Costing To Make Budgetary Control Effective Essay

Question:

Discuss about the Costing to Make Budgetary Control Effective?

Answer:

Ferguson & Son Manufacturing Company is using Budgetary Control to control its costs and reduce inefficiencies. Under the current system, the different departments are given monthly budgets and the performance of the departments is compared with the budgets, and any variation is brought to the notice to the plant manager Mr. Robert Ferguson Jr. Moreover, the plant manager emphasises on making tight budgets so that costs can be reduced to the minimum level but this is posing problems to the machine department and the equipment maintenance departments. The supervisors of the departments feel that though they are working hard to meet the budgets, still their performance is far from satisfactory. This is happening due to the traditional costing system being used by the company currently. The costs are being assigned to the activities in the department by machine hours and labour hours in machine department and equipment maintenance department respectively. The factory overhead costs are being assigned to the units of products in each department by the number of machine hours being used by the activity multiplied by the overhead rate which is pre determined. The pre determined rate for machine shop would be calculated as total overhead cost divided by the total machine hours available. Currently, many special orders are being taken by the company and for each new order; the machine department needs to set up the machine and adjust it. This requires time and adds up the machine hours needed to produce the product, thus increasing the overhead costs for that product. In the process, the big orders which required lesser set up time are being ignored, and the overall costs for the machine department are increasing. Even though the big size orders will give higher profits but machine hours being wasted on small orders set up thus reducing the profitability and quality of machine department. Also the equipment maintenance department, to meet the budgets is running after those activities which require less of labour hours and not by the importance of the activity so that their overhead costs can be reduced. Hence, a machine breakdown in the machine department was not attended by the equipment maintenance department. Hence, the breakdown consumed more time than required and further increased costs for the machine department. Also, the overhead costs are not being assigned to the activities according to their usage of hours, for instance the equipment maintenance department has allocated the costs of supplies it has wasted to other work rather than on which the supplies were wasted. This is because the overhead rate is a common rate for all the activities in the department and hence, the some activities may be assigned higher costs and other low costs.

As a result of the above problems, even though the machine department is working very hard, yet due to rush orders and inadequate help from supporting departments, it is not able to meet the budgets. As such, the employees who are working so hard and yet are not able to receive appreciation, their morale will go down, and they may even quit their jobs. Also, the efficiency and inefficiency of a department is not ascertained properly due to inefficient costs allocation.

The budgets prepared for different departments should be interrelated and interdependent on each other. A master budget should be prepared and on that basis, the departmental budgets should be prepared. The department budgets should be reviewed in relation to other department budgets. Like due to the inefficiency of equipment maintaining department, the machine department could not solve its hydraulic pressure problem on time and as such had to delay its operations, so a control system which works in coordination with all related departments would give better results.

System inefficiencies occur due to costs being allocated by labour and machine hours since big orders that require a lot of time to set up are being disrupted for small rush orders. Hence, the time taken to set again the big orders is adding to the costs of the order and affecting its profitability. To remove this inefficiency, the costs should be allocated to the products by the activities which add to the manufacturing costs and the products requiring more of the expensive activities should be charged more overhead costs than the ones requiring less of the expensive activities. On the face, the small rush orders look profitable but the loss incurred on big orders are more than the profits made by small orders. The company should focus more on products which give the maximum contribution to the company’ profits like the big orders in this case and according to such importance, the budgets should be allocated. In this case, higher budgets should be allocated for the big orders to the machine department, and all the departments should work in coordination to fulfil the bigger orders first and then the small orders. Like the equipment department gave more importance to the inspection of forklift trucks rather than solving the hydraulics pressure breakdown. This led to time loss for the machine department and hence they could not meet the budgets. Here, the equipment maintainenace department should have solved the machine problem first as the production was being hampered. The budgets should be designed in such a way that the important tasks are taken up first which contribute maximum to the company’s profits.

The budgetary system should also ensure that costs are assigned to the activities the activities to which it relates to and not any other activity.

Activity Based Costing assigns overhead costs to the products in a more logical manner as compared to Traditional Costing. Under ABC, the costs are first assigned to the activities which are the real cause of the occurrence of the overhead. After that, it assigns the costs of those activities to the products or services according to their usage of the activity. Some of the common activities under a manufacturing sector include machine set ups, machine maintenance, quality check; special engineering, etc. the importance of ABC has increased due to an increase in the automation technology which has increased the manufacturing overhead costs. Moreover, some products are produced in large batches while the others in small batches, under such situation, ABC helps in logical allocation of resources.

As a result of ABC costing, the management will be able to identify the activities which are resulting in higher costs like set up costs and identify products like small rush orders which are using the most of these activities. Such activities or products could be reviewed, and efforts should be taken to reduce the activity costs wherever possible. Rather than blaming the whole department for high costs, costly activities could be improved. Products which are using more of these expensive activities but contributing less to company revenues should be stopped producing, and those contributing more to the company’s profits should be continued.

Every company has short term and ling term goals to be achieved, and they make strategies to accomplish these goals. The strategies are executed by the employees of the firm and hence, it is necessary to clearly communicate these goals to the employees, and also the management should align the goals of the individual employees with the company goals. This can be done by employee engagement. While preparing budgets which will help in achieving company goals, the employees should also be referred so that they feel a sense of responsibility and set their goals accordingly. When all the employees are working towards the company goals together, the company is bound to successfully accomplish its goals. The sense of responsibility will increase the productivity of the employees as they feel motivated and increased profitability will lead to higher profits and lower costs for the organization, thus increasing the returns for shareholders.

The different ways in which the budgets could be used to change employee behaviour and align goals in the organization include:

Budgets to be prepared in consultation with the employees as they are the executors.

Budgets clearly communicated to the employees

Budgets should clearly state various tasks to be performed by the employees and the expected costs and profits from such tasks so that they know the value of each task and perform them accordingly.

Return on Investment (ROI) is a measure of profitability which states whether the company is using its resources in an efficient manner to make profits. A company with higher ROI is better placed in the industry. ROI is calculated by dividing the net income by the average capital employed by the company.

Activity Based Costing can be used to make strategic decisions and thus improve the profitability of the company. ABC helps in reviewing a process and thus provides scope for continuous improvement of the process which results in incremental cash flow. The processes or activities which are not yielding high benefits are removed or improved, as a result of which the cash which was tied up in the operations of those processes is freed and there is more of free cash flow.

References

Kaplan, R., Cooper, R. (1991), Profit Priorities from Activity- Based Costing, Harvard Business Review

Cagwin, D., Bouwman, M., (2000), the Association between Activity Based Costing and Improvement in Financial Performance

Turney, P.B., (1991), How Activity Based Costing Helps Reduce Costs, Journal of Cost Management, pg. No. 29-35

Swenson, D. 1995. The Benefits of Activity-Based Cost Management to the Manufacturing Industry. Journal of Management Accounting Research, pg. No.167-180.

Roztocki, N., Schultz, S.M., (2003), Adoption and Implementation of Activity- Based Costing: A Web – Based Survey, State University of New York at New Paltz School of business

Joan, M., (2009), Traditional Versus Activity-Based Product Costing Methods: a field study in a Defense Electronics Manufacturing Company, Proceedings from ASBBS Annual Conference

Sullivan, J., (2011), Increasing Employee Productivity: The Strategic Role that HR Essentially Ignores, accessed online on 7th Feb, 2016, available at

Newman, K.M, (2013), How to Align Employees with Your Company’s Vision, accessed online on 7th Feb, 2016, available at,

Mahal, I., Hossain, A., (2015), Activity Based Costing (ABC) – An Effective Tool for Better Management, Research Journal of Finance and Accounting, Vol. 6, No.4

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