The Traditional Cost Management System - Case Study Example

Traditional Budgetary Tool Introduction Over the recent years, the capital markets have been characterized with heightened calls for the abolishment of the traditional budgetary system. Critics of the system have continued to highlight on the profound limitation of the classical cost management systems that are claimed to be ineffective in the current market dynamics. The prime objective of this essay is to critically evaluate and compare traditional cost management systems and their budgetary model versus emergent approaches to cost management. The discussions will first highlight on the traditional cost management system and their budgetary model. The second section will provide compressive analysis of the current budgeting process and the budgetary tools employed in the traditional budgeting system. In addition, the discussion will expound on the advantages and disadvantages of the identified budgetary model. Subsequently, the essay will examine the relevancy of the traditional budgetary system in the 21st century. The essay will conclude with the evaluation of the ABC systems. Cost Management System According to Garrison and Eric (1999), cost management system (CMS )consists of a set of formal methods formulated for planning and controlling of cost-managing activities of an organization with regards to the short term and long term strategies. Hicks, (2002) noted that CMS serves the following purposes, exploitation of opportunities and fending off of threats through the management of core competence and the linkage of plans and strategies of an organization. Vis a vis, goals of CMS include development of appropriate product costs, evaluation of the life cycle of products and services, control of costs, performance measurement and enhancement of organizational strategies. According to Karolefski (2004), unprecedented dynamics in the capital markets have resulted to two cost management systems; these are mainly traditional cost managements and new approaches to cost management system. Traditional Cost Management System According to Cokins (1998), the traditional cost management system is defined by its assignment of manufacturing overheads based on the subsequent volume of cost drivers. The traditional CMS, therefore, assigns the organizations indirect costs to the items being produced based on the number of items being manufactured, direct labor hours and production machine hours. In the traditional CMS, the management assumes that the manufacturing overhead cost is underlined by the volume metric of the prime cost drivers. In addition, Bourne (2005) noted that the traditional CMS were developed at a period when the direct material and direct labor were key components of the manufacturing costs. According to CIMA (2004), the cost allocation process of the traditional CMS is in form of three stages, accumulation of costs within the production or non-production departments, allocation of costs of non-production department to the production department and the subsequent allocation of the revised production department costs to the products and services of the organization. Dugdale and Lyne (2006) noted that the respective cost determined by the traditional CMS had inherent defects such as the charging for resources that were never utilized in the production process through the assigning the cost of idle capacity to goods and services. Increased criticisms from managerial accountants have identified profound limitations relating to the traditional CMS cost allocation process. The critics argue that the costing system in the job order production demands excessive tracking of costs to individual jobs within an institution. Similarly, the overhead apportionment rates have be criticized to be too broad while variable driven costs are still being apportioned to products and services by use of volume-based rates that should not apply. Additionally, the apportionment rates have been founded on productive resources that are considered to be operating at same level of performance intensity. Furthermore, the costing system fails to incorporate costs associated with product related activities that are without the main manufacturing centers such as research and development, marketing and distribution. As results of these limitations, key players in the capital market believe that the traditional CMS have become irrelevant to accounting management practices. New Approaches to Cost Management System In light of the identified weakness in the traditional CMS, there emerged a new approaches to CMS that would adequately address CMS issues relating to lack of relevance, reduction of costs, inflexibility, conflict with lean production concepts and the inaccurate links to financial accounts (Horngren, 2000). Gurton (1999) therefore, noted that the alternative approaches to CMS should be characterized with multi-dimensional focus on cost related objects such as processes, functions, people, products, customers, and services. The strategic CMS should also focus more on cost planning and control as opposed to tracking and reporting of costs. In addition, emergent systems should underpin the decision-making process that relate to investment decisions, pricing, product elimination and the introduction of products. Activity-based costing (ABC) CMS has been identified by Marginson and Ogden (2005), as the most appropriate alternative CMS that best upholds the concepts and objectives of the strategic management practices. According to Cooper and Gould (2004), ABC is a two-stage approach that allocates indirect costs products on the basis of cost drivers at various levels. The system hence identifies activities as the primary cost objects. ABC employs the costs of the activities as the foundation of building costs of related cost objects. The first stage entails the assignment of resource costs to the identified activities being performed in the organization. According to Pineno (2009) resource costs include costs of labor, equipments and power. Subsequently, in the second stage, the activity costs are allocated to cost object such as setting up of machines, material handling and quality control and inspection. Unlike the traditional CMS, in the ABC, the allocation of costs to activities is primarily based on the consumption of resources that have been utilized. Daly (2001) added that alternative approaches to cost management system include lean cost management, theory of constraint (TOC), balance score card and target costing. Lean cost management refers to an emergent approach to financial evaluation that makes wastes and the related costs visible and hence facilitating their mitigation when identified. On the other hand, TOC uses the constraint management cycle (CMC) concept to identifying organizational constraints and their respective elevation. The balance scorecard encompasses a myriad of management accounting tools being employed either independently or in concurrently. These include panning and budgeting tools, decision support tools, product costing analysis mechanism, and performance evaluation tools (Brimson, 1997). Budgeting Pilkington and Crowther (2000), defined a budget as financial plans that provide the framework for directing and assessing the performance of individuals or sections of an organization. The budget is hence inherently defined by planning, measurability and time aspects. The planning aspect underscores the organization’s statement of intent or strategic goals. The identified organizational plan should further be measured within the stipulated duration for the budget. Leitch (2004) further noted that budgeting entails the formulation of entrepreneurial goals, establishment of financial blueprints, subsequent selection of the actions aimed at achieving the objectives and initiation of undertakings that would optimize organization’s plans. According to Cokins (1998), organization’s budget enhances the business growth and competitive advantage through the coordination, planning, control, and management of finance of the firm’s key activities. To further this, Wallander (1999) noted that corporate budgets served three principle purposes. These include the coordination of organization’s financial undertakings, internal and external communication of organization’s financial expectations and motivation of firm’s managers to pursue the interests of the company. The increased consideration of budgeting as process has led to the emergence of two approaches to the corporate budgeting process, the traditional budgeting approach and alternative budgeting methods (CIMA, 2004). According to Weiss and Hartle, (1997), the traditional budgeting approach uses an incremental approach whereby the subsequent budget is based on the previous budget. The management thus adjusts the present corporate budget by either increasing or lower the allocation of previous expenditures based on the nature of performance desired. On the other hand, alternative approaches to budgeting focus on addressing the limitations identified in the incremental concept of traditional budgeting approach. One of the widely used alternative budgeting method is the zero-based budgeting. According to zero budgeting approach, no budgetary line should be transferred from one period to the following budget. Zero budget approach facilitates optimization of resources allocation by mandating managers to justify activities within their respective departments for budgetary allocation of resources. Vis a vis, the new approach assigns resources on the basis of business justification for every activity being undertaken by an organization. Traditional Budgeting Tool Incremental Budgeting Against the widespread debate on its limitations in the current capital markets, incremental budgeting method presents profound advantages. According to Cokins (1998) unlike alternative methods of budgeting, the incremental approach is easy to prepare hence consumes less time. Similarly, the process is easy to understand and hence junior staff can be allocated to undertake it. Due to the consistency approach throughout an organization, the method highly discourages conflicts between departmental managers. In addition, the effect of budgetary changes within an incremental budgetary method are rapidly recognized (Hicks, 2002). However, the incremental budgetary method presents significant drawbacks that deems it inappropriate in the present capital market dynamics. The budget encourages rigid planning that lack flexibility. Unlike the zero based method, the incremental method encourages underperformance since employees only strive to meet the lowest targets as opposed optimization of resources. The method further promotes wastage of resources when managers intentionally spend budgetary funds to meet the set deadlines. The approach also majorly focuses on the short-term financial performance thereby neglecting the chief drivers of shareholders values. The approach has further been criticized for being back looking, as a result, focusing on past budgets instead of future strategies. Additionally, the entire process is underscored by data that are no longer relevant or consistent with latest priorities of the organization. Similarly, due to its rigidity, incremental method results to corporate budget that is rather reactive as opposed to being proactive. Furthermore, the usage of the previous budget as its base erroneously assumes that the previous budget elements are relevant and satisfactory with the prevailing market dynamics. The Relevance of the Traditional Budgeting Model in the 21st Century Organizations in the 21st century have predominantly adopted strategic management models that underpin the lean production and management systems. On the contrary, the traditional budgeting model has been associated with increased utilization of time and resources. According to Garrison and Eric (1999) lean management, refers to management approach that focuses on the continuous improvement and enhancement of efficiency through long term strategies that result to incremental changes. Otley, (2001) noted that that time managers and controllers of budget consume extensive time preparing corporate budget. Studies by Horngren et al (1999) noted that organizations spend over 25, 000 person days while planning and undertaking performance management activities per $ 1 billion turnover. Despite the advent modern analytical software for management accounting, Hicks, (2002) noted that it still takes 12.9 weeks to sanction the budget while 91 % of the respondents indicated that their budget went off track during the year. Cooper and Gould (2004) further added that the incremental budgeting model entails numerous repetitive steps that entail the participation of managers at every level. Studies indicated that the process consumes 20 -30 % of the time of executive managers. The depletion of corporate resources and time consumption results to reduced organizational performance. The continual disparity between principles of traditional budgeting models and the aspects of lean production and management system deeply demonstrate the irrelevancy of the model in the capital market of the 21st century. Information in the 21st century has been transformed into pertinent organizational resources through the integration of information technology. On the other hand, the decision-making process has been founded on the availability, accuracy and relevance of information that guides the formulation of corporate strategies. According to writings by Weiss and Hartle (1997) traditional budgets provide outdated information that may not be deemed effective in the decision-making process. Heightened competition and advancement in communication technologies dictates that the current budgetary approaches provide agility that could aid in the future forecast of financial position of organizations. Organizations in the 21st century, therefore, should promptly react to capital market dynamics due to rapidly changing regulations, budding competition, emergent competition and unprecedented economic dynamics. However, incremental budgets provide outdated information due to their annual cycle. It hence imperative that organizations implement budgetary tool that would enhance agility in responding to constantly evolving business environment. Bourne (2005) further noted that traditional budgeting approach was out of sync with the 21st century due to its limitation of organizational change. Traditional budgets are broadly focused on cost reduction as opposed to developing new talents, promoting innovativeness and creativity. Success organizations in the 21st century have been predominantly defined with transformational leadership structures that have been built on value creation thus impacting competitive advantage and organizational developments. Additionally, 21st century has been marked with the proliferation of intellectual assets that roughly account for 80-90 % of the market capitalization. Sadly, the traditional budgeting approach offers limited tools that could account for these assets. Subsequently, these organizations are faced with the challenge of formulating strategic management policies that have been built on the intellectual assets. Activity Based Costing (ABC )and Balance Scorecard Paraajepa et al., (2006). defined ABC as an emergent approach to costing and monitoring of activities that entails tracking of resources consumption and costing of the final outputs. Resources are, therefore, allocated to activities and the activities assigned to cost objects based on the identified consumption estimates. The ABC, thus, first accumulates the overheads of every organizational activity. The next stage encompasses the assignment of the identified costs of the activities to products and services that are causing the activity. The first stage of the ABC is hence known as the activity analysis. Here, the process identifies the best output measures of activities cost drivers their implications on the costs of manufacturing a product or delivering services (Cokins, 1998). The entire process is underpinned by its accumulation of costs through activities as opposed to cost accumulation through functional areas in the case of traditional budgeting approach. According to Pienaar and Penzhom (2000), balance score refers to a strategic management system that facilitates the alignment business activities to corporate strategy and further monitors the performance of the strategic goals within a given duration. vis a vis, the BSC provides an elaborate performance measuring system for the financial aspect of ABC. The BSC provides a frame work for organizational evaluation of the costing system from a multifaceted perspective that highlights on the financial; customer; learning and innovation, and internal business perspectives. Vis a vis, BSC facilitates the identification of financial and non financial activities and subsequent assignment of targets that evaluates performance of the activities against set objectives. Vis a vis, the BSC serves as a tool for the integration of sustainable mechanisms such as ABC into corporate strategy and embedment of the ABC framework throughout the company. Traditional Budgeting System and Alternative Budgeting System Application by Companies The alternative forms of budgeting approaches have been widely implemented by state governments of united state. According to Lindahl (1997), the state of Arizona utilizes a performance-based budgetary system that integrates strategic planning, program evaluation and performance measurement systems. The program authorization review (PAR), agencies are mandated to provide one-page report overview for its performance projections for the upcoming fiscal year with a regular budget request. Similarly, the state of Oregon also operates a performance based budget. Oregon states utilize Oregon bench marks to evaluate the performance of key agencies in the state. According to a study by Obiajulum And Njilefack, (2008), the Guinness Nigeria plc employs the incremental budgetary method by basing its current budget specific on the previous budget. Obiajulum and Njilefack (2008), noted that the allocation of resources in the company was based on volume of production, comparison of actual costs against planned and measures to correct costs divergences. The core objective of management is thus to keep minimum costs while sustaining the working capital. Vis a vis, the identified characteristics of the company resonates with the aspects of traditional budgetary approach. References 1) Brimson, A. (1997). Activity Accounting: An Activity-Based Costing Approach.New York: Wiley. 2) Cokins, G. (1998). ABC Can Spell a Simpler, Coherent View of Costs. Computing Canada.24, no. 32: 34-35. 3) Cokins, G (1998). Why Is Traditional Accounting Failing Managers?Hospital Material Management Quarterly. 20, no. 2(): 72–80. 4) Daly, J (2001). Pricing for Profitability: Activity-Based Pricing for Competitive Advantage. New York: Wiley,. 5) Garrison, R., and Eric W (1999). Managerial Accounting. 9th ed. Boston: Irwin McGraw- Hill,. 6) Hicks, D. T (2002). Activity-Based Costing: Making It Work for Small and Mid-Sized Companies.2nd ed. New York: Wiley, 7) Horngren, C. T., Gary L. Sundem, and William O. S. (1999). Introduction to Management Accounting.11th ed. Upper Saddle River, NJ: Prentice Hall,. 8) Karolefski, J (2004). Time Is Money: How Much Are Your Customers Costing You? Food Logistics. 9) Lindahl, F W (1997). “Activity-Based Costing Implementation and Adaptation.”Human Resource Planning20, no. 2. 10) Bourne, M. ( 2005) . New Year, new planning and budgeting system. CIMA Insight. 11) Cooper, T. and Gould, S. (2004). Can we all go beyond budgeting?CIMA Insight. 12) Dugdale, D. and Lyne, S. (2006) Budgeting. Financial management, 32-36. 13) Hope, J. and Fraser, R. ( 2001) Figures of hate. Financial management, 22-25. 14) Leitch, M. ( 2004) Beyond budgeting should be more adaptable, says research. CIMA Insight. 15) Marginson, D. and Ogden, S. (2005) Budgeting and innovation. Financial management, 29-31. 16) Pilkington, M. and Crowther, (March 2007) D. Budgeting and control. Financial management, 29-30. 17) CIMA (2004). Better budgeting. CIMA Technical Report. London: CIMA/ICAEW 18) Horngren, C. T (2000). Cost accounting: A management emphasis. New Jersey, Prentice Hall, . 19) Gurton, A (1999). Bye-bye budget - the annual budget is dead. Accountancy, 60-70, 1999. 20) Otley, D. (2001) Extendingthe boundariesof management accountingresearch,BritishAccountingReview,33,(2001).24 3-261. 21) Paraajepa, B., Rossiter, M., and Pantano, V (2006). Insights from the balanced scorecard performance measurement system: Successes, failures and future – a review’’. Measuring Business Excellence, 10.3, 4-14. 22) Pienaar, H. and Penzhom, C (2000) Using the balanced scorecard to facilitate strategic management at an academic information service. Library, 50, 202-209, 23) Pineno, C. J (2009). The budgeting process: A realistic approach including activity-based costing and model for a non-profit organisation. ASBBS E-Journal, 5, 1, 10-18,. 24) Wallander, J (1999). Budgeting – An unnecessary evil. Scandinavian Journal of Management, 15: 402-421,. 25) Weiss, T. B. and Hartle, F (1997). Reengineering performance management: Breakthroughs in achieving strategy through people. Boca Raton: Lucie Press. 26) Obiajulum, M. And Njilefack, L. (2008). Budgetary And Management Control Process In A Manufacturing:Case Of Guinness Nigerian Plc. Read More