Approaches to budgets p5

Assumed knowledge

 

3 builds on the following knowledge from PM:

 

• Absorption costing and activity-based costing

 

• Budgeting

 

• Standard costing and variances

 

 

2      Introduction

 

In   1 we said that ‘performance management is any activity that is designed to improve an organisation’s performance and ensure that its goals are being met’. Budgeting will assist with performance management since it is an important tool for planning and control within an organisation and contributes to performance management by providing benchmarks against which to compare actual results (through variance analysis) and develop corrective measures.

 

It is important that the organisation understands the relative merits of the different budgeting approaches and chooses the approach that is most suitable for them.

 

3      Purposes of budgeting

 

A budget is a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year.

 

Budgeting serves a number of purposes:

 

• Planning

 

• Control

 

 

• Communication

 

• Co-ordination

 

• Evaluation

 

• Motivation

 

• Authorisation

 

 

 

Purposes of budgeting

 

 

 

Budgeting serves a number of purposes:

 

Planning

 

A budgeting process forces the business to look into the future. This is essential for survival since it stops management from relying on ad hoc or poorly co-ordinated planning.

 

Control

 

Actual results are compared against the budget and action is taken as appropriate.

 

Communication

 

The budget is a formal communication channel that allows junior and senior staff to converse.

 

Co-ordination

 

The budget allows co-ordination of all parts of the business towards a common corporate goal.

 

Evaluation

 

Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. The budget may be used to evaluate the actions of a manager within the business in terms of costs and revenues over which they have control.

 

Motivation

 

The budget may be used as a target for managers to aim for. Rewards should be given for operating within or under budgeted levels of expenditure. This acts as a motivator for managers.

 

Authorisation

 

The budget acts as a formal method of authorisation for a manager for expenditure, hiring staff and the pursuit of plans contained within the budget.

 

Delegation

 

Managers may be involved in setting the budget. Extra responsibility may motivate managers. Management involvement may also result in more realistic targets.

 

4      Participation in budget setting

 

A top-down (or non-participative) budget is one that is imposed on the budget holder by senior management.

 

A bottom-up (or participative) budget involves the divisional managers of an organisation having the opportunity to participate in the setting of the budgets.

 

It is important that you can discuss the relative merits of these two approaches and recommend the most appropriate method for a given organisation.

 

	Advantages of bottom-up		Advantages of top-down
	budgeting		budgeting
•	Improved motivation due to a	•	Avoids budgetary slack
	sense of ownership and		(i.e. divisional managers may be
	empowerment.		tempted to set targets that are
•	It increases divisional		too easy to achieve).
		•
	managers’ understanding		Avoids dysfunctional behaviour
	(which has an additional benefit		(i.e. divisional managers lack a
	if personal targets are set from		strategic perspective, focusing
	the budget).		on the needs of the division
•	Frees up senior management		and, as a result, budgets may
			not be in line with corporate
	resource.
			objectives).
•	Improves the quality of decision
		•	Senior managers retain control.
	making since divisional
		•
	managers are close to their		Budget setting process can be
	product markets.		quicker.
		•	Avoids the problem of bad
			decisions from inexperienced
			managers.

 

An organisation may use a mix of the two approaches and each approach may be used to a greater or lesser extent in different divisions. It will be up to senior management to decide on the level of central control to exercise, based on the skills and needs of the divisional managers.

 

5      Methods of budgeting

 

Different approaches to budgeting were studied in PM. In this exam it is important that you not only understand each of the techniques but that you can compare the techniques and evaluate their relative strengths and weaknesses.

1 Fixed and flexible budgeting

 

A fixed budget is a budget prepared at a single level of activity.

 

A flexible budget is a budget prepared with the cost behaviour of all cost elements known and classified as either fixed or variable. The budget may be prepared at a number of activity levels and can be ‘flexed’ or changed to the actual level of activity for budgetary control purposes.

 

Test your understanding 1

 

 

 

A company has the following budgeted and actual information for a department.

 

	Budget	Actual
Level of activity (units of output)	1,000	1,200
Cost ($)	20,000	23,000

 

Required:

 

• Assuming all costs are variable, has the company done better or worse than expected?

 

• If $10,000 of the budgeted costs are fixed costs, the remainder being variable, has the company performed better or worse than expected?

 

Advantages and disadvantages of flexible budgeting

 

	Advantages		Disadvantages
	Should enable better	•	May be perceived by some as ‘moving
	performance evaluation as		the goal posts’ resulting in demotivation –
	comparing like with like.		especially if bonuses are lost despite
			beating the original budget.
		•	Difficulties splitting costs into fixed and
			variable elements.
		•	In the long run it could be argued that all
			costs are variable.
			117

 

Test your understanding 2

 

Redfern hospital is a government funded hospital in the country of Newland. Relevant cost data for the year ended 31 December 20X0 is as follows:

 

• Salary costs per staff member were payable as follows:

 

	Budget	Actual
	($)	($)
Doctors	100,000	105,000
Nurses	37,000	34,500

 

Budgeted and actual staff were 60 doctors and 150 nurses.

 

• Budgeted costs for the year based on 20,000 patients per annum were as follows:

 

	$	Variable cost	Fixed cost
		(%)	(%)
Other staff costs	1,440,000	100	–
Catering	200,000	70	30
Cleaning	80,000	35	65
Other operating costs	1,200,000	30	70
Depreciation	80,000	–	100

 

Variable costs vary according to the number of patients.

 

• The actual number of patients for the year was 23,750. Actual costs (excluding the cost of doctors and nurses) incurred during the year were as follows:

 

	$
Other staff costs	1,500,000
Catering	187,500
Cleaning	142,000
Other operating costs	1,050,000
Depreciation	80,000

 

Required:

 

Prepare a statement which shows the actual and budgeted costs for Redfern hospital in respect of the year ended 31 December 20X0 on a comparable basis.

 

5.2 Incremental budgets

 

An incremental budget starts with the previous period’s budget or actual results, and adds (or subtracts) an incremental amount to cover inflation and other known changes.

 

Suitability

 

• It is suitable for stable businesses, where costs are not expected to change significantly.

 

• There should be good cost control.

 

• There should be limited discretionary costs.

 

	Advantages		Disadvantages
•	Quickest and easiest method.	•	Builds in previous problems and
•	Assuming that the historic		inefficiencies.
	figures are acceptable, only the	•	Uneconomic activities may be
	increment needs to be justified.		continued.
•	Avoids ‘reinventing the wheel’.	•	Managers may spend up to their
			budget to ensure that they get an
			increment from the highest
			possible base figure in the
			following year.

 

 

Incremental approach to budgets

 

AW produces two products, A and C. In the last year (20X4) it produced 640 units of A and 350 units of C incurring costs of $672,000. Analysis of the costs has shown that 75% of the total costs are variable. 60% of these variable costs vary in line with the number of A produced and the remainder with the number of C.

 

The budget for the year 20X5 is now being prepared using an incremental budgeting approach. The following additional information is available for 20X5:

 

• All costs will be 4% higher than the average paid in 20X4.

 

• Efficiency levels will remain unchanged.

 

• Expected output of A is 750 units and of C is 340 units.

 

Required:

 

What is the budgeted total variable cost of product C (to the nearest

 

$100) for the full year 20X5?

 

Solution:
20X4 costs:
Total variable costs	=	75% × $672,000	=	$504,000
Proportion relating to product C	=	40% × $504,000	=	$201,600
Cost per unit of product C	=	$201,600/350	=	$576
20X5 budget costs:
Inflated cost per unit of C	=	1.04 × $576	=	$599.04
Total variable cost for product C	=	340 × $599.04	=	$203,674
i.e. $203,700 to nearest $100.

 

 

Question practice

 

 

The NW Entertainments Company (NWEC) is a privately owned organisation which operates an amusement park in a rural area within the North West region of a country which has a good climate all year round. The amusement park comprises a large fairground with high-quality rides and numerous attractions designed to appeal to people of all ages.

 

The park is open for 365 days in the year.

 

Each day spent by a guest at the park is classed as a ‘Visitor Day’. During the year ended 30 November 20X3 a total of 2,090,400 visitor days were paid for and were made up as follows:

 

Visitor category	% of total visitor days
Adults	40
14–18 years of age and Senior Citizens	20
Under 14 years of age	40

 

Two types of admission pass are available for purchase, these are:

 

The ‘One-day Visitor’s pass’ and the ‘Two-day Visitor’s pass’, which entitles the holder of the pass to admission to the amusement park on any two days within the year commencing 1 December.

 

The pricing structure was as follows:

 

• The cost of a One-day pass for an adult was $40. Visitors aged 14– 18 years and Senior Citizens receive a 25% discount against the cost of adult passes. Visitors aged below 14 years receive a 50% discount against the cost of adult passes.

 

• The purchase of a Two-day Visitor’s pass gave the purchaser a 25% saving against the cost of two One-day Visitor’s passes.

 

• 25% of the total visitor days were paid for by the purchase of One-day passes. The remainder were paid for by the purchase of Two-day passes.

 

Total operating costs of the park during the year amounted to $37,600,000.

 

NWEC receives income from traders who provide catering and other facilities to visitors to the amusement park. There are 30 such traders from whom payments are received. The amount of the payment made by each trader is dependent upon the size of the premises that they occupy in the amusement park as shown in the following summary:

 

Size of premises	No. of Annual	Payment per
	Traders	Trader
		$
Large	8	54,000
Medium	12	36,000
Small	10	18,000

 

The income from each trader is received under 3 year contracts which became effective on 1 December 20X3. The income is fixed for the duration of each contract.

 

All operating costs of the park incurred during the year ending

30 November 20X4 are expected to increase by 4%. This has led to a decision by management to increase the selling price of all categories of admission passes by 4% with effect from 1 December 20X3. Management expect the number of visitor days, visitor mix and the mix of admission passes purchased to be the same as in the previous year.

 

NWEC also own a 400 bedroom hotel with leisure facilities, which is located 20 kilometres from the amusement park.

 

During the year ended 30 November 20X3, the charge per room on an all-inclusive basis was $100 per room, per night. The total operating costs of the hotel amounted to $7,950,000. Average occupancy during the year was 240 rooms per night. The hotel is open for 365 days in the year.

 

It is anticipated that the operating costs of the hotel will increase by 4% in the year ending 30 November 20X4. Management have decided to increase the charge per room, per night by 4% with effect from

1 December 20X3 and expect average occupancy will remain at the same level during the year ending 30 November 20X4.

 

The revenue of the hotel is independent of the number of visitors to the amusement park.

 

Required:

 

Prepare a statement showing the budgeted net profit or loss for the year to 30 November 20X4.

 

Answer

 

NWEC Budgeted Profit and Loss Statement for year to 30 November 20X4

 

Amusement Park – admission receipts:	$	$
One-day pass:
Adults:	8,696,064
14–18 years, senior citizens	3,261,024
Under 14 years	4,348,032
Two-day pass:
Adults:	19,566,144
14–18 years, senior citizens	7,337,304
Under 14 years	9,783,072
	–––––––––	52,991,640
Other revenue Income from traders		1,044,000
		––––––––––
Total revenue – park		54,035,640
Operating costs		39,104,000
		––––––––––
Budgeted profit of park		14,931,640
Hotel income	9,110,400
Hotel operating costs	8,268,000
Budgeted profit of hotel	–––––––––	842,400
		–––––––––
		15,774,040
		–––––––––

 

Workings:
No. of Visitor days for year to 30 November 20X4	= 2,090,400
One-day passes = 2,090,400 × 25%	= 522,600
Two-day passes (2,090,400 × 75%)/2	= 783,900

 

Admission fees applicable from 1 December 20X3. (increased by 4% per annum).

 

 

								3
				One-day pass ($)			Two-day pass ($)
	Adults			41.60 (40*1.04)		62.40 (41.60*2 less 25%)
	14–18 years; senior citizens			31.20 (30*1.04)		46.80 (31.20*2 less 25%)
	Under 14’s			20.80 (20*1.04)		31.20 (20.80*2 less 25%)
	Split	One-day pass revenue			Two-day pass revenue
	40%	209,040	$41.60	$8,696,064	313,560		$62.40	$19,566,144
	20%	104,520	$31.20	$3,261,024	156,780		$46.80	$ 7,337,304
	40%	209,040	$20.80	$4,348,032	313,560		$31.20	$ 9,783,072
		–––––––			–––––––
		522,600			783,900

5.3 Zero based budgets

 



Zero based budgeting (ZBB) is a method of budgeting that requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero.

 

Suitability

 

• Fast moving businesses/industries

 

• Discretionary costs such as research and development (R&D).

 

• Public sector organisations such as local authorities.

 

ZBB process

 

There are four distinct stages in the implementation of ZBB:

 

• Managers should specify for their responsibility centres those activities that can be individually evaluated.

 

• Each of the individual activities is then described in a decision package. The decision package should state the costs and revenues expected from the given activity. It should be drawn up in such a way that the package can be evaluated and ranked against other packages.

 

• Each decision package is evaluated and ranked usually using cost/benefit analysis.

 

• The resources are then allocated to the various packages.

 

A decision package was defined by Peter Pyhrr (who first formulated the

ZBB approach at Texas Instruments) as:

 

‘A document that identifies and describes a specific activity in such a manner that senior management can:

 

A evaluate it and rank it against other activities competing for limited resources and

 

B decide whether to approve or disapprove it.’

 

A decision package is a document that does the following:

 

• Analyses the cost of the activity. (Costs may be built up from a zero base, but costing information can be obtained from historical records or last year’s budget.)

 

• States the purpose of the activity.

 

• Identifies alternative methods of achieving the same purpose.

 

• Assesses the consequence of not doing the activity at all, or performing the activity at a different level.

 

• Establishes measures of performance for the activity.

 

Pyhrr identifies two types of package:

 

• Mutually-exclusive packages. These contain different methods of obtaining the same objective.

 

• Incremental packages. These divide the activity into a number of different levels of activity. The base package describes the minimum effort and cost that is needed to carry out the activity. The other packages describe the incremental costs and benefits when added to the base.

 

ZBB exercise

 

 

 

A company is conducting a ZBB exercise, and a decision package is being prepared for its materials-handling operations.

 

• The manager responsible has identified a base package for the minimum resources needed to perform the materials-handling function. This is to have a team of five workers and a supervisor, operating without any labour-saving machinery. The estimated annual cost of wages and salaries, with overtime, would be $375,000.

 

• In addition to the base package, the manager has identified an incremental package. The company could lease two forklift trucks at a cost of $20,000 each year. This would provide a better system because materials could be stacked higher and moved more quickly. Health and safety risks for the workers would be reduced, and there would be savings of $5,000 each year in overtime payments.

 

• Another incremental package has been prepared, in which the company introduces new computer software to plan materials-handling schedules. The cost of buying and implementing the system would be $60,000, but the benefits are expected to be improvements in efficiency that reduce production downtime and result in savings of $10,000 each year in overtime payments.

 

The base package would be considered essential, and so given a high priority. The two incremental packages should be evaluated and ranked. Here, the forklift trucks option might be ranked more highly than the computer software.

 

In the budget that is eventually decided by senior management, the forklift truck package might be approved, but the computer software package rejected on the grounds that there are other demands for resources with a higher priority.

 

 

Test your understanding 3

 

 

 

For a number of years, the research division of Z has produced its annual budget (for new and continuing projects) using incremental budgeting techniques. The company is now under new management and the annual budget for 20X4 is to be prepared using ZBB techniques.

 

Required:

 

Explain how Z could operate a ZBB system for its research projects.

 

 

	Advantages		Disadvantages
•	Inefficient or obsolete operations	•	The time involved and the cost of
	can be identified and		preparing the budget are much
	discontinued.		greater than for less elaborate
•	ZBB leads to increased staff		budgeting methods.
	involvement at all levels. This	•	It may emphasise short-term
	should lead to better		benefits to the detriment of long-
	communication and motivation.		term benefits.
•	It responds to changes in the	•	The budgeting process may
	business environment.		become too rigid and the
•	Knowledge and understanding of		company may not be able to
			react to unforeseen opportunities
	the cost-behaviour patterns of
			or threats.
	the organisation will be
	enhanced.	•	There is a need for management
•	Resources should be allocated		skills that may not be present in
			the organisation.
	efficiently and economically.

 

• Managers may feel demotivated due to the large amount of time spent on the budgeting process.

 

• It is difficult to compare and rank completely different types of activity.

 

• The rankings of packages may be subjective where the benefits are of a qualitative nature.

 

5.4 Rolling budgets

 

A rolling budget is one that is kept continuously up to date by adding another accounting period (e.g. month or quarter) when the earliest accounting period has expired.

 

Suitability

 

• Accurate forecasts cannot be made, e.g. in a dynamic business environment or in a new business.

 

• For any area of business that needs tight control.

 

	Advantages		Disadvantages
•	The budgeting process should	•	More costly and time consuming.
	be more accurate.	•	An increase in budgeting work
•
	Much better information upon		may lead to less control of the
	which to appraise the		actual results.
	performance of management.	•	There is a danger that the
•	The budget will be much more		budget may become the last
	‘relevant’ by the end of the		budget ‘plus or minus a bit’.
	traditional budgeting period.	•	The budget may be demotivating
•
	It forces management to take the		because the targets are
	budgeting process more		changing regularly.
	seriously.

 

 

Test your understanding 

 

A company uses rolling budgeting and has a sales budget as follows:

 

	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Total
	$	$	$	$
Sales	125,750	132,038	138,640	145,572	542,000

 

Actual sales for Quarter 1 were $123,450. The adverse variance is fully explained by competition being more intense than expected and growth being lower than anticipated. The budget committee has proposed that the revised assumption for sales growth should be 3% per quarter for Quarters 2, 3 and 4.

 

Required:

 

Update the budget figures for Quarters 2–4 as appropriate.

 

Question practice

 

The question below is taken from a past exam and is an excellent example of how the examiner may expect you to compare the different budgeting techniques. Make sure that you attempt this question and review the recommended answer.

 

Test your understanding 5

 

 

 

The Drinks Group (DG) has been created over the last three years by merging three medium-sized family businesses. These businesses are all involved in making fruit drinks. Fizzy (F) makes and bottles healthy, fruit-based sparkling drinks. Still (S) makes and bottles fruit-flavoured non-sparkling drinks and Healthy (H) buys fruit and squeezes it to make basic fruit juices. The three companies have been divisionalised within the group structure. A fourth division called Marketing (M) exists to market the products of the other divisions to various large retail chains. Marketing has only recently been set up in order to help the business expand. All of the operations and sales of DG occur in Nordland, which is an economically well-developed country with a strong market for healthy non-alcoholic drinks.

 

The group has recruited a new finance director (FD), who was asked by the board to perform a review of the efficiency and effectiveness of the finance department as her first task on taking office. The finance director has just presented her report to the board regarding some problems at DG.

 

Extract from the finance director’s Report to the Board

 

‘The main area for improvement, which was discussed at the last board meeting, is the need to improve profit margins throughout the business. There is no strong evidence that new products or markets are required but that the most promising area for improvement lies in better internal control practices.

 

Control

 

As DG was formed from an integration of the original businesses

(F, S, H), there was little immediate effort put into optimising the control systems of these businesses. They have each evolved over time in their own way. Currently, the main method of central control that can be used to drive profit margin improvement is the budget system in each business. The budgeting method used is to take the previous year’s figures and simply increment them by estimates of growth in the market that will occur over the next year. These growth estimates are obtained through a discussion between the financial managers at group level and the relevant divisional managers. The management at each division are then given these budgets by head office and their personal targets are set around achieving the relevant budget numbers.

 

Divisions

 

H and S divisions are in stable markets where the levels of demand and competition mean that sales growth is unlikely, unless by acquisition of another brand. The main engine for prospective profit growth in these divisions is through margin improvements. The managers at these divisions have been successful in previous years and generally keep to the agreed budgets. As a result, they are usually not comfortable with changing existing practices.

 

F is faster growing and seen as the star of the Group. However, the Group has been receiving complaints from customers about late deliveries and poor quality control of the F products. The F managers have explained that they are working hard within the budget and capital constraints imposed by the board and have expressed a desire to be less controlled.

 

The marketing division has only recently been set up and the intention is to run each marketing campaign as an individual project which would be charged to the division whose products are benefiting from the campaign. The managers of the manufacturing divisions are very doubtful of the value of M, as each believes that they have an existing strong reputation with their customers that does not require much additional spending on marketing. However, the board decided at the last meeting that there was scope to create and use a marketing budget effectively at DG, if its costs were carefully controlled. Similar to the other divisions, the marketing division budgets are set by taking the previous year’s actual spend and adding a percentage increase. For M, the increase corresponds to the previous year’s growth in group turnover.’

 

End of extract

 

At present, the finance director is harassed by the introduction of a new information system within the finance department which is straining the resources of the department. However, she needs to respond to the issues raised above at the board meeting and so is considering using different budgeting methods at DG. She has asked you, the management accountant at the Group, to do some preliminary work to help her decide whether and how to change the budget methods. The first task that she believes would be useful is to consider the use of rolling budgets. She thinks that fast -growing F may prove the easiest division in which to introduce new ideas.

 

F’s incremental budget for the current year is given below. You can assume that cost of sales and distribution costs are variable and administrative costs are fixed.

 

	Q1	Q2	Q3	Q4	Total
	$000	$000	$000	$000	$000
Revenue	17,520	17,958	18,407	18,867	72,752
Cost of sales	9,636	9,877	10,124	10,377	40,014
Gross profit	7,884	8,081	8,283	8,490	32,738
Distribution costs	1,577	1,616	1,657	1,698	6,548
Administration costs	4,214	4,214	4,214	4,214	16,856
Operating profit	2,093	2,251	2,412	2,578	9,334

 

The actual figures for quarter 1 (which has just completed) are:

 

	$000
Revenue	17,932
Cost of sales	9,863
Gross profit	8,069
Distribution costs	1,614
Administration costs	4,214
Operating profit	2,241

 

On the basis of the Q1 results, sales volume growth of 3% per quarter is now expected.

 

The finance director has also heard you talking about bottom-up budgeting and wants you to evaluate its use at DG.

 

Required:

 

Evaluate the suitability of incremental budgeting at each division.

 

(8 marks)

 

Recalculate the budget for Fizzy division (F) using rolling budgeting and assess the use of rolling budgeting at F.

 

(8 marks)

 

Recommend any appropriate changes to the budgeting method at the

Marketing division (M), providing justifications for your choice.

 

(4 marks)

 

Analyse and recommend the appropriate level of participation in budgeting at Drinks Group (DG).

 

(6 marks)

 

(Total: 26 marks)

 

5.5 Activity-based budgeting (ABB)

 

Before we look at activity-based budgeting, it is useful to review the activity based models in general.

 

5.5.1 Activity-based costing (ABC)

 

Aim: the aim of ABC is to calculate the full production cost per unit. It is an alternative to absorption costing in a modern business environment.

 

Reasons for the development of ABC

 

 

 

• Absorption costing is based on the principle that production overheads are driven by the level of production. This was true in the past when businesses tended to produce only one product or a few simple and similar products. However, a higher level of competition has resulted in the diversity and complexity of the products increasing. As a result, there are a number of different factors that drive overheads, not simply the level of production.

 

• Production overheads are a larger proportion of total costs in modern manufacturing since manufacturing has become more machine intensive and less labour intensive. Therefore, it is important that an accurate estimate is made of the production overhead per unit.

 

Steps in ABC

 

Step 1: Group production overheads into activities (cost pools), according to how they are driven.

 

Step 2: Identify cost drivers for each activity, i.e. what causes the activity costs to be incurred.

 

Step 3: Calculate an overhead absorption rate (OAR) for each activity.

 

Step 4: Absorb the activity costs into the product.

 

Step 5: Calculate the full production cost and/or the profit or loss.

 

The question below recaps the calculation of the full production cost per unit using traditional absorption costing and using ABC. Make sure that you understand the calculation and that you can comment on the reasons for the differences between the full production cost per unit under the two costing methods.

 

 

Test your understanding 6

 

Trimake makes three main products, using broadly the same production methods and equipment for each. A conventional absorption costing system is used at present, although an activity based costing (ABC) system is being considered. Details of the three products for a typical period are:

 

	Hours per unit		Materials per unit	Volumes
Product	Labour	Machinery	$	Units
X	½	1½	20	750
Y	1½	1	12	1,250
Z	1	3	25	7,000

 

Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis. The rate for the period is $28 per machine hour (i.e. the OAR) and a total of 23,375 machine hours were worked.

 

Traditional absorption costing would give a full production cost per unit as follows:

 

	X	Y	Z
	$	$	$
Materials	20	12	25
Labour	3	9	6
	––––	––––	––––
Total direct cost	23	21	31
Production overhead @ $28 per hour	42	28	84
	––––	––––	––––
Total	64	49	115

 

Further analysis shows the total production overhead of $654,500 is not entirely driven by machine hours and can be divided as follows:

 

	%
Costs relating to set-ups	35
Costs relating to machinery	20
Costs relating to materials handling	15
Costs relating to inspection	30
	––––
Total production overhead	100

 

The following total activity volumes are associated with the product line for the period as a whole:

	Number of	Number of movements	Number of
	set-ups	of materials	inspections
Product X	75	12	150
Product Y	115	21	180
Product Z	480	87	670
	––––	––––	–––––
Total	670	120	1,000

 

Required:

 

Calculate the cost per unit for each product using ABC principles.

 

Advantages and disadvantages of ABC

 

		Advantages		Disadvantages
	•	Provides a more accurate cost	•	Limited benefit if overheads are
		per unit leading to better pricing,		primarily volume related or a
		decision making and		small proportion of total costs.
		performance management.	•	It is impossible to allocate all
	•
		It provides a better insight into		overheads to specific activities.
		what drives overhead costs	•	The choice of activities and cost
		resulting in better control of
				drivers might be inappropriate.
		costs.
			•	The benefits might not justify the
	•	It recognises that overhead costs
				costs since a large amount of
		are not all related to production
				data must be collected.
		and sales volumes.
	•	It can be applied to all overhead
		costs, not just production
		overheads.
	•	It can be used just as easily in
		service costing as product
		costing.
132

 

 

 

5.5.2 Activity based management (ABM)

 

Activity based management (ABM) is the use of ABC information for management purposes to improve operational and strategic decisions. Performance should improve as a result.

 

• By identifying the underlying drivers of activities, ABM provides an understanding of the resource implications of various courses of action and therefore ensures that unfeasible courses of action are not taken.

 

• It can assist in re-pricing or eliminating unprofitable products.

 

• It may eliminate the need to carry out certain activities which do not add value to the customer.

 

• It may identify ways to produce a product more efficiently by understanding what drives the costs.

 

• It may identify design improvements.

 

• It can assist in improving relationships with customers and suppliers.

 

• Can be used to decide which products to develop and which strategies to pursue.

 

In summary, ABM can help managers to make decisions that benefit the whole organisation, not just their activities’ bottom line and ensure that the needs of the customer are being met.

 

Two types of ABM

Illustration 1 – Operational ABM

 

 

One of the biggest advantages of ABM is that costs are categorised by activities rather than traditional cost categories. For example:

Traditionalcostingsystem		ABMsystem
Cost of sales	X	Direct material cost	X
Staff costs	X	Direct labour cost	X
Factory rent	X	Indirect costs
Maintenance	X	Schedule production jobs	X
Depreciation	X	Machine set-up	X
	–––	Receiving materials	X
Total costs	X	Supporting existing products	X
	–––	Introducing new products	X
			–––
		Total costs	X
			–––

 

Having costs categorised by activity provides more relevant information to managers:

 

• There may be activities that don’t add value and these could be stopped.

 

• There may be activities that cost more than expected and the manager can use their knowledge of the activity’s cost driver to reduce the cost. For example, the cost of setting up the machines could be reduced by having longer production runs.

 

Test your understanding 7

 

 

 

Required:

 

Briefly discuss the potential risks associated with ABM.

 

 

Illustration 2 – The application of ABM at DHL

 

 

The international postal and logistics company, DHL saw its margins decreasing and used ABM to reverse this trend.

 

• Falling margins were mainly due to changes in products, destinations and customer mixes.

 

• The company concluded that they did not have sufficient visibility of margins to enable better pricing policies (and had different policies in different countries) so implemented ABC.

 

• A greater understanding of margins allowed DHL to design and implement a new pricing structure that was adopted worldwide and helped them to improve its margins.

 

Question practice

 

The question below is from a past exam and is an excellent question showing the step-up from PM to APM. Calculations may be tested but they will be used to form the basis of your decisions and will generally only be worth a small number of marks. Make sure that you attempt this question and learn from the answer. You may find it difficult to attempt a past exam question in full at this stage of your studies but it is important that you understand the level that you are expected to reach by the time you come to sit the exam.

 

 

Test your understanding 8

 

 

Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite television signals. Navier supplies the major satellite TV companies who install standard satellite dishes for their customers. The company also manufactures and installs a small number of specialised satellite dishes to individuals or businesses with specific needs resulting from poor reception in their locations.

 

The chief executive officer (CEO) wants to initiate a programme of cost reduction at Navier. His plan is to use activity-based management (ABM) to allocate costs more accurately and to identify non -value adding activities. The first department to be analysed is the customer care department, as it has been believed for some time that the current method of cost allocation is giving unrealistic results for the two product types.

 

At present, the finance director (FD) absorbs the cost of customer care into the product cost on a per unit basis using the data in table 1. He then tries to correct the problem of unrealistic costing, by making rough estimates of the costs to be allocated to each product based on the operations director’s impression of the amount of work of the department. In fact, he simply adds $100 above the standard absorbed cost to the cost of a specialised dish to cover the assumed extra work involved at customer care.

 

The cost accountant has gathered information for the customer care department in table 2 from interviews with the finance and customer care staff. She has used this information to correctly calculate the total costs of each activity using activity-based costing in table 3. The CEO wants you, as a senior management accountant, to complete the work required for a comparison of the results of the current standard absorption costing to activity-based costing for the standard and specialised dishes.

 

Once this is done, the CEO wants you to consider the implications for management of the customer care process of the costs of each activity in that department. The CEO is especially interested in how this information may impact on the identification of non-valued added activities and quality management at Navier.

 

Navier Dishes (information for the year ending 31 March 20X3)

 

Customer care (CC) department

 

Table 1: Existing costing data
	$000
Salaries	400
Computer time	165
Telephone	79
Stationery and sundries	27
Depreciation of equipment	36
	––––

707

 

Note:

 

• CC cost is currently allocated to each dish based on 16,000 orders a year, where each order contains an average of 5.5 dishes.

 

Table 2: Activity-costing data
Activities of CC dept		Staff Comments time
Handling enquiries and preparing	40%	relates to 35,000 enquiries/
quotes for potential orders		quotes per year
Receiving actual orders	10%	relates to 16,000 orders in
		the year
Customer credit checks	10%	done once an order is
		received
Supervision of orders through	15%
manufacture to delivery
Complaints handling	25%	relates to 3,200 complaints
		per year

 

Notes:

 

• Total department cost is allocated using staff time as this drives all of the other costs in the department.

 

• 90% of both enquiries and orders are for standard dishes. The remainder are for specialised dishes.

 

• Handling enquiries and preparing quotes for specialised dishes takes 20% of staff time allocated to this activity.

 

 

• The process for receiving an order, checking customer credit and supervision of the order is the same for both a specialised dish order and a standard dish order.

 

• 50% of the complaints received are for specialised dish orders.

 

• Each standard dish order contains an average of six dishes.

 

• Each specialised dish order contains an average of one dish.

 

Table 2: Activity-based costs
Handling enquiries and preparing	Total	Standard	Specialised
quotes	282,800	226,240	56,560
Receiving actual orders	70,700	63,630	7,070
Customer credit checks	70,700	63,630	7,070
Supervision of order through
manufacture to delivery	106,050	95,445	10,605
Complaints handling	176,750	88,375	88,375
	–––––––	–––––––	–––––––
Total	707,000	537,320	169,680
	–––––––	–––––––	–––––––

 

Required:

 

• Evaluate the impact of using activity-based costing, compared to the existing costing system for customer care, on the cost of both types of product.

 

(13 marks)

 

• Assess how the information on each activity can be used and improved upon at Navier in assisting cost reduction and quality management in the customer care department.

 

Note: There is no need to make comments on the different product types here.

 

(12 marks)

 

(Total: 25 marks)

 

Student accountant article: visit the ACCA website, www.accaglobal.com, to review the article on ‘activity-based management’.

 

5.5.3 Activity-based budgeting (ABB)

 

Now that we understand the concepts of ABC and ABM, we can review the final approach to budgeting, ABB.

 

Activity-based budgeting (ABB) uses the principles of ABC to estimate the firm’s future demand for resources and hence can help the firm to acquire these resources more efficiently.

 

Illustration 3 – Steps in ABB

 

The operating divisions of Z have in the past always used a traditional (absorption costing) approach to analysing costs into their fixed and variable components. A single measure of activity was used which, for simplicity, was the number of units produced. The new management does not accept that such a simplistic approach is appropriate for budgeting in the modern environment and has requested that the managers adopt an activity-based approach to their budgets in the future.

 

Required

 

Explain how ABB would be implemented by the operating divisions of Z.

 

Solution

 

Step 1: Estimate the production and sales volumes of individual products or customers.

 

Step 2: Estimate the demand for organisational activities.

 

Step 3: Determine the resources that are required to perform organisational activities.

 

Step 4: Estimate for each resource the quantity that must be supplied to meet the demand.

 

Step 5: Take action to adjust the capacity of resources to match the projected supply.

 

		Advantages		Disadvantages
	•	ABB draws attention to the costs	•	A considerable amount of time
		of ‘overhead activities’ which can		and effort might be needed to
		be a large proportion of total		establish an ABB system
		operating costs.		(identifying the key activities and
	•	It recognises that it is activities		their cost drivers).
		that drive costs. If we can control	•	ABB might not be appropriate for
		the causes (drivers) of costs,		the organisation and its activities
		then costs should be better		and cost structures.
		managed and understood.	•	It may be difficult to identify clear
	•
		It provides information for the		individual responsibilities for
		control of activity costs, by		activities.
		assuming that they are variable,	•	It could be argued that in the
		at least in the longer-term.
				short-term many overhead costs
	•	ABB can provide useful		are not controllable and do not
		information for a total quality		vary directly with changes in the
		management (TQM)		volume of activity for the cost
		environment, by relating the cost		driver. The only cost variances to
		of an activity to the level of		report would be fixed overhead
		service provided.		expenditure variances for each
				activity.
138

 

ABB

A company has prepared an activity-based budget for its stores department. The budgeted costs are:

 

	Cost driver	Budgeted cost
Receiving goods	Number of deliveries	$80 per delivery
Issuing goods from	Number of stores’	$40 per requisition
store	requisitions
Ordering	Number of orders	$25 per order
Counting stock	Number of stock counts	$1,000 per count
Keeping records	–	$24,000 each year
Supervision	–	$30,000 each year

 

Activity		Actual cost
		$
Receiving goods	45 orders delivered	3,450
Issuing goods	100 requisitions	4,400
Ordering	36 orders	960
Counting	2 stock counts	1,750
Record keeping		1,900
Supervision		2,700
		––––––

 

15,160–––––

 

Required:

 

Prepare a variance report for the month.

 

Solution:
Activity		Expected	Actual	Variance
		cost	cost
		$	$	$
Receiving goods	45 orders delivered	3,600	3,450	150 F
Issuing goods	100 requisitions	4,000	4,400	400	A
Ordering	36 orders	900	960	60	A
Counting	2 stock counts	2,000	1,750	250 F
Record keeping		2,000	1,900	100 F
Supervision		2,500	2,700	200	A
		––––––	––––––	–––––
		15,000	15,160	160	A
		––––––	––––––	–––––

 

6      Variances

 

6.1 Recap of the basics of variance analysis

 

In PM you learnt that variance analysis was a key element of management control:

 

• Targets and standards are set reflecting what should happen.

 

• Actual performance is then measured.

 

• Actual results are then compared with the (flexed) standards, using variance analysis.

 

• “Significant” variances can then be investigated and appropriate action taken.

 

This process thus facilitates “management by exception”.

 

Spend a little bit of time reviewing the variances covered in PM to ensure you are comfortable with the calculations and the meaning of each variance.

 

6.2 Different types of budget variance

 

Taking the different types of budgeting approach discussed above we can summarise the likely implications for variance analysis as follows:

 

Type of budget	Implications for variances
approach
Fixed v flexible	•	Variances arising from fixed budgets are less
budgets		likely to be useful for controlling a business as
		actual and budget figures may not be comparing
		like with like in volume terms.
	•	This is why variances are usually calculated by
		reference to flexed budgets.
Incremental v	•	A problem with incremental budgeting is that
ZBB budgets		managers will often spend their allowance to
		ensure they keep it for subsequent periods. As a
		result, favourable variances are likely to be small
		and will not reveal possible areas for further
		gains.
	•	With ZBB the targets may be unrealistic since this
		budgeting technique is often used in areas where
		there is a high degree of uncertainty.
		Furthermore, targets may be too difficult as the
		culture of ZBB is to eliminate all waste. As a
		result the firm may have more adverse variances
		but these may be due more to planning issues
		than operational ones.

 

ABB	•	Traditional variance analysis will have to be
		adapted to focus on activity costs. For example, a
		rate variance may become (actual rate per unit of
		cost driver – standard rate) × actual cost driver
		volume. The resulting variances should facilitate
		better control and planning for overheads as it
		focusses on what generates the costs.

 

6.3 Planning and operating variances

 

The variances calculated can be further divided into planning and operational elements if at the end of the period, with the benefit of hindsight, it is known that the original budget was unrealistic and therefore a decision is taken to amend the budget.

 

• The planning variance is the difference between the original standard and the revised one.

 

• Planning variances are thus those which arise due to inaccurate forecasts or standards in the original budget setting.

 

• Operational variances are then the remainder due to the decisions of operational managers.

 

• An operational variance is the difference between this revised standard and actual performance.

 

From a performance management perspective the advantage of this approach is that line managers can concentrate on improving operational matters for which they are genuinely responsible. For example, a sales price variance could be split to indicate how far sales prices were incorrectly estimated in the budget (planning) and how well the sales managers have done in negotiating high prices with customers (operational).

 

On the other hand the disadvantage of planning and operational variances is that too often all adverse variances are explained away as being planning errors.

 

Another problem is when the revised standards are harder than the original ones and managers are assessed on operating variances. They could get demotivated by moving targets, especially if they have lost a bonus that they would have achieved under the original standards.

 

The calculations were covered in PM. However, some examples have been included below for revision purposes.

 

Planning and operational variances for sales volume

 

Test your understanding 9 – Market size and share

 

Hudson has a sales budget of 400,000 units for the coming year based on 20% of the total market. On each unit, Hudson makes a profit of $3. Actual sales for the year were 450,000, but industry reports showed that the total market volume had been 2.2 million.

 

• Find the traditional sales volume variance.

 

• Split this into planning and operational variances (market size and market share). Comment on your results.

 

Planning and operational variances for labour efficiency

 

Test your understanding 10

 

The standard hours per unit of production for a product is 5 hours. Actual production for the period was 250 units and actual hours worked were 1,450 hours. The standard rate per hour was $10. Because of a shortage of skilled labour it has been necessary to use unskilled labour and it is estimated that this will increase the time taken by 20%.

 

Required:

 

Calculate the planning and operational labour efficiency variances.

 

Planning and operational variances for material price and usage

 



Test your understanding 11

 

Holmes uses one raw material for one of their products. The standard cost per unit at the beginning of the year was $28, made up as follows:

 

Standard material cost per unit = 7 kg per unit at $4 per kg = $28.

 

In the middle of the year the supplier had changed the specification of the material slightly due to problems experienced in the country of origin, so that the standard had to be revised as follows:

 

Standard material cost per unit = 8 kg per unit at $3.80 per kg = $30.40.

 

The actual output for November was 1,400 units. 11,000 kg of material was purchased and used at a cost of $41,500.

 

Calculate

 

• material price and usage variances using the traditional method

 

• all planning and operational material variances.

 

7      Forecasting

 

7.1 Introduction

 

A number of forecasting methods were reviewed in PM including:

 

• the hi-low method

 

• regression analysis

 

• time series analysis

 

• the learning curve model.

 

The learning curve model will be recapped briefly below:

 

7.2 The learning curve effect

 

As workers become more familiar with the production of a new product, the average labour time (and average labour cost) per unit will decline.

 

Wright’s Law states that as output doubles, the average time per unit falls to a fixed percentage (referred to as the learning rate) of the previous average time.

 

The learning curve effect can be calculated using the following formula:

 

y = ax^b

 

where:

 

y = the average time (or average cost) per unit/batch a = time (or cost) for the first unit/batch x = output in units/batches

 

b = log r/log 2 (r = rate of learning, expressed as a decimal).

 

The formula can be used to forecast the cost of labour but would normally be examined as part of a bigger forecasting question such as the one below.

 

The learning curve and the steady state

 

The learning effect will only apply for a certain range of production. Once the steady state is reached the direct labour hours will not reduce any further.

 

Test your understanding 12

 

 

BFG is investigating the financial viability of a new product, the S-pro. The S-pro is a short-life product for which a market has been identified at an agreed design specification. The product will only have a life of

12 months.

 

The following estimated information is available in respect of the S-pro.:

 

• Sales should be 120,000 in the year in batches of 100 units. An average selling price of $1,050 per batch of 100 units is expected.

 

• An 80% learning curve will apply for the first 700 batches after which a steady state production time will apply, with the labour time per batch after the first 700 batches being equal to the time of the 700th batch. The labour cost of the first batch was measured at $2,500. This was for 500 hours at $5 per hour.

 

• Variable overhead is estimated at $2 per labour hour.

 

• Direct material will be $500 per batch for the S-pro for the first 200 batches produced. The second 200 batches will cost 90% of the cost per batch of the first 200 batches. All batches from then on will cost 90% of the batch cost for each of the second 200 batches.

 

• S-pro will require additional space to be rented. These directly attributable fixed costs will be $15,000 per month.

 

A target net cash flow of $130,000 is required in order for the project to be acceptable.

 

Note: At the learning curve rate of 80% the learning factor (b) is equal to – 0.3219.

 

Required:

 

Prepare detailed calculations to show whether S-pro will provide the target net cash flow.

 

Exam focus

 

The examiner is more likely to give you a completed or part completed forecast and ask you about flaws or assumptions.

 

Limitations of the learning curve model

 

The learning curve model only applies if:

 

• there are no breaks in production: a break in production may result in the learning effect being lost.

 

• the product is new: the introduction of a new product makes it more probable that there will be a learning effect.

 

• the product is complex: the more complex the product, the more probable that the learning effect will be significant and the longer it will take for the learning effect to reach the steady state.

 

• the process is repetitive: if the process is not repetitive, a learning effect will not be enjoyed.

 

• the process is labour intensive: the learning effect will not apply if machines limit the speed of labour.

 

8      Exam focus

 

Exam sitting	Area examined	Question	Number of
		number	marks
Sept/Dec 2016   Rolling and incremental budgets		2	25
Sept/Dec 2015	ABC	3(a)	8
Mar/June 2016	ABC and ABM	3	25
Sept/Dec 2015	Weaknesses in budgeting system	2(a)	13
June 2014	Variances, budgeting evaluation,	4	25
	beyond budgeting
June 2013	ABC and ABM	2	25
December 2012	Budgeting	2	25
December 2010	ABC, beyond budgeting	2	25

 

Test your understanding 1

 

 

 

At first sight, the costs are higher meaning the company has done worse, from a cost control angle, but then the activity level is 20% higher than planned. If all costs are variable, we would expect costs to rise in line with activity, making expected costs 20,000 × 1.2 = $24,000. In this case the company has done better than expected.

 

The fixed costs of $10,000 will NOT rise in line with activity levels where as the variable costs of $10,000 will increase in line with activity levels. Therefore, the expected cost of the actual level of activity will be ($10,000

 

• 2) + $10,000 = $22,000. The actual cost is $23,000 so the company has spent more than expected.

 

 

Test your understanding 2

 

(W1) Actual patient numbers were 18.75% above budget, i.e. ((23,750 – 20,000) ÷ 20,000) × 100 = 18.75%. Therefore, budgeted variable costs should be increased by 18.75%.

 

Cost statements for the year ended 31 December 20X0

 

	Budget	Actual
	$	$
Doctors	60 × $100,000 = 6,000,000	60 × $105,000
		= 6,300,000
Nurses	150 × $37,000 = 5,550,000	150 × $34,500
		= 5,175,000
Other staff	1.1875 (W1) × 1,440,000 =	1,500,000
costs	1,710,000
Catering	(1.1875 (W1) × $200,000 × 70%) +	187,500
	($200,000 × 30%) = 226,250
Cleaning	(1.1875 (W1) × $80,000 × 35%) +	142,000
	($80,000 × 65%) = 85,250
Other operating	(1.1875 (W1) × $1,200,000 × 30%)	1,050,000
costs	+ ($1,200,000 ×70%) = 1,267,500
Depreciation	80,000	80,000
	–––––––––	–––––––––

 

 

Total costs

 

14,919,000

 

14,434,500

 

 

Test your understanding 3

 

 

 

The managers/researchers responsible for each project should decide which projects they wish to undertake in the forthcoming period. These projects will be a mixture of continued projects and new projects.

 

For the projects which have already been started and which the managers want to continue in the next period, we should ignore any cash flows already incurred (they are sunk costs), and we should look only at future costs and benefits. Similarly, for the new projects we should only look at the future costs and benefits.

 

Different ways of achieving the same research goals should also be investigated and the projects should go ahead only if the benefit exceeds the cost.

 

Once all the potential projects have been evaluated, if there are insufficient funds to undertake all the worthwhile projects, then the funds should be allocated to the best projects on the basis of a cost-benefit analysis.

 

ZBB is usually of a highly-subjective nature. (The costs are often reasonably certain, but usually a lot of uncertainty is attached to the estimated benefits.) This will be even more true of a research division where the researchers may have their own pet projects which they are unable to view in an objective light.

 

 

Test your understanding 4

 

 

 

The revised budget should incorporate 3% growth starting from the actual sales figure of Q1.

	Quarter 2	Quarter 3	Quarter 4
	$	$	$
Sales	127,154	130,969	134,898

 

Workings

 

• Budget = $123,450 × 103%

 

• Budget = $127,154 × 103%

 

• Budget = $130,969 × 103%

 

Test your understanding 5

 

 

 

• The current method of budgeting at all divisions is incremental budgeting. The advantages of incremental budgeting are that it is simple and easy; therefore, it does not take up much time and resources in the finance department, which is constrained by the new information system implementation. It is suitable in organisations where the business is stable and so historic figures represent a solid base from which to consider small changes. The problems associated with incremental budgeting are that it consolidates existing practices into the targets and so tends to stifle innovation. As a result, inefficient and uneconomic activities will not be challenged and opportunity for cost savings may be missed. Also, managers may deliberately spend up to their budget limits in order to ensure that they get an increment from the highest possible base figure in the next budget.

 

At the different divisions

 

As S and H are stable businesses, it makes sense to continue to use incremental budgeting at these divisions. Change at these divisions may not seem necessary as it would create resistance from the divisional managers. However, incremental budgeting is not consistent with continuous improvement which may be required to reduce costs and improve profit margins in these divisions.

 

At F, the incremental budgets will be rapidly out of date in such a growing business. The current problems of management dissatisfaction and poor quality control may be resulting from divisional management trying to meet their targets with a budget that is not suitable for the growth occurring. They may be cutting corners to meet budget and so buying poorer materials or failing to increase capacity and so not making deliveries.

 

At M, incremental budgeting is intensifying complaints from the other divisions, who already see M as an unnecessary expense. Incremental budgeting is insufficiently critical of the existing spending and it can lead to unjustified increases.

 

• A rolling budget is one where the budget is kept up to date by adding another accounting period when the most recent one expires. The budget is then rerun using the new actual data as a basis. At Drinks Group, with its quarterly forecasting, this would work by adding another quarter to the budget and then rebudgeting for the next four quarters.

 

Rolling budgets are suitable when the business environment is changing rapidly or when the business unit needs to be tightly controlled.

 

The new budget at F would be:

 

	Current	Current	Current	Current	Current	Next
	year	year	year	year	year	year
	Q1	Q2	Q3	Q4	Total	Q1
	$000	$000	$000	$000	$000	$000
Revenue	17,932	18,470	19,024	19,595	75,021	20,183
Cost of sales	9,863	10,159	10,464	10,778	41,264	11,101
Gross profit	8,069	8,311	8,560	8,817	33,757	9,082
Distribution costs	1,614	1,662	1,712	1,764	6,752	1,817
Administration costs	4,214	4,214	4,214	4,214	16,856	4,214
Operating profit	2,241	2,435	2,634	2,839	10,149	3,051

 

Based on the assumptions that cost of sales and distribution costs increase in line with sales and that administration costs are fixed as in the original budget.

 

The budget now reflects the rapid growth of the division. Using rolling budgets like this will avoid the problem of managers trying to control costs using too small a budget and as a result, choking off the growth of the business. The rolling budgets will require additional resources as they now have to be done each quarter rather than annually but the benefits of giving management a clearer picture and more realistic targets more than outweigh this.

 

However, it may also be worth considering going beyond budgeting altogether in order to avoid this constraint problem.

 

• At M, as noted in part (a), incremental budgeting may not be a suitable choice of budget method. A more appropriate budgeting system for such a project-based function is zero-based budgeting (ZBB). Marketing operates around campaigns that often run for fixed periods of time and do not fit neatly into accounting periods which further undermines the use of incremental budgeting. It can be seen as a series of projects. This type of operation is best controlled by having individual budgets for each campaign that the divisional managers must justify to senior management at the start. ZBB requires each cost element to be justified, otherwise no resources are allocated. This approach would please the manufacturing divisional managers, as they will see tight control. It will not hobble M as there are few fixed overheads in marketing as it mainly involves human capital. ZBB is often used where spending is discretionary in areas such as marketing and research and development.

 

• The management style currently used at DG is top-down, budget-based with some degree of participation by divisional managers. Given the irritation being expressed by the divisional managers, the senior management could consider making the control process more participatory. This would involve shifting to more bottom-up setting of control targets. This could involve the divisions preparing budgets or else dropping budgeting altogether.

 

Bottom-up control involves the divisional managers at DG having an opportunity to participate in the setting of their budgets/targets. It is also known as participative control for that reason. It has the advantages of improving motivation of the divisional managers by creating a greater sense of ownership in the budget/targets. It increases the manager’s understanding, which has additional benefits if personal targets are then set from the budget. Bottom-up processing frees up senior management resource as the divisional managers do more of the work. It can also improve the quality of decision making and budgeting as divisional managers are closer to their product markets.

 

Bottom-up control can be contrasted with top-down budgeting.

A top-down budget is one that is imposed on the budget holder by the senior management. It is controlled by senior management and avoids budgets that are not in line with overall corporate objectives or that are too easily achieved.

 

At DG, the current approach does have involvement from the budget holders and so is participatory. This is important as the managers are set targets based on budgets, although the finance department involvement should help to avoid the issues of lack of strategic focus and slack that are noted above. The introduction of rolling budgets could be delegated to the F managers as they will be happy to take on the solution to their constraint problems. It would be wise to keep some involvement by senior finance staff in reviewing the budget – particularly, the key growth assumptions. The introduction of ZBB at M will require the involvement of budget holders as they will prepare the original proposal. These suggestions will have the advantage of encouraging innovation although it will loosen central control. Senior management will need to assess whether the managers of the stable divisions (H and S) can be relied on to drive down costs without the close oversight of the head office that is provided by a top-down approach.

 

Thus, some level of bottom -up budgeting fits well with both the current and future plans for financial control at Drinks Group. Although, the senior management will have to decide on the different level of central control to exercise, based on the skills of the divisional management and the degree of latitude that they require in order to improve their operations.

 

Test your understanding 6

 

(W1) Overheads
Type of overhead	%	Total overhead
		$
Set-ups	35	229,075
Machining	30	130,900
Material’s handling	15	98,175
Inspection	30	196,350
	––––	–––––––
	100	654,500
	––––	–––––––

 

Step 1: Group production              Step 2: Identify cost drivers for

 

overhead into activities                  each activity

 

Set-ups                                                         Number of set-ups

 

Machining                                                    Number of machine hours

 

Material’s handling                                 Number of movements of materials

 

Inspection                                                   Number of inspections

 

Step 3: Calculate an OAR for each activity
Activity cost (W1)		Cost driver		OAR = activity cost ÷
				cost driver
Set-ups = $229,075		670 set ups		$341.90 per set up
Machining = $130,900		23,375 machine hours  $5.60 per machine
				hour
Materials handling =		120 material		$818.13 per
$98,175		movements		movement of material
Inspection = $196,350		1,000 inspections		$196.35 per
				inspection
Step 4: Absorb activity costs into products
	Product X		Product Y	Product Z	Total
		$	$	$	$
Set-ups	25,642.50		39,318.50	164,112.00	229,073
Machining		6,300	7,000	117,600	130,900
Materials handling		9,817.56	17,180.73	71,177.31	98,175.60
	––––––––		––––––––	–––––––––	–––––––––
Total production	71,212.56		98,842.23	484,443.81	654,498.60
overhead	––––––––		––––––––	–––––––––	–––––––––
Production		94.95	79.07	69.21
overhead per unit

 

 

				3
	Step 5: Calculate the full production cost per unit
		Product X	Product Y	Product Z
		$	$	$
	Direct costs (from question)	23.00	21.00	31.00
	Production overhead (step 4)	94.95	79.07	69.21
		––––––	––––––	––––––
	Full production cost under ABC	117.95	100.07	100.21
		––––––	––––––	––––––
	Full production cost under	64	49	115
	absorption costing

 

ABC has resulted in a significant change in the full production cost per unit. The cost of products X and Y have approximately doubled whereas the cost of product Z has decreased by approximately 13%.

 

 

Test your understanding 7

 

 

 

• Some activities will have an implicit value which is not necessarily reflected in the financial value of the product. For example:

 

–    A pleasant workplace can help attract/retain the best staff. A risk of operational ABM is that this activity is eliminated.

 

– A low value customer may open up new leads in the market. A risk of strategic ABM is that this customer is eliminated.

 

• A full cost benefit analysis should be carried out to establish if the cost of the extra work required to obtain the more accurate information is less than the potential savings to be enjoyed as a result of the more accurate assessment.

 

 

Test your understanding 8

 

 

 

• Current absorption costing

 

(Workings to support quantitative results are given below.)

 

The CC department represents an overhead to the operations at Navier. Its costs are currently allocated in a simple fashion by dividing the total departmental cost by the number of dishes to obtain a cost of customer care for each dish as $8.03. This cost will then be added to other costs (such as materials and labour used in production) to obtain a total cost per dish. This cost can then be compared to the selling price per dish in order to obtain a figure for the profit per dish.

 

In addition, the FD adds a further $100 per specialised dish in order to compensate for the extra work involved. However, this leads to an over-absorption of total cost since the $8.03 will absorb fully the

 

• costs and an additional $160,000 (1,600 specialised dishes at $100) of costs may be incorrectly absorbed.

 

ABC costing

 

The problem at Navier is that it sells two different types of dish and these products use different amounts of the company’s resources. The activity-based analysis shows that the cost of customer care per standard dish is in fact lower than the current cost allocated at $6.22 per dish. This means that these dishes are making a higher profit per unit than would be given using the existing costing system. The specialised dishes are costing $106.05 each in customer care so it is vital that their price reflects this much higher cost base. The major activities that contribute to this higher cost are dealing with initial sales enquiries and handling complaints. This is not surprising, as the specialised dishes represent a bespoke service which will not be easily reduced to a standard set of steps.

 

Given the size of the difference between the ABC cost ($106.05) and the current initial estimate of absorbed cost ($8.03), it is not surprising that there have been efforts to correct for this difference. The finance director’s estimate of $108.03 to cover the costs of customer care for the specialised dishes is fairly accurate but, of course, the addition of this extra amount should have required the cost for the standard dishes to be reduced from $8.03 in order to compensate for the allocation of more cost to the specialised dishes. It is not clear if this is being done.

 

The advantage of the ABC analysis is that it shows the activities that are driving the higher costs and, therefore, this analysis opens the opportunity to consider if the customers of the specialised dishes value the additional work. If not, then ABM would require the non-value adding processes be removed/reduced. A survey of customer attitudes and a comparison with competitors’ service standards would shed light on the perceived value of these activities.

 

A question that should arise in relation to the ABC exercise undertaken here is whether it has been worth the effort, given that the finance director does appear capable of reasonably accurately estimating the costs without undertaking the time-consuming ABC analysis. Of course, the problem of over-allocation of total costs would have to be corrected in any case.

 

• The information in the workings below shows that the main cost activities of the CC department are pre-sale preparation (handling enquiries and quotes) and post-sale complaints handling. Together, these activities consume 65% of the resources of the customer care department.

 

The pre-sale work is essential for the organisation and the department converts 46% (16,000/35,000) of enquiries to orders. It would be beneficial to try to benchmark this ratio to competitor performance although obtaining comparable data will be difficult, due to its commercially sensitive nature.

 

However, the complaints handling aspect is one which would be identified as non-value adding in an activity-based management analysis. Non-value adding activities are those that do not increase the worth of the product to the customer, common examples are inspection time and idle time in manufacturing. It is usually not possible to eliminate these activities but it is often possible to minimise them. Complaints handling is not value adding as it results from failure to meet the service standards expected (and so is already included in the price paid).

 

Complaints handling links directly to issues of quality management at Navier as improved quality of products should reduce these costs. These costs are significant at Navier as complaint numbers are 20% (3,200/16,000) of orders. Complaints may arise in many ways and these causes need to be identified. As far as the operation of the CC department is concerned, it may cause complaints through poor work at the quotation stage where the job is improperly understood or incorrectly specified to the manufacturing or installation teams. This leads to non-conformance costs as products do not meet expected standards and, in this case, complaints imply that these are external failure costs as they have been identified by customers.

 

Quality of the end product could also be affected by the supervision activity and in order to ensure that this is functioning well, the CC department will need to have the authority to intervene with the work of other departments in order to correct errors – this could be a key area for prevention of faults and so might become a core quality activity (an inspection and prevention cost).

 

The other activities in the department are administrative and the measures of their quality will be in the financial information systems. Order processing quality would be checked by invoice disputes and credit note issuance. Credit check effectiveness would be measured by bad debt levels.

 

Workings:
Customer care (CC) department
Standard absorption cost per dish
			$000
Salaries			400
Computer time			165
Telephone			79
Stationery and sundries			27
Depreciation of equipment			36
			———
			707
			———
Total CC cost		$707,000
Number of dishes (5.5 × 16,000)			88,000
Standard absorption cost per dish			$8.03
Finance director’s adjusted cost per specialised dish			$108.03
Activity-based costs
	Total	Standard	Specialised
	$	$	$
Handling enquiries and preparing	282,800	226,240	56,560
quotes
Receiving actual orders	70,700	63,630	7,070
Customer credit checks	70,700	63,630	7,070
Supervision of order through	106,050	95,445	10,605
manufacture to delivery
Complaints handling	176,750	88,375	88,375
	——–—	——–—	———–
Total	707,000	537,320	169,680
	—–——	——–—	———–
Average dishes per order		6	1
No of orders		14,400	1,600
Total number of dishes		86,400	1,600
ABC absorption cost per dish		$6.22	$106.06

 

Test your understanding 9 – Market size and share

 

 

 

• Traditional sales volume variance

 

• (Actual units sold – Budgeted sales) × Standard profit per unit

 

• (450,000 – 400,000) × $3 = $150,000 F.

 

• Planning and operational variances The revised (ex-post) budget would show that Hudson should expect to sell 20% of 2.2 million units = 440,000 units.

 

Original sales × standard margin = 400,000 × $3 = $1,200,000 Market size = $120,000 F

Revised sales × standard margin = 440,000 × $3 = $1,320,000 Market share = $30,000 F

Actual sales × standard margin = 450,000 × $3 = $1,350,000

 

Total sales volume variance = $120,000 F + $30,000 F = $150,000 F

 

Comment:

 

Most of the favourable variance can be attributed to the increase in overall market size. However, some can be put down to effort by the sales force which has increased its share from 20% to 20.5% (450,000/2,200,000).

 

Managers should only be appraised on the operational variance, i.e. the market share variance.

 

 

Test your understanding 10

 

 

 

AH×SR	1,450 × $10	= $14,500
		Operational variance	$500 F
RSH × SR	1,500 × $10	= $15,000
		Planning variance	$2,500 A
SH×SR	1,250 × $10	= $12,500
			$2,000 A

 

Test your understanding 11

 

• Traditional variances

 

AQAP =		$41,500
		Price variance	$2,500 F
AQSP =   11,000 × $4 =		$44,000
		Usage variance	$4,800 A
SQSP =	1,400×7×$4=	$39,200

 

• Planning and operational variances

 

Price
AQ×AP			= $41,500
			Operational variance	$300	F
AQ × RSP	11,000	× $3.80	= $41,800
			Planning variance	$2,200	F
AQ×SP	11,000	× $4	= $44,000
				$2,500	F
Usage
AQ×AP	11,000	× $4	= $44,000
			Operational variance	$800	F
AQ × RSP	11,200	× $4	= $44,800
			Planning variance	$5,600	F
AQ×SP	9,800 × $4		= $39,200
				$4,800	F

 

 

			3
		Test your understanding 12
		BFG net cash flow calculation
		Sales units	120,000
			$
		Sales revenue	1,260,000
		Costs:
		Direct material (W1)	514,000
		Direct labour (W2)	315,423
		Variable overhead (W3)	126,169
		Rent	180,000
		Net cash flow	124,408
		Target cash flow	130,000
		The target cash flow will not be achieved.
		Workings:
		W1  Direct material
		Batches	$
		First 200 @ $500	100,000
		Second 200 @ $450	90,000
		Remaining 800 @ $405	324,000
			–––––––
		Total	514,000
		W2  Direct labour
		y = axb
		where; a = 2,500 and b = –0.3219
		Total cost for first 700 batches (x = 700);
		700 × 2,500 × 700 –0.3219	$212,423
		Total cost for first 699 batches (x = 699);
		699 × 2,500 × 699 –0.3219	$212,217
		Cost of 700th batch ($212,423 – $212,217)	$206
		Total cost of final 500 batches;
$206 × 500			$103,000
		Total labour cost ($212,423 + $103,000)	$315,423

 

W3  Variable overhead

 

Variable overhead is $2 per labour hour, or 40% of the direct labour cost.