ACCTING7014 | Accounting | The Importance Of Activity Based Budgeting

Question:

Background:

You are recently employed as a graduate consultant in a management consultancy firm and are assigned to a team. One of your firm’s clients is currently evaluating its budgeting system. The CEO of your client had recently attended a seminar on Activity-Based Budgeting (ABB) in private companies and would like to know whether ABB is suitable to the company. Your manager has asked your team to prepare a report for the client

Required:

You are required to prepare a report to comment on the suitability of ABB for a company of your choice (your firm’s client). The report should cover the followings:

a) A description of your firm’s client

b) A description of the ABB and its features

c) In what ways ABB is different from traditional budgeting systems

d) A discussion on whether the ABB is suitable to your firm’s client

Introduction

Activity based budgeting (ABB) is the management process that is based on the activity level rather than using the past year data to develop the current budgets. It can be said that under activity based budgeting one can easily locate the resource consumption of each item clearly and that has made it very popular among various industry sectors such as mining, retail etc. The report has examined the importance of ABB in mining industry and how it can be implemented in BHP Billiton. The comparison between the ABB and traditional budgeting has been explained in detailed in order to prove the importance of ABB. The implementation of ABB in BHP has been critically explained to get an idea whether ABB is suitable to be implemented in the selected company or not.

A: Description of BHP Billiton (A client of consultancy firm)

BHP Billiton is the famous multinational company based in Australia. It is known as Anglo-Australian multinational entity that deals in mining and petroleum sector. The purpose of the company is to deal in extraction of resources from mines and process them further to provide various resources to the emerging economy. Some of major resources that BHP Billiton deals in are oil, gas, metals, aluminum, uranium, gold, silver, nickel and coal. Apart from these resources there are some other resources that company has its contribution through joint agreements with other companies. BHP is world largest diversified resource company that provides almost all kinds of mining and oil & gas resources to their valued customers. The company’s headquarter is located in Melbourne, Australia (BHP: About us, 2018). BHP Billiton is very big company that requiresmaking budgets every year so that it can allocate the scared resources in useful manner. As objectives and requirement changes every year in BHP Billiton it is important to have adopt such a budget method that provides useful information through taking in to account the available resources (material and labour) and business objectives of the company. It is also essential to consider the future demand in allocation of resourcesso that purpo

B: A description of the ABB and its features

Activity-based budgeting (ABB) can be defined as a method of costing that involves recording, researching and developing an analysis of the business activities that is incurring a significant cost for a business. The method is used for promoting high amount of transparency in the process of budgeting and realizing accurate cost incurred in the business activities. The method of costing involves allocating the revenue realized from the overall business activities to the significant unit causing the occurrence of that activity. It is a management accounting tool that involves developing an analysis of the overall business activities for taking decisions regarding resources allocation (Dayananda, 2002).

The activity-based budgeting can be regarded as a method that involved developing budgets with the use of activity-based costing that involves accurate allocation of overhead costs and thus improving the operational efficiency. The method involves identifying the cost drivers by considering all the relevant processes that are involved in that activity. The unwanted activities are eliminated that significantly results in improving the operational efficiency by reduction in the costs involved in production process of the company. Thus, a company can attain competitive advantage by lowering the price of its good and services as compared with that of the competitors. In addition to this, this type of budgeting helps in gaining an in -depth into the each of the business activities by a business manager and thus eliminating all type of bottlenecks associated with an activity. This leads to synchronization of business activities and reaching the organizational aims and objectives effectively (Hansen, 2007).

The identification of the individual activities helps in accurate allocation of resources to them and thus development of accurate budget for each activity. The business nowadays are emphasizing on adopting the use of activity-based budgeting systemfor accurate planning so that they gain an insight into the business expenses that are expected to incur on the basis of ach level of activity. The method involves primarily identification of the overall activities involved in a business process. This is followed by examining the cost drivers that can be stated as the items responsible for incurring revenue or expenses for the company. The next step of the process is to determine the number of units related with activity and cost per unit activity which is multiplied by the activity level to gain results (Cokins, 2004). The major feature of activity-based budgeting can be stated as follows:

• The method ishighly useful for a company to refine its cost planning by reducing the number of activities through elimination of unwanted activities
• It is an important tool for management planning as it helps the business managers to gain an insight into the type of business activities and the significant problems associated with them
• The budget prepared can help the managers to improve the profitability position of a company by reducing the number of activities require for revenue realization (BPP Learning Media, 2012)
• It assist manager in taking important decisions relating introduction of a new product by analyzing the cost structure of a business and determining the funds available to take initiatives regarding developing new products and processes
• It helps the bushiness managers to attain organizational objectives by gaining an estimate of the operational expenses and thus determining the funds required to attain the predetermined goals
• The method of budgeting can however be regarded as more costly than other types of budgeting system used by a company. This is because it involves more analysis of business activities and requiring more resources for overcoming the inaccuracy in a budget
• The method is highly useful for allocation of overhead costs as per the number of business activities and therefore attaining accurate budgeting results regarding the expenses to be realized (Hansen, 2007)

C: Difference between Traditional budgeting and activity based budgeting

Traditional budgeting is a method of accounting that depends on method applied in traditional costing. It means the preparation of traditional budgets it critically based on allocation, apportion and absorption of overheads in products. In this section the differences between traditional costing and activity based budgeting has been explained in detail. The approach used by the traditional budgeting refers to as incremental approach. In this approach past year data is used by the cost manager to derive the current year budgets. So it can be said that this method preparation of budgets is very simple and easy to understand (Horngren, 2009).

There are many differences between the activity based budgeting and traditional budgeting in relation to the manner of preparation, its importance, uses, information conveyed, focus, approach and many other. In traditional budgeting system company takes in previous year data or information to set the budget target and goals. It means whole budget is drawn is from the previous year figure with minor adjustments to the change in sales volume, change in expenditure, change in management policies etc. There is no need to evaluate each activity every time the budget is prepared. On the other hand in activity based budgeting does not intake the data and information of past year budget and allocates the available resources on the bases of efficiencies of business operations. It means while preparing the activity based budgets cost manager has to evaluate each activity processed in the company and draw the budget that results in maximum output and optimum utilization of resources. There has been orientation difference between the traditional costing budgeting and activity based budgeting as traditional budgeting is accounting oriented while activity based budgeting helps in decision making and it is also project oriented (Weston and Brigham, 2015).

The activity based budgeting helps in identification and measuring the effect of the unused capacities but traditional only measures the effect but do not identify the unused activities. The main focus of the activity based budgeting is on the volume of work and cost of processes while traditional budgets focuses on the departmental cost and ignores the cost of total process. So it can be said that activity based budgeting drive a more meaningful approach to allocate the resources while traditional costing considers only the cost that occurs at departmental level ignoring work volume and other criteria. The traditional budget does not consider the economic conditions and available resources such as labour and material. On the other hand ABB takes in account the economic conditions and total available resources before making the plan to prepare the activity based budgets. Activity based budgeting make use of cost drivers to allocate the resource to each department while there is no phenomenon of using the cost driver to allocate the resources for each departments. So it can be said that there is proper ranking of business activities before making allocation. It is referred to as optimum utilization of resources. No ranking procedures have been followed while making the activity based budgets. Activity based budgeting is regarded as the most cost saving budgeting process due to its characteristics of eliminating the activities that do not perform well. In traditional budgeting, all the budgets the critically derived from the previous year budgets with some changes that indicates it shows up all the unnecessary activities but does not provide with option to eliminate them. While in activity based budgeting functions and goals of the business are analyzed before selecting the target activities and on the basis of that all those activities that does result in optimum output has been eliminated (Ward, 2012).

In preparation of activity based budgets there is major role of managers of each department while in traditional budgeting there is no role managers as top level management takes in their own decision to make allocation of resources to allocate the resources to each department. The level of clarity provided by the traditional budgets is lower than the activity based budgeting as every figure in ABB have been derived using the logic. In the today’s world budget should be such that it reflects the objectives and aims of business not the previous conditions of the business (Bromwich and Bhimani, 2011).

D: Discussion Regarding Suitability of ABB for Wesfarmers

BHP Billiton Inc, a leading mining company within Australia, can gain large benefits by adopting the use of activity-based budgeting method that helps in reduction of the operational expenses and maximize its profitability position. BHP has a complex business model at present as it is involved in production of different type of mining products and therefore the adoption of such a method of budgeting would prove to be beneficial for elimination of unwanted activities. This in turn will help in improving the revenue realized by the company to maximize the efficiency of all its operations. The use of activity-based budgeting can help the company in achieving the satisfaction of customers thus promoting its sustainable growth and development (Moustafa, 2005).

It has been cited by different specialists in the field of management accounting that ABB can help the mining companies to accurately track the volume of their activities that helps in allocation of resources required for carrying out the activities in order to attain the predetermined sales and production objectives. The implementation of the activity-based budgeting method within BHP can be done through the adoption of the following steps:

• Developing an estimate regarding the total volume of products to be manufactured based on the sales target for identifying the major factors of budget development
• This is followed by determining the activities of the company involved in production process
• The resources are then allocated o each activity for carrying out the production process
• Identifying the overall resources required for meeting the customer demands (Hicks, 2011)

The major operational process within BHP that incurs significant expenses and overhead costs and thus required to be analyzed with the use of ABB budgeting system are production and administrative processes. The analysis and segregation of the activities under each type of the production process would help in developing an estimate regarding the total value of product quantities that will be obtained and expected sales revenue to be realized. The identification of the number of activities, cost drivers and removal of unwanted activities by analysis of each of the activity involved in the production and administrative process through the use of ABB would help in gaining an accurate prediction regarding the complete cost to be incurred during the overall process (Dayananda, 2002). The use of ABC budgeting method can be done by the company to identify the major activities and type of expenses to be incurred under each of its major operational process. For example, production process can be segregated into the major activities of hewing, coal exploration, maintenance and transportation. On the other hand, administrative activities can consist of maintain accounting records, payroll, maintaining employee records, identifying performance indicators and developing fiscal records. This is followed by identification of the specific expenses that each activity will incur by developing cost driver. The allocation of their resources to each activity is carried out on the basis of cost driver to gain an accurate estimate of the overall cost to be incurred by a company in its operational process in the future (Moustafa, 2005).

The method of ABB helps in achieving relevant results for the overall cost by developing a relation between the volume of product and services manufactured and resources consumed. Thus, it can be said that can prove to be a useful technique for the company to carry out financial planning and budget reporting. The use of this approach can help the management accountants in collection of realistic data regarding the expenses to be incurred by initiating reduction of costs and thus refining the cost structure of the company. The accurate determination of the cost of each business activity identified in the overall production process can help the company to gain an estimate regarding the volume of products manufactured and thus determination of whether they are sufficient in meeting customer demand. Thus, it helps in achieving customer’s satisfaction by meeting the customer demand effectively. Also, the elimination of the differences between the planned costs and the cost incurred will help further the management to identify the areas of discrepancies. The resource consumed by each activity can help in taking effective decision by the management to transfer the extra resource of a product having deficiency in the resource allocation (Moustafa, 2005).

Thus, it can be said that the method of ABB budgeting helps the management accountant in analyzing the trends of the cost data. This helps them to take accurate strategic decision regarding the future growth and development of the company. The method helps the accountants to gain realistic information regarding the cost objects and the required level of resources consumed that helps developing an accurate forecast regarding the current and cost and the resources required by the company (Bromwich and Bhimani, 2011). The major advantage of ABB method to be realized by the company can thus be stated as follows:

• It helps in gaining an emphasis on the cost consumed by the overhead activities that constitutes a large proportion of the overall operating costs
• It recognize the activities that drive the cost and thus identification of cost driver would eventually help n their better management and control by developing their in-depth analysis
• It can prove to be highly useful for the company for achieving quality management by matching the cost of each activity to the level of resource consumed and thus determining the issues in quality

However, the company also needs to consider the potential issues that can negatively impact the adoption of ABB method on its profitability position. The major aspect that needs to be considered in this respect is incurring a significant amount of time for identifying the key activities and the associated cost drivers. This can cause a shift in the operational focus of the company that can lead to a decline in the volume of product or services manufactured. Also, the mining companies involving different type of overhead expenses that are not under the control and thereby vary with the changes in the volume of activity. In addition to this, it will result in incurring huge cost by the company for identification of each type of operational activity and developing their in-depth analysis. On the basis of overall analysis, it is recommended hat BHP should adopt the use of ABBB for better management of its cost structure but should take proactive steps for reducing its drawbacks in order to release maximum benefits from its implementation (Tatikonda and Tatikonda, 2001).

Conclusion

On the basis of evaluation it has been found that ABB method preparing budgets proves to very successful in mining industries as it can be easily implemented in BHP Billiton. There are numerous examples of where it is proved that activity based budgeting is much successful over the traditional budgeting approach.

References

BHP: About us. 2018. [Online]. Available at: https://www.bhp.com/ [Accessed on: 26 September, 2018].

BPP Learning Media. 2012. ACCA Paper P5 - Advanced Performance Management Practice and revision kit.BPP Learning Media.

Bromwich, M. and Bhimani, A., 2011. Management accounting: Pathways to progress. Cima publishing.

Capsuneanu, S. 2013. Implementation of Activity-Based Budgeting method in the economic entities from mining industry of Romania.International Journal of Academic Research in Accounting, Finance and Management Sciences 3 (1), pp. 26–34.

Cokins. 2004. Activity-Based Cost Management:Making It Work. Tata McGraw-Hill Education.

Dayananda, D. 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press.

Hansen, D. 2007. Cost Management: Accounting and Control.Cengage Learning.

Hicks, D. 2011.Activity-Based Costing: Making It Work for Small and Mid-Sized Companies. Willey.

Horngren, C.T., 2009. Cost accounting: A managerial emphasis. Pearson Education.

Moustafa, E.2005. An Application of Activity-Based-Budgeting in Shared Service Departments and Its Perceived Benefits and Barriers under Low-IT Environment Conditions. Journal of Economic & Administrative Sciences 21(1), pp. 42 -72.

Tatikonda, L.U and Tatikonda, R.J. 2001.Activity-Based Costing For Higher Education Institutions.Management Accounting Quarterly 2 (2), pp. 19-27.

Ward, K., 2012. Strategic management accounting.Routledge.

Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.