Accounting essay help study on: Budgeting adopted in United Consultancy

Introduction

United Consultancy is a company specializing in providing consultancy services to theF&B industry. The recent operating period 2 for the company saw an increase in the profit from the budgeted profit. Hence in the following report we analyse the pros and cons of the current budgeting techniques and suggested some other techniques.A.    1 Explains the present approach to budgeting adopted in United Consultancy and critically evaluate the advantages and disadvantages of involving consultants in the preparation of future budgets

 Marginal and Absorption costing are methods generally used for preparing profit statements, value inventory and assist in pricing decision.

These two methods can be further explained as follows:

Absorption Costing absorbs all manufacturing/production costs into inventory valuation. These costs include direct material, direct labor, direct expenses, variable production overheads, as well as fixed production overheads.

Hoare (n.d, p.1) states that Absorption costing principles must be used when preparing financial statements for external purposes. One of the key principles of absorption costing is that inventory and units produced must include a share of all production costs, both fixed and variable, incurred in getting them to their present condition.Absorption costing allows companies to clearly and completely show information about their financial condition. It also allows companies to price more accurately, ensuring that the final price of a product or service takes into account the actual costs that went into them. This is particularly useful for small businesses which need to give more consideration to overhead expenses.Absorption costing is also known as full costing or full absorption costing, and it is used in a variety of ways by companies which wish to create a complete picture of their financial situation, including in the calculation of taxes and sales reports.Data taken from absorption costing shows the entire picture, together with fixed costs, so does not conveniently provide this information.

One way in which absorption costing can be helpful is when a company wants to make sure that a retail price accurately reflects the costs involved in the production of a good. This can be especially critical with small companies which lack financial reserves, and therefore cannot afford to take a loss or to sell products without accounting for overhead. For example, agarment manufacturer might think not just about the cost of wool and labor for making a sweater, but also the costs of knitting machines, the factory where the machines are installed, the cost of running the machines, insurance, and other types of overhead costs. (wisegeek,n.d.)

On the contrary, Marginal Costing absorbs only variable manufacturing/production costs into inventory.Marginal costing is a special technique of analysis and presentation of costs, which helps themanagement in decision-making. This technique enables the management to understand the effectof a change in a volume of output on costs and profit. Its importance lies in solving the managerialproblems.

Marginal costing is not an independent system of costing similar to process costing, operatingcosting or Job costing. In marginal costing, the cost of a unit comprises only variable costs. Fixedcosts are treated as period costs and written off to costing Profit & Loss Account. Consequently,finished goods and work in progress are valued at marginal cost i.e. Prime cost plus variableoverheads. (Narotama, 2011, p454)

Under Marginal Costing Procedure, costs are separated into fixed and variable costcomponents. Fixed costs and variable costs are differentiated. Fixed costs are treated as periodcosts, regardless of the volume of output. Fixed costs are charged, directly, to Profit and LossAccount. Variable costs are treated as the cost of product. With change in the volume of output,the effect on profits is studied.Only variable costs are treated as cost of manufacture of the product, underMarginal Costing.

Main Features Of Marginal Costing: Costs are divided into two categories, i.e., fixed costs and variable costs.

1.  Fixed cost is considered as period cost, not considered for determination of product cost and valuation of inventories.
2.  Prices are determined, with reference to marginal cost and contribution required.
3.  Profitability of departments and products is determined, with reference to theircontribution.
4.  Closing stock is valued on the basis of variable costs only.
5. In presentation of cost data, display of contribution assumes dominant role.

The accounting approach can affect the pattern of calculated profits; influence employee behavior, and provide management with relevant and useful information for planning and control purposes.

Some Salient Features of Absorption Costing are (Rajasekaran, 2011, p.686):

1. Fixed as well as variable costs are allotted to cost units and total overheads are absorbed according to the activity level.
2. Absorption costing aims at linking all costs to production.
3. Absorption costing allocates costs to the finished products.
4. In Absorption costing for variable costs, the proportionate allocation for inventories passing through various stages of production may be accurately made.
5. But for fixed costs, the allocation of costs that is, transfer of fixed costs from one period to another, cannot be accurately made.
6. Administration, selling and distribution expenses are treated as period costs and are not allotted to cost units.
7. Under absorption costing, not only fixed overhead but also direct material, direct labour, direct expenses and variable factory overhead are treated as the product cost.
8. Absorption costing may also be designed as the job order or process cost for which the actual or standard costs are utilized.

The reason why we have used Absorption costing is because of the following advantages:

1. Absorption Costing gives attention to both fixed and variable costs; that is, all production costs are considered regardless of whether they are variable or fixed. And, this is very important when it comes to pricing decisions since the manufacturer can have a clear picture of the profit margin to be made on each sale, as all costs would have been incorporated into the product cost.

1. Absorption costing provides realistic periodic profits if company has a natural business cycle; profits are realistic in the sense that all production costs are matched to sales volume, rather than production volume as under Marginal Costing.

1. It is consistent with external reporting requirements; in fact, International Accounting Standard Board recommends the use of absorption costing method over marginal costing, which is considered more useful for internal reporting.

1. The absorption costing method shows less fluctuation in net profits in case of constant production but fluctuating sales.

The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions. Absorption costing information may not always provide the best signals about how to price a product, reach conclusions about discontinuing a product, and so forth.

Some more Disadvantages of absorption costing are as follows:

1. As explained in the advantages for manufacturers this approach is beneficial but For a consultancy charges are generally based on hourly basis, so taking into consideration the variable cost incurred in consultancy services viz., salary of consultant, travelling charges and Marginal costing would be much better.
2. Absorption costing is generally preferred for internal reporting but when it comes to actual reporting Marginal costing is preferred.
3. It is not a good method for evaluation of new projects because the fixed cost is the sum cost that is already been considered and in order to evaluate new projects we should consider the next present value of the marginal cash flows only.

A 2. Critically discusses the format of the operating statement for period 2

                                                                                    Budget           Actual             Variance

Chargeable consultancy hours                            2,400             2,500              100

$                      $          $

Administration staff salaries – fixed                     15,000            15,750            750

Consultants’ salaries – fixed                                 80,000            84,000            4,000

Casual wages – variable                                        960     600     360

Motor and travel costs – fixed                                4,400 4,400 –

Telephone – fixed                                                    600     800     200

Telephone – variable                                              2,000 2,150 150

Printing, postage & stationery – variable                         2,640 2,590 50

Premises and equipment costs – fixed                3,200 3,580 380

­­­­­­­­­­                                                                                ————-      ————–       ———–

Total costs                                                     110,400 116,480      6,080

Fees charged                                               180,000 200,000 20,000

                                                                         ————–     ————–       ———–

Profit                                                                           69,600            83,520            13,920

As per the current accounting statement (above), the following may be the reasons for the variances observed in the operating statement as compared to the earlier budgeted figures:

1. Budgeted Chargeable consultancy hours have seen a rise of approx 4% from 2400 to 2500 which can be attributed to increased workload or new projects. This has helped ease our bottom-line as the revenue have exceeded the expectations and a better future budgeting standard will help in better managing therevenue through better resource utilization.
2. Administration staff salaries have also raised by 5% from budgeted $15000 to $15750. This also has a negative impact on bottom line.
3. Consultant salaries have also seen a rise of 5% from $80000 to $84000 majorly due to rise in Chargeable consultancy hours.
4. Casual wages have also seen a decline of 39% from budgeted $960 to $600 which will have a positive effect on bottom-line though such a large variance is not a
5. Motor and Travel costs have seen no variance.
6. Telephone-fixed was budgeted as $600 but there was a 33% increase at the time of actual reporting.
7. Telephone-variable also saw an increase of 7.5% from budgeted $2000 to $2150.
8. Printing, postage, stationary & premises and equipment costs also saw an upward variance.

The final profit saw an upward variance of 20% which majorly was due to 18% increase in actual fees charged as compared to the budgeted Fees charges. This can be attributed to better consultancy hours expenditure.

1. B.     Explain how a spreadsheet could be set up so that a flexed budget and variance calculations could be rapidly produced by inserting only the actual data, assuming that variable costs are thought to vary in line with chargeable consultancy hours.

We have created a spreadsheet separating current capacity and increased capacity. The two different costs i.e. Variable and Fixed have been separated for the ease of use. Attached is the spreadsheet which is reusable as per the requirements of the company.

1. C.    Critically discuss the suitability of Zero-Based Budgeting for United Consultancy. Your discussion must clearly explain the advantages and disadvantages of Zero-Based Budgeting and supported by the real-world examples.

Government budgeting was established in Great Britain in the late 17th century. The enactment of the 1689 Bill of Rights gave taxing authority to Parliament as opposed to the King. Parliament gradually established spending programs and by the 1820s published detailed annual financial statements showing revenues and expenditures and a projected surplus or deficit. The usage of budgets by the United States government did not begin until 1800 when a law was passed for the Secretary of the Treasury to submit an annual financial report to Congress. This action was not taken by the Treasury department, and instead, federal government agencies developed their own reports and submitted them to the Treasury.Early business budgets focused on controlling costs and little emphasis on measuring effectiveness. In the early 1900s, the use of budgets increased due to the necessity for industries to implement more careful factory planning. A systematic plan of budgeting arose from two areas: industrial engineering and cost accounting. Scientific methods were used by industrial engineers to arrive at production standards, which could then be used to estimate future operations and performance standards. Cost accountants used budgeting to establish standard costs and to estimate future expected costs in a budgetary form. Also at this time, texts on budgeting and managerial accounting began to emerge.

As zero-based budgeting gained traction in the 1970s among public budgeting constituents, it also gained popularity among private enterprises, and during this time a number of organizations modified and implemented the system.

Zero Based budgeting requires starting from the scratch. It is an approach which requires cost benefit analysis & for a consultancy firm it is of prime importance to have costs in relation to the benefits as if the benefit is not in line with the expected rate of cost then a manger can decide to take an alternative approach.(Accountingtools, n.d.)

As explained later in this assignment one of the major advantages of Zero Based budgeting is its alternative approach advantage i.e. it provides the managers to take an alternative approach in case of another optimum approach availability.

Also as we have seen the large variance in the current budgeting method of absorption costing there is a high probability that in future this could put a negative impact on the bottom-line of the company if variance moves in downward direction. Going ahead we will try and understand the Zero Based Budgeting by looking at its advantages and disadvantages.

Zero budgeting is a method in which all expenses must be justified for each new period, rather than the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. A zero-based budgeting start from a “zero base” and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one.(Investopedia 2012)

It allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization, where costs can be first grouped, then measured against previous results and current expectations.

In reality, a manager is assumed to have a minimum amount of funding for basic departmental operations, above which additional funding must be justified. The intent of the process is to continually refocus funding on key business objectives, and terminate or scale back any activities no longer related to those objectives.

The basic process flow of ZBB is as follows (Accountingtools, n.d.) :Identification of business objectives.

1. Creation of alternative methods for accomplishing each objective.
2. Evaluation of alternative methods for accomplishing each objective.
3. On the basis of planned performance levels evaluate alternative funding levels.
4. Setting up of priorities as per the requirements.

Some of the unique characteristics of Zero Based Budgeting Model are:

1. Zero Based Budgeting requires us to justify and prioritize all activities before allocating any resources. i.e all the resources are prioritized as per the requirements before the allocation is done.
2. All the business forecasts should start from a zero base by justifying allexpense requests in complete detail. Whether the total forecast is increasing or decreasing , The zero base is indifferent to the same.
3. All relevant activities need to be grouped into decision packages. We need to justify each in terms of the company’s overall business objectives.
4. ZBB requires us to rank Packages in order of priority.
5. ZBB reverses the working process of the traditional forecasting methods we may have been accustomed to, In other word, it is a technique that helps to enhance good planning and decision-making for our business.
6. In the traditional incremental approach, a manager needs to only justify increases over the previous year’s projections. This means, what has been already spent is automatically sanctioned. In the case of ZBB, you do not make reference to the previous levels of expenditure. You must review every business function comprehensively and all associated expenditures rather than approving only increases.

The term “Zero-Based Budgeting” is sometimes used in personal finance to describe the practice of planning for every dollar of income that we receive, and then adjusting some part of our plan downward for every other part that we may need to adjust upward.

The paring back expenses in layers concept can also be used in reverse, where we delineate the specific costs and capital investment that will be incurred if we add an additional service or function. Thus, management can make discrete determinations of the exact combination of incremental cost and service for their business. This process will typically result in at least a minimum service level, which establishes a cost baseline below which it is impossible for a business to go, along with various gradations of service above the minimum.

Advantages of Zero Based Budgeting:Results in efficient allocation of resources as it is based on needs and benefits

1. Zero-base budgeting requires to identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business
2. Helps in negating or spotting Budget inflation by managers. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot
3. ZBB helps in Detecting inflated forecasts
4. It helps in better communication channel being set up between the management as zero-base budget generally sparks a significant debate among the management team about the corporate mission and how it is to be achieved
5. It helps in goal clarity
6. Elimination of non-key activities as zero-base budget review forces managers to decide which activities are most critical to the company. By doing so, they can target non-key activities for elimination or outsourcing.
7. ZBB helps in increasing focus as the zero-base budgeting concept requires managers to link expenditures to activities, which in turn forces them to define the various missions of their departments – which might otherwise be poorly defined.
8. Identification and elimination of redundancy can be expedited as the review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where management wants it to be centred
9. Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically
10. ZBB helps in better and efficient resource allocation as the process is conducted with the overall corporate mission and objectives in mind that an organization should end up with strong targeting of funds in those areas where they are most needed.
11. Identifies and eliminates wastage and obsolete operations.
12. Identifies opportunities for outsourcing.

As we can see from the above advantages that ZBB is more inward looking. It has a strong, introspective look at the mission of a business and exactly how the business is allocating its resources in order to achieve that mission.

Disadvantages of Zero-Base Budgeting:

Like every other budgeting method Zero Based Budgeting too has its share of disadvantages. As we have looked at various advantages of ZBB in detail let’s look at the various disadvantages of ZBB.

1. The biggest disadvantage of zero-base budgeting is the exceptionally high level of effort required to investigate and document department activities; this is a difficult task even once a year, which causes some entities to only use the procedure once every few years, or when there are significant changes within the organization. To counter this many organizations follow the alternative of using zero-base budgeting on a rolling basis through different parts of a company over several years, so that management can deal with fewer such reviews per year.
2. As it is a cumbersome process good level of training is required by managers to make the best use of ZBB.
3. Requirement of additional staff as Creation of a zero-base budget from the ground up on a continuing basis calls for an enormous amount of analysis, meetings, and reports, all of which requires additional staff to manage the process.
4. Scope of Gamesmanship as some managers may attempt to skew their budget reports to concentrate expenditures under the most vital activities, thereby ensuring that their budgets will not be reduced.
5. It can be difficult to determine or justify expenditure levels for areas of a business that do not produce “concrete,” tangible results. For example, what is the correct amount of marketing expense, and how much should be invested in research and development activities?
6. Difficult to define decision units and decision packages, as it is very time-consuming and exhaustive.
7. It forces us to justify every detail related to expenditure. As a result activities like research and development are threatened whereas activities like production benefit.
8. Large data analysis as in large companies the amount of data and forms are very large and thus it poses a major challenge.
9. Requirement of significant amount of time to complete the ZBB is another disadvantage as compared to other budgeting techniques.

Behavioural Impact of ZBB:

There is one more important aspect of ZBB i.e. its behavioral aspect which also needs to be kept in mind.The impact of budgeting on organizations was probably first studied by Argyris in the 1950s. These studies show some of the behavioral effects resulting from the way budgets are used in organizations. The results of his research showed that the particular process used could cause dysfunctional behavior in subordinates, regardless of the degree of technical refinement of the budgetary system. In the 1970s, Hopwood’s studies inquired into the effects of budgets on human behavior. These studies showed that the use by a superior of a budget-constrained style of evaluation gave rise to significant levels of job-related tension; had adverse effects on peer and subordinate-superior relationships, and was implicated in manipulative behavior on subordinates. A long line of studies have been performed since then to uncover an array of variables that govern the effects of reliance on budgets on behavioral outcomes, including managerial performance. Examples of these variables include budgetary participation, task uncertainty, environmental uncertainty, strategy, and culture.

Zero-based budgeting may require an extensive amount of time, money, and paper work; but it does provide a systematic method of addressing an organization’s financial concerns, in turn enabling an organization to better allocate its resources. A combination of zero-based budgets with rolling budgets or some other form of budgeting that spreads the work of justifying new budgets each cycle is one way to incorporate zero-based budgeting without undo stress at the same time for all managers with budgetary responsibility.

Conclusion

As per our analysis Zero Based Budgeting model will help in better budgeting forecast. As discussed above the various advantages of Zero Based Budgeting, this technique helps in creating a more intrinsic and inward looking but at the same time having Zero Based Budgeting also has its share of disadvantages including a significant requirement of time when compared to Absorption costing.

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