Management Accounting-Performance Evaluation: Grahame Steven Compares Budgeting Methods and Considers Whether the Activity-Based Approach Provides a Basis for Better Financial Planning

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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 [pounds sterling] and budget sales were 9m [pounds sterling]. The operations manager estimated that the sales office would incur costs of 200,000 [pounds sterling] 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 [pounds sterling]--ie, 9,000,000 [pounds sterling] / 8,000,000 [pounds sterling] x 200,000 [pounds sterling].

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. …