Activity based budgeting and setting of standards

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Activity based budgeting and setting of standards

Activity based budgeting and setting of standards

Soon after Nick had the budget discussion with Sue, he invited her over for a cup of coffee.  While sipping the coffee he mentioned to Sue:

“It is not only the budgeting process that needs fixing, I am concerned about the process for cost control”.  We follow the traditional method of variance analysis of direct material, direct labour and overhead.   However, I would question the initial standards that were set so long ago based on labour intensive manufacturing departments. Each time we introduce a new product the manufacturing division sets the standards for direct material price and usage, direct labour rate and efficiency and overheads.  I believe direct labour variances are no longer relevant as we have fully automated systems for at least 75% of the production process.  This has caused fluctuations in the overhead variances.  Further, we produce a mix of standard products and made to order products for customers, this makes traditional cost control systems in place irrelevant.  Take the example of flexible medical device packaging.   Our expertise and product line breadth will provide the customer with the most cost-effective packaging solution to protect and maintain the sterility of their device until the moment the package is opened.  From packaging design through to validation, we offer a range of value-added services to supplement customers’ in-house resources and reduce the time to market.  Equipped with the broadest technology base in the industry, we customise packaging solutions to individual requirements for package configuration, performance, processing, opening features, and sterilisation.  Pouches and bags, form fill seal packaging, flow wrap films and fluids wrapping are some of the items we produce as sterilised packaging.  As you can see there is a significant component of overheads in manufacturing and delivering these sterilised packaging.”    

Sue replied to Nick saying:

“It seems that you may have an out-dated cost control system in place, have you thought of introducing Activity Based Budgeting based on Activity Based Costing? This may suit your circumstances more than the existing conventional cost control system”.  

Nick was interested in Sue’s suggestion.  He wanted to know more about the Activity Based Budgeting and asked Sue to explain the nuts and bolts of the Activity Based Budget.  Sue explained to Nick how the methodology would suit a situation where there are significant proportion of overhead costs and multiple cost drivers.  She said to Nick:

“By implementing Activity Based Budgeting, you can compare standard costs with actual performance and extract variances for cost control.”  

She gave an example of the Activity Based Budget to Nick.

Discussion questions

Q3 In the budgeting topic you have learnt that participation of managers in the budget setting process has both advantages and disadvantages. Do you think the same issue is relevant to the setting of standards? Explain, with examples, using AMCOR scenario.