MANAGEMENT CONTROL SYSTEM

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods
for allocating indirect (overhead) costs to products.
Both methods estimate overhead costs related to production and then assign
these costs to products based on a cost-driver rate. The differences are in the accuracy and
complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC,
and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more
complex and more accurate than traditional costing. This method first assigns
indirect costs to activities and then assigns the costs to products based on the products’ usage of
the activities.

Activity-based costing is an accounting method that assigns costs to products or

services based on the activities and resources that make up the overhead of
manufacturing a product or providing a service, whereas traditional methods allocate
production costs based on specific factors, such as labor, materials, marketing and
other sources of overhead. Activity-based costing is more logical and efficient for
companies making customized products because overhead costs are not spread evenly
across all products. For example, a low-volume product may necessitate minimum
machine hours as well as multiple indirect costs and a high-volume product may require
maximum machine hours with no indirect costs. If the overhead of both products is
based solely on machine-hours, as is usually the case with traditional costing methods,
then the overhead costs of the low-volume product would not be accurate, which could
result in the company suffering significant financial losses.

Meaning of Activity Based Costing (ABC)

Activity Based Costing is an accounting methodology used for assigning
accurately the extent of resources consumed and overhead costs incurred
to produce a product or service on the basis of value adding activities.
Features or Characteristics of Activity Based Costing
The features or characteristics of Activity Based Costing are briefly
explained below.

1. The total cost is divided into two types i.e. fixed cost and variable cost
which is necessary to provide quality information to design a suitable cost
system in a manufacturing concern.

2. The proper distinction is made between the cost behavior patterns.

3. The cost behavior patterns are volume related, diversity related, events
related and time related.

4. The appropriate cost driver has to be identified for tracing the overhead
to a product.

5. The cost drivers dictate the cost behavior pattern.

Advantages Of ABC
The primary advantage of the ABC accounting method is accurately determining the overhead
costs required for creating or manufacturing a product. Some other advantages of using ABC are:

Provides benefits in industries where other methods do not work

Traditional accounting methods might not work in specific industries, such as the service industry.
This is because the service industry has minimal direct costs. Even then, you can use the ABC
accounting method since you can directly apply these costs to the type of service the company
provides. It can help you improve pricing in the service industry and improve results.

Gives accurate data for profit margins

As the ABC accounting method considers the non-manufacturing and indirect costs, it can improve
a company's profit margin. When a company has accurate profit margins, it becomes easier to
make essential business decisions. It can help reduce production costs, allowing the company to
enhance their profit margin while improving its pricing strategies. Using ABC, managers can
identify products of no or little value, which helps customers remove products from inventory and
allocate resources to more profitable products. It can help in reducing wastage and channelise
resources into more productive items.

Evaluates the efficiency of productions

Companies can use the ABC accounting method to evaluate the influence of management,
efficient processes and the overall cost of different departments. Companies can use the ABC
accounting method to assign value to indirect costs, treating them as direct costs. Understanding
the indirect cost of each activity makes it easier to make improvements.

Provides insight into the distribution cost

Typically, a company uses various channels, such as retail stores, distributors and online stores.
For a company, distribution costs are overhead costs and the ABC system breaks these costs
based on the requirement of each channel. When a company has information about the distribution
cost of each channel, it becomes easier to choose the most profitable channel.

Gives details about facility costs

Using the ABC accounting method, organisations can understand the overhead cost of the
production facility. This helps managers and management understand production expenses at
different facilities. With information about facility costs, managers can select the right strategies to
help companies save money.

Helps in creating a budget

The ABC accounting method can help a company identify areas where it spends its money. When
a company creates their budget, they try to get as specific as possible about the incoming and
outgoing money in the organisation. When managers know about activities on which they might
overspend, they can search for new methods for reducing the overall cost.

Helps in product pricing

Another benefit of using ABC is ensuring accurate product pricing. Product pricing is a challenging
decision to make. Failing to account for all these costs can lower the pricing of your products. As a
result, a company might not incur the desired profit margin. ABC method helps managers assign
the cost of each activity. Using this data, managers can account for every cost a company incurs to
create or manufacture a product.

What are the Steps of Activity-Based Costing?

Activity-based costing is best explained by walking through its various steps. They are noted below.

Step 1. Identify Costs

The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in
the entire process, since we do not want to waste time with an excessively broa d project scope. For
example, if we want to determine the full cost of a distribution channel, we will identify advertising
and warehousing costs related to that channel, but will ignore research costs, since they are related to
products, not channels. Generally, the scope of an ABC project should be kept fairly narrow, to make
the project easier to manage and more cost-effective.
Step 2. Load Secondary Cost Pools

Create cost pools for those costs incurred to provide services to other parts of the company, rather
than directly supporting a company’s products or services. The contents of secondary cost pools
typically include computer services and administrative salaries, and similar costs. These costs are
later allocated to other cost pools that more directly relate to products and services. There may be
several of these secondary cost pools, depending upon the nature of the costs and how they will be
allocated. It can help to avoid a large number of cost pools, to reduce the complexity of the ABC
system.

Step 3. Load Primary Cost Pools

Create a set of cost pools for those costs more closely aligned with the production of goods or
services. It is very common to have separate cost pools for each product line, since costs tend to occur
at this level. Such costs can include research and development, advertising, procurement, and
distribution. Similarly, you might consider creating cost pools for each distribution channel, or for
each facility. If production batches are of greatly varying lengths, then consider creating cost pools at
the batch level, so that you can adequately assign costs based on batch size.

Step 4. Measure Activity Drivers

Use a data collection system to collect information about the activity drivers that are used to allocate
the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost
pools to cost objects. It can be expensive to accumulate activity driver information, so use activity
drivers for which information is already being collected, where possible. Or, if you have a choice of
activity drivers, use the one for which the associated data collection cost is the lowest.

Step 5. Allocate Costs in Secondary Pools to Primary Pools

Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.

Step 6. Charge Costs to Cost Objects

Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a
separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool
by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then
allocate the cost per unit to the cost objects, based on their use of the activity driver.
Step 7. Formulate Reports

Convert the results of the ABC system into reports for management consumption. For example, if the
system was originally designed to accumulate overhead information by geographical sales region,
then report on revenues earned in each region, all direct costs, and the overhead derived from the
ABC system. This gives management a full cost view of the results generated by each region, and
therefore of the sources of the profits that the region is generating.

Step 8. Act on the Information

The most common management reaction to an ABC report is to reduce the quantity of activity drivers
used by each cost object. Doing so should reduce the amount of overhead cost being used. In addition,
it can be useful for the controller to monitor the actions taken by management in response to ABC
reports. If management is no longer taking any action, then it may be necessary to shut down the ABC
reporting system; otherwise, the company is incurring a reporting cost without benefiting from any
actions to enhance operations.

BUDGETARY CONTROL

INTRODUCTION Budgetary control and standard costing systems are two essential tools frequently used
by business executives for the purpose of cost planning and control. In the case of budgetary control, the
entire exercise starts with the setting up of budgets or targets and ends with the taking of an action, in case
the actual figures differ with the budgetary ones.

Budgeting: It is a means of coordinating the combined intelligence of an entire organisation into a plan of
action based on past performance and governed by rational judgment of factors that will influence the
course of business in the future.

CHARACTERISTICS OF BUDGET The main characteristics of budget are as follows:

1. A budget is concerned for a definite future period.
2. A budget is a written document.
3. A budget is a detailed plan of all the economic activities of a business.
4. All the departments of a business unit co-operate for the preparation of a business budget.
5. Budget is a mean to achieve business and it is not an end in itself.
6. Budget needs to be updated, corrected and controlled every time when circumstances change.
Therefore, it is a continuous process.
7. Budget helps in planning, coordination and control.
8. Different types of budgets are prepared by industries according to business requirements.
9. A budget acts as a business barometer.
10. Budget is usually prepared in the light of past experiences.
11. Budget is a constant endeavour of the Management.
MEANING OF BUDGETARY CONTROL
“It is the system of management control and accounting in which all the operations are forecasted and
planned in advance to the extent possible and the actual results compared with the forecasted and
planned ones.

The salient features of such a system are the following:

1. Determining the objectives to be achieved, over the budget period, and the policy or
policies that might be adopted for the achievement of these ends.
2. Determining the variety of activities that should be undertaken for the achievement of
the objectives.
3. Drawing up a plan or a scheme of operation in respect of each class of activity, in physical
as well as monetary terms for the full budget period and its parts.
4. Laying out a system of comparison of actual performance by each person, section or
department with the relevant budget and determination of causes for the discrepancies, if
any.
5. Ensuring that corrective action will be taken where the plan is not being achieved and, if
that be not possible, for the revision of the plan.

PREPARATION OF BUDGETS
1. Definition of objectives: A budget being a plan for the achievement of certain operational
objectives, it is desirable that the same are defined precisely. The objectives should be
written out; the areas of control demarcated; and items of revenue and expenditure to be
covered by the budget stated. This will give a clear understanding of the plan and its scope
to all those who must cooperate to make it a success.
2. Location of the key (or budget) factor: There is usually one factor (sometimes there may
be more than one) which sets a limit to the total activity. For instance, in India today
sometimes non-availability of power does not allow production to increase in spite of heavy
demand. Similarly, lack of demand may limit production. Such a factor is known as key
factor. For proper budgeting, it must be located and estimated properly.
3. Appointment of controller: Formulation of a budget usually required whole time services
of a senior executive; he must be assisted in this work by a Budget Committee, consisting of
all the heads of department along with the Managing Director as the Chairman. The
Controller is responsible for coordinating and development of budget programmes and
preparing the manual of instruction, known as Budget manual.
4. Budget Manual: Effective budgetary planning relies on the provision of adequate
information to the individuals involved in the planning process. Many of these information
needs are contained in the budget manual. A budget manual is a collection of documents
that contains key information for those involved in the planning process.
Typical contents could include the following:
• An introductory explanation of the budgetary planning and control process, including a
statement of the budgetary objective and desired results.
• A form of organisation chart to show who is responsible for the preparation of each
functional budget and the way in which the budgets are interrelated.
• A timetable for the preparation of each budget. This will prevent the formation of a
‘bottleneck’ with the late preparation of one budget holding up the preparation of all
others.
• Copies of all forms to be completed by those responsible for preparing budgets, with
explanations concerning their completion.
• A list of the organization’s account codes, with full explanations of how to use them.
• Information concerning key assumptions to be made by managers in their budgets, for
example the rate of inflation, key exchange rates, etc.
5. Budget period: The period covered by a budget is known as budget period. There is no
general rule governing the selection of the budget period. In practice the Budget Committee
determines the length of the budget period suitable for the business. Normally, a calendar
year or a period co-terminus with the financial year is adopted. The budget period is then
sub-divided into shorter periods; it may be months or quarters or such periods as coincide
with period of trading activity.
6. Standard of activity or output: For preparing budgets for the future, past statistics
cannot be completely relied upon, for the past usually represents a combination of good
and bad factors. Therefore, though results of the past should be studied but these should
only be applied when there is a likelihood of similar conditions repeating in the future. Also,
while setting the targets for the future, it must be remembered that in a progressive
business, the achievement of a year must exceed those of earlier years. Therefore, what
was good in the past is only fair for the current year.

Behavioral Aspects in Budgeting

How the budget is administrated will affect their effectiveness and efficiency in achieving the organization’s goals.
Besides using budget to forecast the organization’s coming year’s performance, it also serves another purpose. It can
be used as a performance evaluation on the managers’ actual performance against the budgeted performance. By
doing so, the organization is trying to use budget as a tool for control. When the performance evaluation is linked
with any form of rewards and penalty system, there are possibilities that the managers will distort any information
and data passed to upper level of management (i.e. their superiors). The managers may underestimate the revenue,
over-estimate the costs required. It can have an effect on their job performance, which will be reflected on their
annual appraisals. All these will affect their salary increment, annual bonus, chances of promotion etc. The manager’s
behavior towards the budget will be influenced as the actual performance of budget will either have a favorable or
adverse effect on his job appraisal.

Below are the behavioral aspects of budgeting, which will arise:

Dysfunctional Behavior
When the budget’s goals are the same as managers’ goals, the actual performance will meet the expected level of
performance or even exceed the expectations. This is called goal congruence. It refers to the alignment and
consistency of individual’s goals (in this instance, it is the manager) with the organizations’ goals. The managers will
be motivated to aim for the goals of the organization, as this will also lead them towards their individual goals. In the
case of goal incongruence, the managers are not motivated at all. They may put in minimum efforts (in worse case
scenario, no efforts from the managers) towards the budget, thus affecting the actual performance.

In the situations whereby the budget shows unrealistic targets from the management and/ or the budget is
implemented badly, the employee may react adversely to the budget. This will cause an impact on the actual
performance. Usually it does not meet the expected level of performance, and it will affect the organization’s goals
(short term and long term) and objectives. The display of managers’ behaviors, which conflicts with the
organization’s goals and objectives, is dysfunctional behavior.

Participative Budgeting
Budget is usually prepared either top down or bottom up. Under the top down budget method, top management
prepares the budget and pass on the information to the employee as what they need to do in the budget. There is no
involvement and communication from other employee. When there is participation from the employee, they become
involved in the budgeting process. They form part of the budget. It gives them a sense of commitments and they also
foster a sense of belongings toward the budget. When they feel committed, they will be motivated aiming for the
targets. By encouraging participation from the employee, it helps to increase motivation levels and reduce resistance
level to the budget as well as reduce possible conflict within organization. It also increases employee’ initiatives,
performance level and their morale on their jobs. By allowing participation from employee, it is likely the budget’s
targets will become the employee’ goals. They contribute to the development of the budget. This type of budgeting
allows both top management and its employee to have a better understanding on each other’s roles and areas of
concerns where budget is concerned. For example, the top management will know whether the targets set is
reasonable and realistic when they hear from employee, and employee will know the dilemma the management
needs to consider when they need to make decision between two or more choices.
Budgetary Slack
The difference between the allocated resources and the actual required resources is the budgetary slack. The
managers introduce the budgetary slack, also known as padding the budget, during the budget preparation process.
They will underestimate the revenues and overestimate the costs and expenses. In this way, they can request for
more allocation of resources from the organization. There is a tendency for the managers to do in almost all
organizations, across industries. The managers will have past experiences when preparing the budget. The actual
amount of expenditure allocated to them is lesser than what they have requested for inside the budget. They will
tend to add in a mark-up percentage of what they have estimated for. In this way, even if the actual amount of
expenditure get reduced, the amount allocated to them does not differ much from what they have planned for.
Managers will also built a budgetary slack by underestimating the amount of revenue and overestimating the costs.
When the actual performance exceeds the budget performance, it appears that the managers have performed above
the expectations of budget. There is high chance that the manger has taken advantage of the budgetary slack. The
actual performance may not have been met if not for the budgetary slack. When the actual performance has a direct
link to the incentives, the manager has a higher possibility of building a budgetary slack.

Definitions:
Financial performance measurement:
Financial performance measurement is a measure of financial health of a company. These
measures are used to determine that how well a company is using its available resources in order to
generate sustainable revenues and operating income.
Non-financial performance measurement:
Non-financial performance measurement is a measure for establishment of non-financial
indicators of a business. These measures focus on the long-term success and the qualitative aspects
of a business.

Difference between financial performance measurement

and non-financial performance measurement:
The main points of difference between financial performance measurement and non-financial
performance measurement are given below:

1. Primary Focus:
Financial performance measurement usually concentrate attention on the short-term success
factors of a business. The primary focus of these measures are the revenues, profits and cash flows
of the company. Whereas, non-financial performance measurement indicates deficiencies in those
areas of business that can affect the long-term strategic success of an organization. The main focus
of these measures is the satisfaction of customers and their retention, brand development,
employee motivation, the capacity of organization, market share etc.
2. Primary Addressee:
The primary addressee of the financial performance measures of a company are shareholders.
Simultaneously, these measures are used by different other stakeholder groups
including, creditors and debt holders, competitors, potential investors, tax authorities etc. The
main addressee of the non-financial performance measurement of a business is the management of
that company as the focus of these measurements is the indication of discrepancies within the
internal systems of a business.
3. Reports:
The financial performance of the company is reflected in the financial statements. These financial
statements are prepared and made public, where external stakeholders have access to
them. Statement of financial position (balance sheet), statement of profit or loss (income
statement) and statement of cash flows are some examples. The non-financial measures are
important for the internal management of a company and therefore are generated internally. These
reports can vary according to the individual needs of a business or company.
Some standard reports or tools used for measuring non-financial performance indicators are
balanced score card (financial, customer, internal processes, growth), building block model
(dimensions, standards, rewards) etc.
4. Application:
Both financial and non-financial performance indicators can be applied to companies that have a
primary goal to earn profits and increased revenues. Many organizations especially not-for-profit
organizations do not have a primary goal to surge profits rather these organizations focus upon
the efficiency and effectiveness of their services and operations. For example, hospitals, charities,
state-run welfare institutes etc. Such organizations use non-financial performance measures to
evaluate their performance because use of financial indicators becomes irrelevant for them.
5. Accuracy of information:
Financial performance indicators provide a limited scope regarding the long-term maximization
of shareholder’s wealth. Additionally, these can be manipulated by the management of a company
by applying creative accounting or window-dressing. However, non-financial performance
indicators not only take into account all the aspects of a business that can nurture a well-grounded
organizational strategy, these metrics have less chance of manipulation and fabrication if
formulated, implemented and evaluated properly.
Conclusion:
Deciding suitable performance indicators for a company is a difficult task.
Traditionally, managers and potential investors used to rely upon the financial performance
metrics only. Recently trends have been shifting towards the importance and relevance of non-
financial measures within businesses. The reason behind this is the realization that apart from the
financial activities of an organization, it is the key performance indicators that ensure the long-
term growth and development of a business. Additionally, the success of many businesses is
dependent upon the intellectual property (intangible assets) rather than the tangible assets like
inventory or machinery etc. Therefore, focus of companies has shifted towards supplementing
customer interests, evolving brand name along with satisfying all other vital stakeholders.

SECTION-D
What is a Balanced Scorecard?
A balanced scorecard is a strategic planning framework that companies use to assign
priority to their products, projects, and services; communicate about their targets or
goals; and plan their routine activities. The scorecard enables companies to monitor and
measure the success of their strategies to determine how well they have performed.

Four Perspectives of the Balanced Scorecard

The following are the key areas that a balanced scorecard focuses on:

1. Financial perspective

Under the financial perspective, the goal of a company is to ensure that it earns a return
on the investments made and manages key risks involved in running the business. The
goals can be achieved by satisfying the needs of all players involved with the business,
such as the shareholders, customers, and suppliers.

The shareholders are an integral part of the business since they are the providers of
capital; they should be happy when the company achieves financial success. They want
to be sure that the company is continually generating revenues and that the
organization meets goals such as improving profitability and developing new revenue
sources. Steps taken to achieve such goals may include introducing new products and
services, improving the company’s value proposition, and cutting down on the costs of
doing business.
2. Customer perspective

The customer perspective monitors how the entity is providing value to its customers
and determines the level of customer satisfaction with the company’s products or
services. Customer satisfaction is an indicator of the company’s success. How well a
company treats its customers can obviously affect its profitability.

The balanced scorecard considers the company’s reputation versus its competitors. How
do customers see your company vis-à-vis your competitors? It enables the organization
to step out of its comfort zone to view itself from the customer’s point of view rather
than just from an internal perspective.

Some of the strategies that a company can focus on to improve its reputation among
customers include improving product quality, enhancing the customer shopping
experience, and adjusting the prices of its main products and services.

3. Internal business processes perspective

A business’ internal processes determine how well the entity runs. A balanced scorecard
puts into perspective the measures and objectives that can help the business run more
effectively. Also, the scorecard helps evaluate the company’s products or services and
determine whether they conform to the standards that customers desire. A key part of
this perspective is aiming to answer the question, “What are we good at?”

The answer to that question can help the company formulate marketing strategies and
pursue innovations that lead to the creation of new and improved ways of meeting the
needs of customers.

4. Organizational capacity perspective

Organizational capacity is important in optimizing goals and objectives with favorable

results. The personnel in the organization’s departments are required to demonstrate
high performance in terms of leadership, the entity’s culture, application of knowledge,
and skill sets.

Proper infrastructure is required for the organization to deliver according to the

expectations of management. For example, the organization should use the latest
technology to automate activities and ensure a smooth flow of activities.