“The traditional budget is a rigid tool and should therefore be discarded in practice”. Should the traditional budgetary model be abandoned as suggested above?
Critically evaluate this claim in the light of recent external pressures from the capital market for timely and accurate information. Please support your answer with theoretical arguments and practical examples from lectures and academic journal articles highlighting the extensive use of budgetary system more recently.
Some suggested readings for this question are shown below:
1. Otley, David (2001) Extending the boundaries of management accounting research, British Accounting Review, 33, (2001), pp. 243-261.
2. Van der Stede, Wim (2000) The relationship between two consequences of budgetary control, Accounting, Organizations and Society, 25, (2000), pp. 609-622.
3. Ryan, Bill (2007) Budgeting, the individual and the capital market: a case of fiscal stress. Accounting Forum, 31, (2007), pp. 384-387
Evaluation of the Traditional Budgetary Model in Practice
Huge technological and globalization developments are changing the methods of carrying out businesses activities. The companies are increasingly investing in the technological developments to make the budgeting process more accurate. The developments have led to many businesses operated international through the internet. They need a reliable costing method to facilitate accurate estimation of the costs and the profit to makes plans on how the business would compete effectively. The traditional budgetary method has failed to address the emerging needs of the business by identifying more specific cost drivers of the overhead costs. The traditional budget is a rigid accounting tool and hence its application shoulb be discarded.
The traditional budgeting method is not flexible enough to meet the changing needs of the organizations today. The increasing global competition demands accuracy of the overheads. The manufacturing environment has changed and is characterized by the advanced use of the technology, computers, and the flexible manufacturing methods. The organizations need to understand the cost of every component considering the monetary benefits and risks to ensure the adequate control and the products that do not generate adequate profit. The accounting system should be consistent with the corporate strategies and the changing needs of the organizations such as advancement in technology, commitment towards ensuring the quality of the products, and increase the control of the competitive elements such as lead-time, quality and the cost (Narong, 2009, p.15). The traditional budgeting methods have failed to meet increasing complexity and changing needs of the organizations. Many of the managers of the major organizations believe that the traditions costing methods bring serious cost distortions that hinder the strategic decision-making process. More so, the traditional budgeting method encourages a behaviour that is against the efficient utilization of the company resources and the objectives of the companies.
The traditional budgeting model is built on an erroneous understanding of the overhead apportionments. Mostly, the companies use the labour hours, and the machines hours to allocate the overheads into different cost units. In reality, a single cost driver like the labour hours and the machine hours does not affect the incurrence of the overheads. The rate of consumption of the materials or the labour hours differs among the various product lines and the departments. Some products lines may consume a little amount of a given type of an overhead compared to another. When the absorptions rate used is not the real costs driver of the overhead used in a given product line, the costs will be either over or underestimated (Richards, 2011, p.78). The use of overall absorption rate produces information that is unreliable for use by the managers. They have to come up with strategies to control costs and compete effectively in the market.
The increasing automation of the production processes causes a reduction in the use of the direct labour, and the fragmentation of the products. The automation makes the traditional budgeting method unfit for the cost estimation. The labour hours mainly used as the absorption rate are unreasonable with increased use of machines and the computerization of the major production processes. The increased fragmentation of the products and the departments needs an accurate and specific identification of the cost drivers (Richards, 2011, p.78). The traditional budgetary model was significantly made for the companies with low indirect costs compared to the direct costs, production of the homogenous products, and reduced willingness to collect data. Nevertheless, the companies today have a variety of intricate products, increased amount of data and the overheads increasing than the direct costs. Also, the companies have the increased costs that are not closely identifiable to the product. For instance, the distributions channels have a huge impact on the costs of the product. The application of the traditional budgetary model in today manufacturing industries turns the real prime costs into overheads (Barbu, Căpuşneanu & Briciu, 2011, p. 219). Thus, there is a huge distortion of the costs involved in the production process. Consequently, it is very difficult to identify the relationship between the cost incurred and the cost unit. The companies are in high need for a method that would directly identify the costs processes and the tasks of the company with the cost incurred.
The failure to identify the cost unit with the actual cost driver results in an inaccurate estimation of the costs and failure to supply the relevant information on time. The inaccurate costs are both irrelevant and insignificant for the management and the well-being of the company. The method could not provide the relevant data to management on time. Instead, the traditional budgeting system resulted into under costing or over costing of the products. (Barbu, Căpuşneanu & Briciu, 2011, p. 223). It is evident that the information provided by the traditional budgeting is inaccurate. Thus, the preparation of the inaccurate information would cause managers to make wrong decisions related to the production process. For instance, a decision to increase the production of a product making a loss would affect the profitability of the company drastically. The effect of the under and over costing is the sustenance of the poorly performing products by those products that are making a profit. In the current world, a simple deviation from the actual decisions results in the loss of the company’s competitive advantage.
For instance, consider a Task A and Task B that the overhead costs are allocated in accordance with the labour hours. Task A uses 10 labour hours and Task B 20 labour hours. The overhead incurred by the company was £ 450. The overhead to be allocated to Task A and Task B would be as follows: Task
A: = £ 150
Task B: = £ 300
The need for the automation of the production process made the company to introduce a new machine. The overhead costs increased to 1575 while the labour hours on Task B decreased to 5 hours from thirty hours. The labours hours remained the best absorption method of the tasks cost. The new apportionment will be as follows:
Task A: = 1050
The apportionment of the costs is not equitable. The apportionment of the overheads dependent on the labours hours does not reflect the consistency in allocating costs to the tasks. With the companies, increasingly employing the utilisation of machines and technology there is needs to find a specific driver for the overhead costs.
Dorin and Diaconescu (2014, p. 114) noted that a comparison between the traditional budgetary model and the Activity Based Costing (ABC) method revealed a significant difference in the costs and profits estimated. It was an indication that there was a method that inaccurately predicted the costs incurred by a company. In the traditional costing method, the products either are over or undervalued. The hidden costs that the traditional budgetary model never identified make the ABC method to have a higher figure than the traditional costing method. The lower value of the ABC costing method is explained by the fact that the tradition budgetary model recognition of the hidden cost. Due to the significant ability of the ABC method to recognise huge parts of the indirect costs, the information of the products provided by the method are very significant. The Activity-based method provided more significant cost information. The decisions made using the ABC method leads to increased profit than in the traditional budgetary methodology. Dorin and Diaconescu (2014, p. 115) explained the superiors results of the ABC method compared to the traditional budgetary model as illustrated in the figure below.
Figure 1: A representation on how the decision made from ABC method leads to superior decisions than using the traditional budgetary model.
The use of the Activity Based Method rather than the traditional budgetary model facilitates the accurate estimation of the costs of the company. Unlike the traditional costing methods, the activity-based costing makes efforts to allocate the costs in the way that depicts how the costs were incurred. In the effort to identify the cost drivers more accurately, the accountant must seek to understand the operations of the company in detail (Heisinger, 2008, p. 219). The ability to identify the cost units with the cost drivers makes the method very accurate and significant in decision-making. The accurate information facilitates the managers to make relevant decisions on product pricing, products mix and whether some products line should be eliminated. Moreover, the managers have a full understanding of the relationship between the cost units and the cost drivers. The managers have the capability to identify strategies to reduce the cost of operation and production. The activity based method has been adopted by many companies to curb the disadvantages faced as a result of using traditional budgetary model. The methods are highly used by the major companies in telecommunication, banking and e-commerce. Many companies described the traditional costing to be incomplete. Majorly, the methods allocate overhead costs arbitrarily without the consideration of the crucial relationship between the cost object and the cost driver (Heisinger, 2008, p. 230).
The traditional budgetary method overhead absorptions result in inaccurate information on costs. The inaccurate information is irrelevant to the decision-making process. The method was highly applicable in the 19th and the early 20th century when major of the manufacturing processes applied the labour intensive methods. The increasing technological development leads to huge automation of the production processes. Moreover, the managers are seeking to predict the costs more accurately due to the increased global competition. The traditional budgetary model has failed to address the increased demands of the organisation for accurate information consistent with the technological developments. The use of the method is oriented towards financial data and not the corporate strategies of the companies. The ABC method has the capability to produce data that are more accurate. The ABC method identifies the cost drivers of the major activities of the organisation accurately. The ABC costs information is accurate and reliable to enhance decision making on cost reduction, profitability, budgets and the management. Therefore, the traditional budgetary model should be discarded in practice and other flexible methods like the Activity Based Methods adopted.
Barbu, C. M., Căpuşneanu, S., & Briciu, S. (2011). The analysis of the impact of the abc method on traditional management accounting systems in romania. Anale. Seria Ştiinţe Economice. Timişoara, (XVII), 218-224.
Dorin, I, & Diaconescu, C 2014, ‘The influence of abc cost calculation method on economic entities performance’, Internal Auditing & Risk Management, 9, 2, pp. 111-117, Business Source Complete, EBSCOhost, viewed 6 November 2015.
Heisinger, Kurt. 2008. Introduction to managerial accounting. Boston, Mass: Houghton Mifflin.
Narong, DK 2009, ‘Activity-Based Costing and Management Solutions to Traditional Shortcomings of Cost Accounting’, Cost Engineering, 51, 8, pp. 11-22, Business Source Complete, EBSCOhost, viewed 6 November 2015.
Richards, G. (2011). Warehouse management: a complete guide to improving efficiency and minimizing costs in the modern warehouse. London, Kogan Page.