Steven, Grahame

Grahame Steven compares budgeting methods and considers whether the activity-based approach provides a basis for better financial planning.

Although a number of commentators have questioned the value of budgeting and continue to question it (see September’s Study notes article on paper P1, for example), most companies use budgets, since they provide a framework for strategic direction and operational control. For instance, a CIMA-backed research project involving 41 UK companies last year revealed that only one of the sample didn’t use budgets. It’s clear, therefore, that budgeting is still part of the lifeblood of enterprise, but the key question concerns how to ensure that it remains relevant for modern organisations.

Let’s look at the fictional case study of Great Wall Cellars to compare and contrast conventional budgeting, zero-based budgeting (ZBB) and activity-based budgeting (ABB). This company imports wine from China, which it then resells to off-licences and specialist food and drink outlets in the UK. At present, its customers send their sales orders by post to the sales office. The orders are entered into the computer system and sales confirmations are posted back to the customers. The sales office often has to deal with customer enquiries about orders, since the sales order cycle generally takes between five and ten days.

Great Wall Cellars’ sales director recently produced sales figures for the annual budget after making a detailed analysis of current and projected demand for the company’s products from current and new customers. Forecast sales were £8m and budget sales were £9m. The operations manager estimated that the sales office would incur costs of £200,000 in the current year.

Conventional budgeting, which is an incremental approach, uses a company’s existing operations and current cost structure to determine budget costs. The starting point for this process is to obtain forecast costs for the current year. The next step is to make an adjustment to forecast costs based on budgeted output – eg, sales. The budget for the sales office will be set at £225,000 – ie, £9,000,000 -=- £8,000,000 x £200,000.

The sales office budget includes an inflation adjustment, since the budget selling price has been increased in line with the expected rate of inflation.

Conventional budgeting will provide accurate budget figures for variable costs such as direct materials, direct labour and sales commission, because these have a clear volume-based link with production/ sales. But this approach is unlikely to produce accurate figures for support departments, whose costs are largely fixed and semi-fixed and driven by other factors such as sales orders and purchase orders. In addition, no consideration is given to the cost of providing existing activities, since the focus is on incremental change. Inappropriate business practices may also be perpetuated, because no evaluation of current activities is made.

ZBB was developed in the sixties as an alternative approach to address the deficiencies of incremental budgeting – in particular, the non-evaluation of existing activities. This method asks the following key questions:

* Should an activity be performed?

* How much of an approved activity should be provided?

* How should the activity be undertaken?

* How well should the activity be done?

* Should the activity be performed in-house or subcontracted?

The ZBB approach will ensure that inappropriate activities are not undertaken, since it makes a full evaluation of existing activities in relation to future needs. The main disadvantage of this method is that it is extremely time-consuming, since it requires the gathering, analysis and evaluation of large amounts of data. As a result, it’s used by very few companies.

The activity-based approach to budgeting is a more sophisticated version of traditional absorption costing. Activity-based costing (ABC) uses a number of different bases sales orders, purchase orders, machine set-ups and so on – to charge overheads to products, since it recognises that many support departments’ activities are not driven by volume-related measures such as sales.

ABB uses the costs drivers identified by ABC to derive budgets for support departments. In simple terms, it involves the following stages:

* Determine the key budget factor (sales) for the next budget period.

* Estimate the support activities required for the budget from cost drivers.

* Set the budget for the support activities.

The following information was obtained from Great Wall Cellars’ ABC analysis and used by the sales director to determine the sales department’s budget:

* Sales office cost driver: sales orders.

* Forecast number of sales orders: 40,000.

* The company does not expect to lose any of its current customers, because the demand for Chinese wine is increasing.

* The average sales value per order received from existing customers has been estimated to be ten per cent higher in the next budget period.

* The average sales value received from new customers is expected to be £160 per order.

* Expected rate of inflation for the next budget period: two per cent.

* The maximum capacity of the sales office is six people.

The first step of the ABB analysis in table 1 is to calculate the forecast cost of processing a single sales order – ie, £5. The forecast cost is then adjusted by the budget inflation rate of two per cent to obtain the budgeted cost of £5.10 per sales order. It is then necessary to determine how many sales orders will be received in the next budget period to calculate a total budget.

The average budget value of a sales order from existing customers is expected to rise by ten per cent – ie, from the forecast figure of £200 to £220. This will produce budget sales from existing customers of £8,800,000 (£220 x 40,000) and £200,000 from new customers – ie, £9,000,000 minus £8,800,000. Consequently, the firm will receive 40,000 sales orders from existing customers, plus 1,250 from new customers, in the next budget period.

The final step is to calculate the total sales office budget from the budget cost of processing a single sales order – ie, £210,375.

The ABB analysis in table 1 assumes that costs incurred by the sales office are mostly variable. In practice, it would incur many fixed and semi-fixed costs, including rent, heating, insurance and salaries. The analysis must, therefore, be amended to determine how much of the key resource – staff time – is required to process sales orders to provide a better basis for determining the budget and identifying any problems associated with the sales office. Table 2 contains a revised ABB analysis focusing on staff time.

The firm’s recent ABC project revealed an average processing and query time for a single sales order of 0.2 hours. The total time required for forecast sales orders is, therefore, 8,000 hours. This includes 500 hours of overtime, since the five-person sales-office team is contracted to work only 7,500 hours a year. Great Wall Cellars is considering employing an extra person on a part-time contract, since the current high level of overtime is unpopular with staff.

Forecast figures in table 2 for the sales office indicate that £80,033 will be spent on salaries and £119,967 on overheads in the current year, making a total cost of £200,000.

The time required to process budget sales orders is 41,250 orders x 0.2 hours = 8,250 hours. Because the firm has decided to eliminate overtime, it will need to employ 8,250 ÷ 1,500 = 5.5 people in the sales office to meet the projected workload. Since the extra employee will have a 50 per cent contract, the salary budget will be £15,000 x 5.5 = £82,500.

While overheads have been increased above the inflation rate to £124,000 to take account of the additional staff member, there is no need for extra office space, since the sales office can accommodate a team of six. The total budget figure for the second ABB analysis is consequently £206,500.

By focusing on staff time, the second ABB analysis calculates a better budget figure and gives more information on the sales office’s cost structure than the first analysis. It also provides an insight into the sales office’s cost structure. The firm will incur a step increase in fixed/semi-fixed costs if it has to employ more than six people in the sales office to handle an increase in workload.

The second analysis may be superior, but neither addresses the fundamental issue of working practices. Although the sales office uses an IT system, it appears to be a computerised version of a manual system. Great Wall Cellars needs to re-engineer its business processes to allow the digital transmission of information between itself and its customers to increase efficiency and reduce the number of queries. Companies that implement ABB must ask the type of questions inherent in ZBB to ensure that their practices remain up to date.

P1 further reading

B Scarlett, Management Accounting – Performance Evaluation CIMA Learning System (2007 edition), CIMA Publishing, 2006.

L Burke and C Wilks, Management Accounting – Decision Management CIMA Learning System (2007 edition), CIMA Publishing, 2006.

C Drury, Management and Cost Accounting (sixth edition), Thomson Learning, 2004.

D Dugdale, T Jones and S Green, Contemporary Management Accounting Practices in UK Manufacturing, Elsevier, 2006.

J Innes, F Mitchell and D Sinclair, “Activity-based costing in the UK’s largest companies”, Management Accounting Pesearch, Vol 11, No 3, 2000.

Grahame Steven is a lecturer in the School of Accounting, Economics and Statistics at Napier University, Edinburgh.

Copyright Chartered Institute of Management Accountants Nov 2007

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