a set of statements related to finance but they are also used to plan and control. At the start of the fiscal year it is used as a plan that tells the management what to do. By the end of the fiscal year it serves as a control tool through which management can assess and evaluate the performance of the company. This assessment helps in improving future performance.
The process of creating a budget is initiated by identifying and defining goals for the specific time. Then a plan is devised to achieve those goals. It is very important to make the budgets realistic. A successful budget is always based on the evaluation of the previous performance of the company. This evaluation is carried out by managers. After this evaluation, realistic goals are set for the future year. Creating budgets is a complex and time consuming process. Precision, accuracy and being realistic are very important for the process of creating budgets.
The main reasons for formulating budgets are planning, control and modeling. Budgeting process requires development of an explicit and comprehensive financial plan. It is mandatory to identify and define the financial objectives of the company. It is equally important to identify the actions or steps that need to be taken to achieve the predefined financial goals of the company. The budgeted statements identify the milestones or target points that need to be achieved. The complex process of formulating a budget identifies the crucial tasks that need to be completed so that the objectives of profit maximization and capital are achieved. It is essentially required to explicitly state goals and formulate an unambiguous strategy. During the process of creating a budget the objectives are clearly and distinctly stated along with a plan. Thus budget helps in creating a plan and defining the milestones. Mostly, due to time constraints managers usually push aside the planning phase for the fiscal period. Budgets force managers to work out on detailed plans. This way a roadmap to achieve the financial objectives is laid out.
For success, it is essentially to identify in any potential changes or risks that might harm the business. Budgeting process compels the managers to anticipate such circumstances and take them seriously. This way forecasts based on solid facts are recorded and decisions could be made to mitigate the impacts of such changes.
Budgets can be used to measure the performance of the managers and the employees. Budgets can also be used to encourage and motivate the managers to achieve the goals. The process of identifying goals and devising a plan to achieve them makes them enthusiastic and more determined to achieve those goals. Budgets are also used to appraise the performance of the managers by the upper management. Budget clearly defines the baseline for rewards and plans for compensation. This is a good incentive for the employees to work hard so that goals are achieved.
At the management level the process of budgeting facilitates communication between higher level of management and lower level of management. A well structured and well designed budget clearly communicates the goals, objectives and any forecasts in a language that is understood by all. This way every one knows the financial goals that need to be achieved and understand the plan of action to achieve those goals.
Budgets are an important part of a business plan. They are very crucial for the new and budding businesses as budgets add more weight to the business plan. It was very important for a business to demonstrate that its goals and objectives and the strategy adopted to attain them is realistic and meaningful. Thus a logical, rational and articulate budget plan is important part of a business plan, as budgets declare the financial goals and the plan to achieve those goals. Investors are particularly interested in the reviewing the budget statements.
Another important functionality of budgeting is that they can be used as accountability checks. Actual performance and results can be evaluated and judged against the goals and timelines identified in the budget. Deviations from the budgeted baselines can be identified and used to hold the manager accountable. Also for large organizations, each manager has their own budgets that are later on put together to formulate a master budget for the whole organization. Each manager at lower level is responsible for his budget and can be held accountable in case of any failure or success. If the actual results are better than the results outlined in the budget they are called as favorable variance. It shows that the performance of the manager responsible was excellent but not necessarily all the time. It can be a sign of cleverly setting the goals that are easily attainable and not identifying the realistic or actual goals that are suitable for the potential of the company. Same could be said for unfavorable variances. It is not necessary that the actual performance was lesser than the expected performance due to any mistake on part of the manager. There are chances that the goals set in the budget were unrealistic and hard to achieve or any unknown or unanticipated incident.
The possible conflict arises when a budget is unrealistic. Rather than motivating a manager to achieve the goals, it discourages and de-motivates them. Budges ate devised from top level to lower level. Meaning at lower end the managers are dependent on higher level, making them reluctant step up and give ideas. This does not promote or facilitate innovation. Managers can also manipulate the budget and favor themselves.
Budgeting is a multifaceted and time consuming process. Managers need to be patient and careful, not to mention realistic to gain maximum advantage of budgeting.