MA4023 Management Accounting Techniques

CHAPTER 1 BUDGETING
INTRODUCTION
A number of different approaches to the preparation of budgets have evolved. It is important
to understand what these approaches are, and to appreciate which would be appropriate for
different types of organisations.

The approaches are as follows:

❖ Top-down
❖ Bottom-up
❖ Rolling budgets
❖ Incremental
❖ Zero-based budgeting (ZBB)
❖ Activity-based budgeting (ABB)
❖ Feed-forward control

TOP-DOWN VS BOTTOM-UP BUDGETING

An important factor in budgeting is how much participation managers enjoy in preparing their
won budgets. In some organisations, budgets are prepared centrally, by the finance department,
with the input of senior management. These budgets are then imposed on junior managers, who
are then expected to work towards operating their departments within budget.

Other organisations allow a more participative approach. The managers of each department
prepare the first draft of their budgets, which is then discusses with senior managers. After
some negotiation, changes may be made to the draft to ensure that the final budget meets the
objectives of the whole organisation, before it is approved.

In reality, the decision is not between choosing top-down or bottom-up, but in deciding how
much participation managers of responsibility centres should have in preparing their budgets.

There are many different degrees of participation, for example:

• Managers prepare their own budgets or plans with no intervention by senior management.
• Managers prepare the first draft, which is then amended by senior managers.
• Senior managers prepare the budgets after discussion with the managers responsible.
• Senior managers prepare the budget entirely and the departmental managers have no input
at all.

Factors to Consider
The following factors may be considered in deciding how much participation should be
allowed:
• The attitudes of junior managers to their work. Some junior managers may be very
proactive and want to participate in all aspects of managing their department. If they are
not allowed to participate in budget preparation they will become disappointed and
demotivated. Other managers may be less proactive and require detailed guidance from
above, which top-down approach may be more appropriate.

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• The skills of junior managers relating to budgeting. If their financial skills are weak, then
participation may be limited.

• The amount of interdependence between departments. If departments rely on each other

(e.g. services of one department are consumed by another) then more coordination of the
budgeting process will be necessary. This will require some intervention by senior
management.

• In periods of financial difficulty, when control of the resources and cash flows of the
organisation is essential for survival, senior management should be intervening.

• The amount of “local” knowledge of senior managers. In very large organisations, senior
head-office management may have little knowledge of local conditions at ground level
(i.e. in the divisions or branches). In this case, the participation of local managers in the
preparation of their own budgets is advisable.

• Culture of the organisation. In a “command and control” approach to management,

everything is centrally planned and all junior staff are told what they must do. Top-down
budgeting is often a feature of such organisations. Other organisations may adopt a more
delegated approach, in which managers are given autonomy. They will be given board
guidelines about what is expected of them, but allowed to do the detailed planning without
central intervention, which more likely to adopt a participative approach.

Participation and the Objectives Budgeting

Participation in the budget preparation process may help or hinder these, as follows:
• Planning: Budgets force managers to take time away from managing day-to-day
operations to plan the future of their departments. Clearly, the more involvement junior
managers and staff have in the budgeting process the more they will be forced to plan.

• Coordination: Coordination of the various departments in budgeting is easier if budgeting

is performed centrally and there is less participation.

• Motivation: Managers are more likely to be motivated if they are involved in setting their
own budgets. If managers are given responsibility for managing a department, but may not
actually participate in preparing the budgets for their department, they may become
demotivated.

• Evaluation of performance: Managers may be evaluated on how well they perform against
the budget. In this case, it is important that the budget is set at an appropriate level of
difficulty. It should be challenging, but realistic. If managers participate in preparing their
won budgets, there is a risk of “budgetary slack” (i.e. understanding budgeted revenues
and/or overstating budgeted costs in order to make their budgets easier to achieve).

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Advantages of Top-Down Budgeting

• Senior management have greater control of the budgetary process. The budgets will,
therefore, reflect more accurately the corporate objectives and the long-term plan.

• Where managers prepare their own budgets, and are assessed on how they perform relative
to these, there is a temptation for the managers to add “budgetary slack” (i.e. they overstate
budgeted expenses or understate budgeted revenues to make their budgets easier to
achieve). Using top-down budgeting avoids this risk.

• Since budgets are prepared centrally, the activities of the various departments should be
better coordinated.

• It may be difficult for managers with little financial or accounting knowledge to prepare
budgets for their own departments. Top-down budgeting means that these managers would
not have to prepare their won budgets.

• The various budgets are more likely to be set at the same level of difficulty and would,
therefore, be fairer that if bottom-up budgeting is used.

Advantages of Bottom-Up Budgeting

• Managers are more likely to accept the budgeted targets for their departments and work
towards achieving them if they have been involved in setting the budgets.

• Managers have a more detailed knowledge of the work which their departments do than
senior management and, therefore, can produce more realistic budgets.

• Managers may feel more motivated if they are given greater autonomy and more
responsibility for their departments. Giving managers greater autonomy would normally
include giving them the right to participate in preparing their own budgets.

• At the end of the budget period, when managers’ performance is being assessed, the
managers cannot claim that the budget was unrealistic if they prepare the budget.

• Managers will better understand the financial objectives of the organisation if they are
involved in budgeting. Thus, the budget process can be seen as a type of education given
to non-financial managers.

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ROLLING BUDGETS (FROLLING FORECASTS)

In a rolling budget, the budget horizon (typically one year) is kept constant by adding another
month (or quarter) to the end of the budgeted period as each month (or quarter) expires.

Example:
A budget is prepared for the year 2012.
At the end of January 2012, the actual performance for the month of January is compared
against the budget. Based on this comparison, it may be decided that the budgets for 1 February
to 31 December 2012 should be changed to reflect changes in external factors. Once this has
been done, a budget is also prepared for January 2013. The new budget, therefore, covers 1
February 2012 to 31 January 2013.

Preparation of Rolling Budgets

Rolling budgets are appropriate in situations where the environment changes. A budget is
prepared, typically for a 12-month period. The budget may be broken down into months.

At the end of each month, the budget for the remaining months of the year may be updated to
reflect:
• External changes which have occurred since the original budget was prepared.
• Other areas in which the original budget is considered to be unrealistic in retrospect.

In addition to updating the remaining months of the year, an additional month may be added to
the budgets so there is always a budget for the next 12 months.

Example:
Homeland Airways uses rolling forecasts. At the start of the year, the following quarterly
budget was prepared:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

RM million RM million RM million RM million
Revenue 200 230 400 170
Costs:
Fuel 70 81 120 60
Labour 60 65 70 60
Other 20 23 40 17
Profit 50 61 170 33

It is now the end of Quarter 1, and the company wishes to update the budget as follows:

1. Due to a rise in the world price of oil, budgeted fuel costs for Quarter2, 3 and 4 should
increase to 120% of the amount shown in the original budget.
2. The original budget was based on the assumption that an increase in staff costs of 10%
would be negotiated with the unions. In the event of that, a pay rise of only 5% was agreed.
3. There is no change in budgeted revenues or other costs.
4. Quarter 1 of the following year should be based on the assumption that all items are 10%
higher than budgeted for Quarter 1 of the current year, with the exception of fuel, which
should be 44% higher.

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Required:
Prepare the rolling budget for the four quarters starting with Quarter 2 of the current year.
Quarter 2 Quarter 3 Quarter 4 Quarter 1
RM million RM million RM million RM million

Revenue
Costs:
Fuel
Labour
Other
Profit

Usefulness of Rolling Budgets

• The budget is always updated to reflect external changes. It is therefore more relevant and
more valid for comparison against actual performance.
• There will always be s budget for the next 12 months. This can be useful for planning
things such as cash flows.
• Managers will be more motivated as the budget is more realistic, because it will be updated
to take account of changes which occur outside of their control.

Problems with rolling budgets

• Time consuming.
• Budgets may be changed to hide operational inefficiencies.
• Not necessary in a stable environment.

Appropriateness of Rolling Budgets

Rolling budgets are likely to be more appropriate in industries which are dynamic, where
external changes can lead to the original budget quickly becoming out of date. In stable
industries, little benefit may be obtained by continuously updating the budget, so a rolling
budget may be less useful.

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INCREMENTAL BUDGETING
Use of historical data
An incremental budget is a budget prepared using a previous period’s budget or actual
performance as a basis with incremental amounts added for the new budget period. The
allocation of resources is based on allocations in the previous period. It is not generally
recommended as it fails to take into account changing circumstances. Also, it encourages a
“spend it or lose” mentality, as spending the budget is likely to ensure a reasonable allocation
in the next period.

Usefulness of Incremental Budgeting

• The budget is stable, and change is gradual.
• Managers can operate their departments on a consistent basis.
• The system is relatively simple to operate and easy to understand.
• Conflicts should be avoided if departments can be seen to be treated similarly.
• Coordination between budgets is easier to achieve.
• The effect of change can be seen quickly.

Problems with Incremental Budgeting

• Assumes activities and methods of working will continue in the same way.
• No incentive for developing new ideas.
• No incentives to reduce costs.
• Encourages “spend it or lose” mentality so that the budget is maintained next year.
• The budget may become out of date and no longer relate to the level of activity or type of
work being carried out.
• The priority for resources may be changed since the budgets were set originally.
• There may be budgetary “slack” built into the budget, which is never reviewed.

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ZERO-BASED BUDGETING (ZBB)

Weakness of Incremental Budgeting
• When a budgeting system has been in operation for some time, there is a tendency for the
next year’s budget to be justified by reference to the levels currently being achieved.
However, the analysis process should take into account all changes which should affect
the future activities of the organisation.
• Even using such an analytical base, some organisation find that historical comparisons,
and particularly the current level of constraints on resources, can inhibit innovative
changes in budgets. This can severely handicap an organisation because the budget should
be the first year of the long-term strategic plan. If changes are not started in the budget
period, it will be more difficult for the organisation to make the progress necessary to
achieve long-term objectives.

One way of breaking out of this “cyclical” budgeting problem is to go back to basics and
develop the budget from an assumption of no existing resources (i.e. a “zero base”). Using this
basis, all resources have to be justified, and the chosen way of achieving any specified
objectives has to be compared with the alternatives. For example, in considering budgeted
sales, the current existing sales force would be ignored, and the optimum means of achieving
the sales objectives in a particular market for a particular product or services would be
developed. This might not include any of the sales force, or a different-sized team, and the
company then has to plan how to implement this new strategy.

Features of ZBB
Traditional budgets are normally produced using a “line item” approach, which lists each type
of expense (e.g. staff costs, depreciation, etc) and the amount budgeted by each department.
ZBB is based around activities or programmes that focus on what each department would
actually like to undertake.

A three-stage approach to ZBB may be as follows:

1. Each manager identifies activities or programmes to undertake in the budgeted period. a
“decision package” is then prepared for each activity. This is a mini-budget that shows
how much will need to be spent on the activity. There also may be some narrative
explaining the benefits of the package and quantifying any revenues (or cost savings) if
appropriate.
2. A budget committee reviews all the decision packages and ranks them (in decreasing order
of benefits). Management accepts each package up to the point at which the total budgeted
expenditure is reached.
3. Resources are allocated to the activities selected in Step 2. The budget is then a
consolidation of all the accepted packages.

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Decision Package
A decision package is produced for each activity that the managers wish to undertake in the
following year. For example, in a large accountancy firm a decision package might relate to
“professional training”.

A package may be broken down into:

• a “base level” package, specifying the minimum level of service that would be required;
and
• incremental packages with additional expenditure.

A base package for professional training might include exam registration and study materials.

An incremental package could include training courses.

Decision packages also may be mutually exclusive (i.e. two or more packages are alternative
approaches to the same problem). For example, one package may be to make a component in-
house; another might be to outsource it. It would clearly not make sense for the budget
committee to select both packages.

Usefulness of ZBB
• Forces budget setters to examine every item.
• Allocation of resources is linked to results and needs.
• Develops a questioning attitude.
• Wastage and budget slack should be eliminated.
• Prevents budgets “creeping” based on previous year’s figures with a percentage add-on.
• Encourages managers to look for alternatives.

Problems with ZBB

• It is a complex and time-consuming process. The main problem with ZBB is the huge
amount of managerial time needed to carry out the exercise. Hence, the full process may
be carried out only every five years (for instance). This could, however, result in a business
almost grinding to a halt during the budgeting process. An alternative approach is to look
in-depth at one area of the business each year on a rolling basis so that each area prepares
a ZBB every five years.
• Short-term benefits may be emphasised to the detriment of long-term planning.
• Internal politics can result in annual conflicts over budget allocation.

When ZBB Is Appropriate

ZBB is most appropriate in organisations that have a high portion of discretionary costs. A
discretionary cost means that managers have some choice as to the amount they spend on a
particular item. Discretionary costs normally include items such as research and development,
training and advertising. Expenditure on such items may be reduced without the organisation
ceasing to functions; however, such expenditure does bring benefits. ZBB enables
organisations to reassess how much they spend on such discretionary items.
Organisations which enjoy few such discretionary items od expenditure would not gain as
much from introducing ZBB.

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ACTIVITY-BASED BUDGETING (ABB)

Principles of ABB
Most budgeting techniques assume that cost vary with the level of output. However, costs of
support activities do not necessarily depend on the number of units produced or sold. For these
types of costs, a more sophisticated type of budgeting is appropriate.
Activity-based budgeting (ABB) follows principles of activity-based costing (ABC) “in
reverse”. Having decided how many units to produce and sell, the organisation then needs to
define the cost of the activities required to produce them. These depend on the drivers identified
for each activity.

A typical ABB exercise may follow these steps:

1. Estimate the expected output (units) for each product.
2. Identify the number of units of each activity which will be required to produce the output.
This is based on knowledge of the relationships between the output and the activities
required to be performed to produce the output.
3. Determine the resources needed to perform the activities required. This is based on
knowledge of the drivers – the factors which influence the price of the activities.
4. If the current commitment of resources is such that too many or too few resources exist to
perform the activities required in No.3, then adjust accordingly.

Activity-based budgets are performed by repeating the steps described in this section for all
activities in an organisation and preparing a total budget. Organisations often use a matrix
approach to such budgets, with a column for each activity and a line for each type of
expenditure.

Example:
Alex uses ABC and wishes to adopt an activity-based approach to budgeting.
Having estimated the total budgeted sales for the next financial year (Step 1), Alex has
identified that one of the activities needed to support the budgeted sales is “processing sales
orders”. Alex has identified that 2,800 orders will be received next year (Step 2).

One of the resources needed for processing orders is staff. Each member of staff in the Sales
Order department can handle 60 orders per month, or 720 orders per year. Since Alex expects
2,800 orders next year, the company will need 3.88, or 4 members of staff (Step 3).

Currently, Alex employs 6 members of staff in the Sales Order Processing department. Alex
should consider relocating two members of staff to other departments.

Preparation of ABB
Preparing activity-based budgets is rather like performing ABC in reverse. The following steps
are used:
1. Estimate the budgeted volume of sales and production, in units.
2. For each activity (e.g. machine set-up), estimate the number of units of driver which would
be required to support the budgeted volume of sales and production (e.g. the number of
productions runs).
3. Determine the cost of each unit of driver. This may require an analysis of factors such as
labour time required, labour cost per unit, etc.
4. Calculate the budgeted cost of each activity (number of drivers x cost per unit of driver).

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Example:
ABC Co produced food for farm animals. It produces three ranges of food: poultry, cattle and
sheep. The food is produced and sold in metric tonnes to agricultural wholesalers.
The company is preparing its budgets for the next financial year, and wishes to use an activity-
based approach to budgeting for it overheads.

Direct costs per tonne are as follows:

Poultry Cattle Sheep

Materials RM500 RM700 RM850
Labour cost RM120 RM140 RM800
Weekly production 1,000 750 900

The company uses ABC, and has identified the following support activities for which overhead
costs are incurred:

Activity Driver
Machine set-ups Number of production runs
Ordering materials Number of orders
Storage Tonne days of storage

The expected number of drivers that will be used each week by each of the three products is
shown as follows:

Poultry Cattle Sheep

Production runs 8 15 9
Purchase orders 20 25 30
Tonne days of storage 45 18 36

The management accountant had already calculated the cost per unit of driver for the machine
set-ups and storage as follows:

Activity Cost per unit of driver

Machine set-ups RM500 per production run
Storage RM10 per tonne day

Unfortunately, the management accountant quit at the end of the last month, and you have been
asked to complete the budget.

You have discovered the following information about the purchase order process:
1. Each order takes 30 minutes to process (on average). The cost of employing clerical staff
is RM10 per hour. Clerical staff would work a minimum of 40 hours per week.
2. Office supplies are estimated to be RM180 per clerk per week.
3. Each week would require a desktop computer. The cost of providing the computer is
estimated at RM20 per week.

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Required:
(a) Calculate the cost per purchase order, based on the information provided.
RM
Clerical staff costs (one member of staff)
Office supplies
Computer (one clerk)
Total weekly cost
Number of purchase orders
Cost per order

(b) Prepare the weekly budgeted costs, showing the total budgeted cost of each activity
separately.

RM RM
Materials
Direct Labour
Total direct costs
Indirect costs:
Machine set-ups
Purchase orders
Storage costs
Total indirect costs
Total costs

Advantages of ABB
• Management attention is focused on the activities of the organisation. These are something
which management can control more easily than focusing on total costs.
• Better understanding of what causes costs to be incurred may provide opportunities for
cost reductions.
• May identify non-value added activities which can be estimated.

Disadvantages of ABB
• Complicated and expensive to implement. More suited to large organisations with multiple
products and many drivers.
• Many fixed costs do not vary with changes in the volume of drivers in the short run – so
ABB may provide misleading information.

Appropriateness of ABB
ABB is a complex method. It is likely to be used only in large companies which have the
resources to implement such an approach. It is most appropriate in these situations:
• The organisation has a large volume of overheads.
• There are several different activities to which the overheads relate.
• The organisation has many products with differing production times and methods.
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FEEDBACK AND FEED-FORWARD CONTROL

Feedback Control
A feedback control system is a system in which outputs are monitored against a predetermined
standard, and if there are any deviations from the standard, action is taken to remedy these. The
feedback is the information concerning the difference between the actual output and the desired
output.

A budgetary control system is an example of a feedback control system. For each period, the
actual results are compared against the budget. If the budget was not achieved, then action can
be taken to correct the factor which caused the budget to be missed.

Closed-Loop System
A closed-loop system is any system with feedback. Reliance on feedback makes such systems
reactive rather than proactive.

• Standard: What the system is aiming for (e.g. the budget).

• Sensor: Measures the output of the system (i.e. accumulation of actual data).
• Comparator: Compares the information from the sensor to the standard (e.g. variance
analysis).
• Effector: Control action (e.g. management action to minimise future adverse variances and
repeat favourable variances).

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Open-Loop System
An open-loop system is a system without feedback. There are two reasons for the absence of
feedback:
1. Feedback is not produced (e.g. variance analysis not undertaken).
2. Feedback is produced but not used appropriately (e.g. variances are not communicated to
the appropriate manager).

Positive and Negative Feedback

Positive feedback means that the output has achieved or even exceeded the plan.

Negative feedback means that the output is below the plan (e.g. actual profits are below budget
for a particular period). The cause of negative feedback should be investigated so that
corrective action can be taken to reduce the likelihood of repetition in the future.

Positive results (e.g. favourable variances) should also be investigated, to determine whether
they can be repeated.

Feed-forward Control
The major problem with feedback control systems is that by the time the feedback is receive,
it is too late to take action to correct the deviation for the period under review. If actual costs
are higher than budget, for example, action can be taken which will stop the same deviation
from occurring in future periods. The current period, however, is already history, and no action
can be taken to change that.

In feed-forward control systems, predicted future results are compared against the desired
outcome. If it appears that the desired outcome will not be achieved based on the current
prediction, action can be taken now so that the desired outcome is achieved.

Example:
Alpha operates in a business which is not subject to seasonal variations in demand or costs.
The company has budgeted to make a profit of RM10 million for the current financial year,
which ends on 31 December. On 30 June, profits for the first half of the year are RM4 million.
Based on this, the directors forecast that profits for the year will be only RM8 million, not
RM10 million, unless some action is taken.

Because this information is available halfway through the year, the directors can take action to
remedy the situation to try to achieve the budgeted profit figure of RM10 million for the year.
The forecast profit of RM8 million is therefore feed-forward.
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DIFFICULTIES OF CHANGING A BUDGETARY SYSTEM

Traditional Approaches to Budgeting
The traditional approach to budgeting uses an incremental approach. Changes to budgetary
systems are likely to occur when organisations move away from traditional approaches to
budgeting to more sophisticated methods (e.g. ZBB or ABB).

Difficulties
In changing the approach to budgeting, organisations are likely to encounter the following
obstacles:
• Resistance to change – employees who do not appreciate the value of change may be
reluctant to help, particularly if it required additional work.
• Scepticism – particularly at senior management levels. Managers who do not understand
the benefit of the change may not give their full support.
• Training everyone involved in the process of change. New methods will require an
investment in training so that all those involved will be competent to perform the new
types of budgets.
• Additional time and costs involved in moving to a new system. This may include costs of
consultants and overtime for staff.

UNCERTAINTY IN ENVIRONMENT
Forecasting
A budget is effectively a forecast of what can be achieved. The forecast has to make
assumptions about the external environment.
The following are some of the factors that may cause uncertainty in the budget-setting process:
• The overall economic performance of the markets in which the business sells. Economic
growth may lead to increased demand for products or services.
• Actions of competitors. A competitor’s launch of a great new product may reduce demand
considerably.
• Performance of employees. It may be difficult to estimate how productive employees will
be and how many employees will actually be required.
• Market prices of inputs. The prices of many commodities (e.g. metal and oil) are
determined by highly developed international markets and can be very volatile.
• Demand for new products will be uncertain. Popularity will not be known until the
products have been launched.
The following methods can be used to deal with uncertainty:
• Flexed or flexible budgets
• Rolling budgets
• Revision of the budgets at the end of the period before comparing with actual results.

Flexible Budgets
Flexible budgeting involves preparing two or more budgets, using different assumptions for
each about the level of sales or production. At the end of the financial period, the budget with
the activity level closest to the actual activity level is used for comparing the actual
performance.

Flexed Budgets
At the end of the year, prior to comparing the actual figures against the budget, the budgets are
re-calculated (flexed) using the original budget assumptions, but the actual activity levels. This
means that the comparison is more valid.

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BEHAVIOURAL ASPECTS OF BUDGETING

Factors Which Influence Behaviour

In many organisations, managers are at least partly evaluated on how they perform in relation
to the budget. The budget is, therefore, likely to influence the behaviour of those managers. It
is hoped that the budget will motivate managers to achieve higher profits for the organisation.
Several factors will influence this.

Hopwood’s Management Styles

One of the first management writes to consider the effect of budgets on behaviour was
Hopwood, who carried out a survey of budgeting practices during the 1970s to identify how
budgets influenced the behaviour of managers. He identified three different management styles
in the companies h visited: budget constrained, profit conscious and non-accounting.

Budget-Constrained Style
Managers are evaluated on their ability to meet budgets in the short term. Failure to meet
budgets means that managers will have poor evaluations, even if there was a good reason for
exceeding the budget.

Profit-Conscious Style
In the profit-conscious company, managers are judged more on their ability to contribute to
long-term success rather than simply meeting the budget. Budgets are used, but are applied
more flexibly. For example, of the budget was not reached, but there was a good reason for
this, the manager would not be penalised.

Non-accounting Style
Accounting data is not important for performance evaluation. Qualitative factors are seen as
more important (e.g. customer satisfaction).

The following table summarises the effect of these styles on the behaviour of managers:

Features / Style Budget-constrained Profit-conscious Non-accounting

Involvement with costs High High Low

Job-related tension High Medium Medium

Manipulation of data Extensive Little Little

Relationships with
Poor Good Good
superiors and colleagues

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Setting the Level of Difficulty of the Budget

• Research has shown that:
- Targets can be used to motivate employees;
- If individuals have higher levels of intended achievement, then actual achievement
rises.
• But if targets are too easy to achieve (e.g. basic standards), individuals will not be
motivated to improve performance.
• On the other hand, targets which are too difficult (e.g. ideal standard) can be demotivating.
• Research suggest that targets which are just out of reach are optimal for motivation (e.g.
just above the current standard).
• This only a general rule. The optimal target may be different from individual to individual.
• Note that an adverse variance will be produced even though performance has been
maximised. Care must be taken to ensure that the budgets holder does not react adversely
to this.

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Standards
When setting the level of budget difficulty, four approaches can be used to setting standards:

(i) Ideal Standard

• Calculated assuming 100% efficiency from all factors of production (e.g. no losses, no
idle time, etc).
• Too difficult as a target, therefore, may lead to demotivation.

(ii) Basic standard

• Long-run (underlying) average standard.
• Based on historical data (i.e. past performance).
• Out of date.
• Likely to be too easy to achieve in the future.

(iii) Expected Standard

• Based on normal efficiency (e.g. after normal loss, expected idle time, normal machine
downtime).
• May be useful standard to use in variance analysis.
• But it may not be an appropriate target for motivation as it can be met without any
improvement over normal efficiency.

(iv) Current Standard

• A standard established for use over a short period, reflecting current conditions.
• Obtained by adjusting the expected standard.
• Use is time consuming (e.g. new current standards must be recalculated each month).

Benefits and Difficulties of Employee Participation

Benefit of Employees Participation
• Employees are more likely to accept and work towards targets they have been involved in
setting.
• Employees will be more motivated if they are given more autonomy.
• The targets should be realistic, as employees would not agree to targets which are not.

Potential Problems of Employee Participation

• Employees may try to set targets which are too easy. In budgets, they may add “slack” to
the budgets. Budgetary slack means adding expenses to the budget in excess of what is
really needed.
• Setting the targets is likely to be more time consuming if employees are involved.
• Setting of targets may not be fair, given that some employees will be better negotiators
than others and will, therefore, be able to negotiate lower targets.

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LEARNING CURVE THEORY

The Learning Effect
• If workers specialise, there is a tendency for labour hours per unit to fall as they become
more familiar with the task.
• During World War II, empirical evidence from aircraft production found the rate of
improvement to be so regular that it could be reduced to a formula.
• The learning effects starts from the production of the first unit/batch. Each time cumulative
production then doubles, the cumulative average time per unit falls to a fixed percentage
of the previous average time.

In practice (and in many questions), the learning curve effect does not continue forever. At
some point, a “steady state” is reached – beyond this point, hours per unit is constant.

Example 1:
A product will take 100 hours for the first unit, and an 80% learning curve applies.

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Learning Curve Formula

Although the graph could be used to provide an estimate, it is more accurate to use the
following exam formula: b
y = ax
where y = cumulative average time per unit to produce x units
a = time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (Log LR/Log 2)
LR = the learning rate as a decimal.

Example 2:
Based on the information in Example 1, use the formula to check the cumulative average time
for 8 units.
Note: The index of learning b is given as -0.3219.
-0.3219
Y = 100 x 8 = 100 x 0.512 = 51.2 hours

Example 3:
It is estimated that it will take 500 hours to produce the first unit of a new product. workers
have a 95% learning effect.

Required:
Calculate how long it will take to produce the seventh unit.
Note: the index of learning b is given as -0.074.

Solution:

Average Total
Cumulative average time for first seven
units
Total time for first seven units
Cumulative average time for first six units
Total time for first six units
Total time for the seventh unit

Example 4:
McSporran is a new business. It is budgeting costs for the production fo kilts.
Work studies show that the first batch will have a labour cost of RM2,000 and an 85% learning
effect applies.
In period 1, budget production is 5 batches.
In period 2, budgeted production is 7 batches.
The wage rate per hour will be constant.

Required:
Calculate the budgeted labour cost for period 2.
Note: The index of learning b is given as -0.2345.

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Conditions for a Learning Curve to Apply

• The activity is labour intensive.
• The units are identical (i.e. a repetitive task).
• Low labour turnover.
• No prolonged breaks in production.

Application of Learning Curve Theory

• Standard setting – the labour standard should be set/revised based on the expected learning
effect.
• Budgeting – variable costs are expected to fall with an increase in production – particularly
important to cash budgeting.
• Pricing decisions – an accurate labour cost may be predicted into the future.
• Work scheduling – manpower planning (e.g. as part manufacturing resource planning
system which integrates functions in a manufacturing firm. It encompasses production
scheduling, job costing, control of workforce, performance measurement, etc.)

Reservations About the Learning Curve

When using the learning curve in practice, there are some weakness:
• Knowing what the learning rate will be for new products. The usual assumption is that it
will be similar to products made in the past. This may not always be a valid assumption.

• The learning curve is useful in situations where production of a product takes place on a
continuous basis. Is there is a break in production, however, workers may “forget” the skill
and the learning curve will not be so predictable.

• In the modern business world, many products are tailor-made for customers. The idea of
mass producing identical items, which is where learning curves are strongest, is not always
appropriate.

• In some heavily unionised industries, there may be “go slow” agreements where workers
agree not to work to their full capacity in order to save jobs.

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Steady State
As cumulative output increases, the effect of the learning curve diminishes. When cumulative
output reaches a certain point, there will be no further learning. The time taken per unit reaches
a steady state and all units produced beyond this point will take the same amount of time per
unit.

Example 5:
Supercars produces cars on a production line. One of the production line processes, Process 10,
is labour intensive.
A new model, the XY123, will be introduced to production next month. As this is a new model,
the labourers in Process 10 will have to learn howe to apply this process specfifically to XY123.
The time taken for the first car is expected to be one hour. A learning rate of 85% is expected.
The effect of the learning curve is expected to stop after 30 units have been produced and all
subsequent units will take the same time to produce as the 30th unit.
Supercars has budgeted to manufacture 100XY123s in the first month of production.

Required:
(a) Calculate the labour time per unit which will apply for the 30th and subsequent units.
(b) Calculate the total labout time to make the first 100 units of the XY123.
Note: the index of learning b is given as -0.2345

(a) Labour time for the 30th and subsequent units.

Average hours Total hours

Cumulative average time for first 30 units

Total time for first 30 units

Cumulative average time for first 29 units

Total time for first 29 units

Total time for the 30th and subsequent units

(b) Total labour time for the first 100 units

Hours

First 30 units (per (a))

Next 70 units

Time taken to make the first 100 units (hours)

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Estimating the Learning Rate

Tabular Approach
A learning rate for a new product can be estimated using a tabular approach based on
production to date and the time taken.
when the learning rate stops (i.e. when a “steady state” is reached, as described above) can also
be calculated. This is the point at which the incremental time per unit becomes constant.

Example 6:
Foxy Co makes personal computers. The components for the PCs are bought from various
manufacturers and the factory workers at Foxy Co assemble these to make a finished PC.
Production of a new type of PC has just begun. The management accountant has asked one of
the workers to keep a reocrd of how much time he took to make each new computer. The
worker provided the following summary for the first month:

Incremental time take (minutes)

st
1 unit 340
2nd unit 204
rd th
3 and 4 units 326
th th
5 to 8 units 522
9th to 16th units 964
th nd
17 to 32 units 1,929
Total 4,285

The time shown within each band is the total for that band, not the average per computer.
Required:
(a) Calculate the learning rate that applied to the new PC.

Cumulative output Cumulative total time Cumulative average time per unit
(units) (minutes) (minutes)
1
2
4
8
16
32

As cumulative output doubles from:

1 to 2 units, cumulative average time falls to ____%.
2 to 4 units, cumulative average time falls to ____%.

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(b) Estimate the point at which the learning period finishes.

Incremental time taken Average incremental time
1st unit 340
nd
2 unit 204
rd th
3 and 4 units 326
th th
5 to 8 units 522
th th
9 to 16 units 964
th nd
17 to 32 units 1,929

The average incremental time taken becomes constant after the _____unit. Therefore, this is
the point at which the learning rate stops.

Algebraic Approach
An alternative approach to the tabular approach is an algebraic approach.
This has to be used when only information about the cumulative average time is for two levels
of output.

Example:
The first unit of a product took 300 minutes; the total time taken for the first 8 units was 2,056
minutes. The cumulative average time per unit for the first 8 units is therefore 257 minutes
(2,056÷8).

Cumulative output has doubled three times since the production of the first unit (from 1 to 2,
to 4, then to 8) and the cumulative average time per unit has fallen to 257. If the learning rate
is r:
→ 300 x r3 = 257
257
→ r3 = = 0.8567
300
3
→ r = √0.8567 = 0.9497 i.e. approximately 95%

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Example 7:
Go Fast Cars has just started the manufacture of a new model of its “lighting” sports car. The
time taken for one process was two hours for the first car produced. A budget was prepared
using an expected 80% learning rate based on prior experience.

Recently, the company invested in sophisticated new manufacturing equipment. Workers are
assisted by robots and computerised machine tools in the process in question. As this has
enabled the company to reduce the workforce, a number of labourers have recently been made
redundant.

The actual production time of the first 16 units was higher than expected, suggesting that the
learning rate might be greater than 80%. The budgeted and actual cumulative total times for
the first 16 units are given below in minutes:

Cumulative total Cumulative total Cumulative

Cumulative output
time budgeted time actual average time actual
1 120 120
2 192 216
4 307 389
8 492 700
16 786 1,260

Required:
(a) Calculate the actual learning rate experienced for this process.
(b) Suggest reasons why the actual learning rate was higher than expected.

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