ama 2015 lecture 3

Advanced Management Accounting Lecture 3 *Advanced Management AccountingLecture 3Alternative Budgeting Systems

Advanced Management Accounting Lecture 3

Subject ContentTraditional budgeting systems use last years model as a starting point, making incremental adjustments. Here we look at the weaknesses of this system.We then appraise alternative systems including rolling budgets, zero-based budgeting and activity-based budgeting. We also look at the concept of Beyond budgeting.

Advanced Management Accounting Lecture 3 *


Advanced Management Accounting Lecture 3 *Essential ReadingDrury (2012), Management and Cost Accounting, 8th EditionChapter 15, pages 377-383, incremental budgeting, activity based budgeting and zero-based budgeting.Chapter 16, pages 404-406, fixed and flexible budgeting.


Advanced Management Accounting Lecture 3 *Budgeting methods

Fixed or flexible?

Incremental; Activity Based Budgeting (ABB); Zero Based Budgeting (ZBB)

Periodic or continuous?


Advanced Management Accounting Lecture 3 *

Fixed or flexible? Consider the worked example in your Student Guide, Lecture 3 Worked example 3.1The next few slides consider this example in more detail.Full solution is shown in your Student Guide.


Advanced Management Accounting Lecture 3 *Flexible budget summary

Units 8,000 9,000 10,000 11,000 12,000

000 000 000 000 000Sales revenue 3,200Less: variable cost 1,920Contribution 1,280Less: fixed cost 960Net profit 320


Advanced Management Accounting Lecture 3 *Flexible budget summary

Units 8,000 9,000 10,000 11,000 12,000

000 000 000 000 000Sales revenue 3,200 3,600 4,000 4,400 4,800Less: variable cost 1,920 2,160 2,400 2,508 2,736 Contribution 1,280 1,440 1,600 1,892 2,064Less: fixed cost 960 1,200 1,200 1,200 1,400Net profit 320 240 400 692 664


Advanced Management Accounting Lecture 3 *Fixed budget control statement Original Budget Actual Variance Units 10,000 11,500 1,500

000 000 000Sales revenue 4,000 4,485 485(F)Less variable cost 2,400 2,640 240(A)Contribution 1,600 1,845 245(F)Less fixed cost 1,200 1,340 140(A)Net profit 400 505 105(F)


Advanced Management Accounting Lecture 3 *Flexed budget control statementFlexed Budget Actual Variance Units 11,500 11,500

000 000 000Sales revenue 4,600 4,485 115(A)Less variable cost 2,622 2,640 18(A)Contribution 1,978 1,845 133(A)Less fixed cost 1,400 1,340 60(F)Net profit 578 505 73(A)


Advanced Management Accounting Lecture 3 *Traditional Budgeting Systems May be seen as:Incremental in natureAssumes existing strategic model appliesFocuses on existing resources and changes to such resourcesTakes a short term viewDepartmental/segmental based


Advanced Management Accounting Lecture 3 *Now consider Lecture 3, worked example 3.21. Maintenance cost budget This may be calculated as: 200,000 x 1.02 x 1.03 x 0.95 = 199,614.

Note that the original budget of 200,000 is adjusted by indices which represent the expected change from the base level of 100% in activity, price and efficiency.


Advanced Management Accounting Lecture 3 *Lecture 3, worked example 3.2continued2: Discuss limitationsIt assumes that the current method by which maintenance work is carried out is acceptable. No detail is given about the way in which maintenance is carried out within the company.

It is incremental in nature, in that the existing budget has simply been adjusted to allow for anticipated changes in activity, price and efficiency.


Advanced Management Accounting Lecture 3 *Lecture 3, worked example 3.2continuedTime horizon is twelve months. No effort has been made to link the maintenance requirement, for example, to a longer term plan for replacement of assets.The focus is on the maintenance function. No effort seems to have been made to consider ways in which changes to other aspects of the business may affect the need for maintenance. E.g. a policy of additional expenditure on training of machine operatives in the production departments may result in maintenance expenditure savings.


Advanced Management Accounting Lecture 3 *Traditional Budgeting:WeaknessesResource allocation is not clearly linked to strategic plan and the consideration of alternative strategies. (Consider worked example 3.2 above.)

Tendency to constrain new high priority activities


Advanced Management Accounting Lecture 3 *Traditional Budgeting:Weaknesses

Insufficient focus on efficiency & effectiveness and how they may be achievedLeads to arbitrary cuts being made in order to meet overall financial targetsTends not to lead to management commitment to the budget process


Advanced Management Accounting Lecture 3 *Zero Based Budgeting

Removes implied right of existing activities to continueShifts burden of proof to justify expenditure onto the manager(s)Asks fundamental questions which must be addressed


Advanced Management Accounting Lecture 3 *Zero based budgeting (ZBB)More efficient allocation of resourcesFocus on value for moneyEasier to identify inefficiencyRelates input cost to output benefitsImproved awareness of activitiesChallenges status quo


Advanced Management Accounting Lecture 3 *ZBB Fundamental Questions:Objectives of the activity?To what extent are objectives achieved?How is the achievement measured?Alternative way(s) to meet objectives?Most cost effective alternative?Impact of discontinuing the activity?


Advanced Management Accounting Lecture 3 *ZBB -fundamental questions; using Maintenance as an example What are the objectives of the activity?Objective for production maintenance:The efficient operation of all production machinery in order that demand for products may be efficiently achieved at minimum cost.


Advanced Management Accounting Lecture 3 *ZBB -fundamental questions; using Maintenance as an exampleTo what extent are these objectives achieved?

Achievement of objectives is likely to be a relative measure against the existing plan or budget. Zero based budgeting seeks to examine more closely the absolute measure of the objectives. What is efficient operation? What is minimum cost?


Advanced Management Accounting Lecture 3 *ZBB -fundamental questions; using Maintenance as an exampleBy what mechanism is the achievement measured?Several measures will be used to find out if objectives are achieved. E.g. monitor trends for:the number of maintenance staff the percentage of idle time of maintenance staff the percentage idle time of machines the level of scrap or rework of products average machine running speeds the incidence of work in progress build-up the number of late deliveries to customers.


Advanced Management Accounting Lecture 3 *ZBB -fundamental questions; using maintenance as an exampleIs there an alternative way of meeting the objectives? Is maintenance only carried out when a breakdown occurs? (Reactive approach). Can this be changed to be more proactive? E.g.Implement a routine maintenance programme where preventative maintenance and checks are carried out regularly perhaps weekly or monthly.Carry out major overhauls of machinery at specific time intervals (e.g. three-monthly) or after a specific number of running hours (e.g.1,000 hours).Change tries to prevent machine breakdown.


Advanced Management Accounting Lecture 3 *Changing method of maintenance:Are any of the alternatives cost effective?Measure the cost/benefit impact of breakdown repair provision, routine maintenance and a major overhaul programme.

Breakdown maintenance service is better than no service at all. If you had to wait for an outside repair service to arrive - valuable production time will be lost.


Advanced Management Accounting Lecture 3 *Are any of the alternatives cost effective?Routine preventative maintenance programme should help reduce machine idle time, improve output quality, reduce scrap and rework and avoid late delivery to customers.

Planned major overhaul of machinery at specific time intervals should improve the longer term efficiency of operation of the machinery and defer the requirement of additional investment for replacement assets.


Advanced Management Accounting Lecture 3 *What would be the consequences if the activity was discontinued?Closing department would mean all maintenance work must be sourced externally. Could lead to undue delays in the repair of breakdowns.

May be statutory requirements in areas such as ensuring that machinery meets safety standards or that equipment for the disposal of toxic waste is maintained to a specified safety level. Company may not wish to delegate this aspect of the function to a third party.


Advanced Management Accounting Lecture 3 *Zero Based BudgetingUseful cost classifications:Engineered Costs - in proportion to activity

Discretionary Costs - management judgement in their application

Committed Costs - must be incurred for activity to operate


Advanced Management Accounting Lecture 3 *Example: Safety provision costsEngineered cost: safety goggles issued to employees which are replaced at the end of each shift.Discretionary cost: expenditure on safety conferences or a company safety pamphlet.Committed cost: legal requirement to provide special storage facilities, eg for toxic materials.


Advanced Management Accounting Lecture 3 *Safety provision benefitsExpenditure on safety should lead to:reduction in the amount of production time lost due to industrial accidents. improved profitability through reductions in losses due to labour and machine idle time, material losses and overhead costs not recovered in good production. increased attention to the need for safety may improve the motivation of the workforce help reduce labour turnover rates and consequent replacement costs.


Advanced Management Accounting Lecture 3 *Quantification of ZBB:Evaluate incremental levels of operationQuantify costs and benefits of each levelShare - out of funds by ranking processFunds are allocated using the ranking procedure until the budget funding has been exhausted.


Advanced Management Accounting Lecture 3 *Study GuideLecture 3: Worked example 3.3Cost Benefit Net benefit Ranking 000 000 000 000 Maintenance: Package 1 580 1= Package 2 260 400 140 2 Package 3 120 200 80 4 Accounting: Package 1 460 1= Package 2 160 260 100 3 Package 3 200 240 40 5


Advanced Management Accounting Lecture 3 *Study GuideLecture 3: Worked example 3.3Package 1 for each department is essential to the business and must be implemented. Budget allocation will be as follows. 000Maintenance package 1580Accounting package 1 460Maintenance package 2260Accounting package 2 160Total allocation 1,460This leaves 40,000 unallocated. Perhaps implement part of one of the remaining packages?


Advanced Management Accounting Lecture 3 *Quantification of ZBB ProgrammesUse of qualitative rating scale:Essential to businessCriticalVery useful attributesSignificant benefit - but could be droppedDesirable - but early in drop-out leagueMarginal - only support if funds allowPossible - if significant extra funds availableDoubtful - difficult to justifyUnlikely ever to be funded


Advanced Management Accounting Lecture 3 *ZBB - disadvantagesVery time consumingHigh level of data capture requiredRequires management skill and commitmentSubjective judgements in rankingsCan be threatening to staffMay stress short not long term


Advanced Management Accounting Lecture 3 *Activity Based Budgeting (ABB)Features of ABB system include:Links strategic planning and budgetingIdentifies options and sets parametersFocus on TQMFocus on activities which cause costsChange in strategy is envisaged


Advanced Management Accounting Lecture 3 *Features of ABB system continued:Focus on overall methods improvementIdentify key processes and constraintsMinimum and incremental levels are identified for each activity (ZBB link)Measurement of total performanceInvolvement of entire workforce


Advanced Management Accounting Lecture 3 *Activity Based TerminologyPrimary ActivitySecondary (Support) ActivityValue Added and Non-Value AddedCost DriversActivity Matrix(see study guide Lecture 3, Worked example 3.4)


Activity Cost Matrix - Sales Order DepartmentAdvanced Management Accounting Lecture 3 *

Total costCustomer negotiationsProcessing of ordersImplementing despatchesSales literatureGeneral admin.Cost elementHomeExport000000000000000000000Salaries305308080553030Stores/supplies4583430IT3281248Sundry costs323426710Total4144110489736740Volume of activity2,0006502,3005006,000Cost driverscustomersnegotiationsordersordersdespatchesUnit cost 207.0063.08 45.22 178.0012.17


Advanced Management Accounting Lecture 3 *ABC terminology using our example Primary activity contributes directly to the central mission of a department or organisational unit. E.g. Negotiating with customers; processing orders; implementing dispatches. Secondary activities support the primary activities E.g. Sales literature provision; general administration.

Primary activities will tend to be volume related whereas secondary activities tend to be more fixed.


Advanced Management Accounting Lecture 3 *ABC terminology using our exampleAs a general rule - maximise the ratio of primary to secondary activities - should improved profit levels. Also carry out activities to provide a product or service which meets design specification and is acceptable to customers. Need achieve this in as cost effective a manner as possible.


Advanced Management Accounting Lecture 3 *ABC terminology using our exampleValue added and non-value added activities Key question: Is activity necessary? If necessary, can its efficiency be improved through a total quality management programme? If unnecessary, can it be eliminated? General rule: view primary activities as value added and secondary (support) activities as non-value added.


Advanced Management Accounting Lecture 3 *ABC terminology using our exampleIn our example, all new customer negotiations are value added. Additional negotiations with customers to solve problems are non-value added. Need continuous programme of investigation into ways in which non-value added aspects of an activity can be reduced.


Advanced Management Accounting Lecture 3 *Cost DriversCost driver is the factor which determines the level of resource required for an activity.In our example, cost driver for negotiations with customers assumed to be number of negotiations (budgeted at 650), with average cost per negotiation of 63.08. Time spent on negotiations may vary considerably from one negotiation to another. Cost driver of negotiation cost per minute may be more appropriate.


Advanced Management Accounting Lecture 3 *Cost driver usesCan compare with other companies in the parent group or with industry norms as one measure of the efficiency of provision of activities.May also be monitored through time in order to check whether they are increasing or decreasing.May be used in calculating unit product costs for use in pricing decisions.


Advanced Management Accounting Lecture 3 *Control by expense typeExpense type budget actual variance 000 000 000 Salaries 305 325 20 (A)Supplies 45 50 5 (A)IT cost 32 37 5 (A)Other costs 32 40 8 (A) Total cost 414 452 38 (A) The control focus would be on each expense type in total and not on activities. The emphasis would be to consider ways in which each could or should be brought into line with the budgeted level.


Advanced Management Accounting Lecture 3 *Control by Activity Activity budget actual variance 000 000 000 Customer negotiations 41 61 20 (A) Process home orders 104 78 26 (F) Process export orders 89 120 31 (A) Implement dispatches 73 73 - Sales literature 67 80 13 (A) General administration 40 40 - Total 414 452 38 (A)

Actual costs and part of variances may simply reflect move from original budget plan towards achievement of longer term strategic planning objectives.


Advanced Management Accounting Lecture 3 *Comment on variancesExpansion of export business: Adverse variance of 31,000 for export order processing may reflect increased activity rather than increased cost through inefficiency. Resources switched from home order processing giving favourable variance of 26,000.Cultivation of customer relationships: Adverse variance of 20,000 on customer negotiations could be due to improved quality of customer relationships to secure repeat business. But could also indicate more remedial negotiations on existing orders - non-value added expenditure.


Advanced Management Accounting Lecture 3 *Comment on variancesImprovement in quality of business operations: Sales literature adverse variance of 13,000 may indicate expenditure to improve the quality of information supplied to customers. Minimisation of cost compatible with achieving other objectives: May be aided by having an analysis available for each activity by expense head. E.g. customer negotiations activity may be able to be analysed to show breakdown in expense headings as shown on the next slide.


Advanced Management Accounting Lecture 3 *Break down of Customer negotiationsCustomer negotiations

Expense budget actual variance 000 000 000 Salaries 30 50 20 (A) IT cost 8 8 - Other costs 3 3 - Total cost 41 61 20 (A)


Advanced Management Accounting Lecture 3 *Activity AnalysisSummary of activity model development questions: What activities are being carried out and are they necessary?How effectively are activities carried out and to what quality and standard? Which cost drivers determine the level of resources required for an activityWhat is the relationship between an activity costs driver and its root cause?How can the activity model help in decision making? e.g. in budgeting for product costs?


Advanced Management Accounting Lecture 3 *Activity Based BudgetingPotential Problems:Systems re-design requirementComplexity limiting its use as cost control and decision making baseAcceptance by management and staff


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ama 2015 lecture 3

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