Introduction
A budget can be defined as a financial plan for the future. Budgets are therefore used as planning tools, and thus they are normally prepared before the budget period commences. This is done in order to be able to compare the budgeted activities/outputs with the actual activities/outputs at the end of the budget period. This enables an organization to gauge its performance during the budget period. There are a number of methods that can be used in drawing up budgets and estimating costs. These include flexible budgeting, time costing, activity based costing, etc. This paper focuses on the definitions and inherent characteristics of the aforesaid methods of budgeting and costing.
Flexible budgeting
A flexible budget refers to cost and revenue projections that are guided by sales and production volumes. The costs and revenues therefore change with changing sales volume and production levels. From the above definition, it is apparent that a flexible budget can be said to be an evaluation tool for the performance of an organization. A flexible budget cannot, therefore, be prepared if the budget period has not ended. It is therefore built upon another speculative budget that is adjusted to capture actual performance after the period ends. The latter budget is usually termed as a static budget.
Therefore, in order to prepare a flexible budget, one needs to use the actual production level of the organization at the end of the budget period to make comparisons with actual costs. For instance, “if the factory produced 10, 000 units, then management should compare actual factory costs for 10, 000 units to what the factory should have spent to make 10, 000 units, not to what the factory should have spent to make 9, 000 units or 11, 000 units or any other production level” (Caplan, n.d., p. 1).
The purpose of having a flexible budget is to come up with projections of cost at different levels of activity. To come up with the levels of activity, a number of variables are considered. These include outputs, inputs or even levels (Bentz, n.d., p. 1). The budget is therefore said to be flexible because it depends on a certain level of activity. The main advantage of having a flexible budget is that the budget is made to capture the actual level of output. As mentioned above, the projected cost will be compared with the cost that would have used to produce the actual output.
Another beauty of flexible budgeting is that it can be applied in various budgeting procedures. For instance, it is applicable in preparing acquisition budgets, labor budgets, purchasing plans, activity budgets, production budgets etcetera. This is, especially, the case because each of these budgets has its own variables which are budgeted for, and which have a specific value at the end of the budget period (Bentz, n.d., p. 1). From the above discussion, it is apparent that flexible budgeting is more appropriate in situations where the actual output/activity is variable depending on a number of factors. Therefore, flexible budgeting will be appropriately applied in such situations where the level of output/activity is not easily predictable.
Time costing and Activity Based Costing
Time costing is the method of costing in which time is used as the determinant factor of the amount of cost incurred in a given production activity. For instance, if the item of cost is a machine, the cost that the firm will incur will depend on the number of hours that the machine will be working in the budget period. This is in relation to activity costing. In the case of labor budgets, the cost of labor will depend on the number of hours that workers will be working in the budget period.
Time costing is usually an unreliable method of costing especially when it is applied as a standalone. This is due to the obvious logistic challenges that are likely to be encountered in some areas of costing like production. However, when combined with activity based costing, it becomes a very powerful costing tool. Time costing is appropriately applied in situations where an item of cost like a machine takes a constant period of time per day. When combined with activity based costing, the variable driving cost in the activity based costing method is time.
Activity Based Costing (ABC) is a method of costing in which the overhead costs incurred by a firm are apportioned to cost pools on the basis of real performance and expenditures. This information is normally sourced from the firm’s information records as well as from the staff who are connected directly with the delivery of those products. By doing so, the firm will have allocated costs using all the activities that are involved in production for instance machinery, salaries, and orders among others. Activity based costing is mostly applied by those firms that deal with a variety of products and incur high amounts of overheads.
For instance when assigning the overhead costs of two products; one of high volume production and the other of low volume production activity based costing will be used to overcome the possibility of assigning the overheads on more than one activity. Activity based costing will be able to discern activities such as machine set-ups, special machine testing and engineering services among other activities that are items of cost, and in this case, overheads. Using activity based costing; the high volume production commodity is likely to have high charges of overhead costs than the low volume production commodity (Averkamp, 2011, p. 1). This would not be the case when time costing is used which spreads all overhead costs on machine hours.
Activity Based Costing is the approach that is commonly used by most firms since it captures all the costs incurred in the production of a product thus giving fair costs to all products. As a result, decision makers base their shareholders value maximization and productivity decisions on this. Activity Based Costing is again preferred because of its high degree of accuracy in cost allocation especially in instances where the products have different labor-hours.
Differences between time costing and activity based costing
The main difference between time costing and activity based costing is that the latter allocates overheads on how they have been applied in the production of given commodities. Time costing on the other hand spreads all overheads of the items of cost on all commodities regardless of their degree of application. Secondly, time is the only driver of cost in time costing while in activity based costing, a number of drivers of cost, time included, can be used (Emblemsvag, 2010, p. 1).
Another difference is that activity based costing is used in firms that have a variety of products and that have huge overheads while time costing is mostly used in firms that have a few products, preferably one product. Basically, time costing is one of the conventional methods of costing, and thus it is appropriately applied in conjunction with other costing methods, while ABC can be appropriately used alone in almost all firms.
Conclusion
As evidenced in the discussion above, there are a number of methods of costing. The appropriateness of the method of costing that a firm chooses depends on the specific situation of the firm. The choice of the method of costing can potentially affect the accuracy with which a firm estimates its costs, and thus it can consequently affect the accuracy in the profit estimation of the firm. As stated in the discussion, a flexible budget is appropriately used in situations where the variables driving costs are not easily predictable, and thus the need to use the actual value of the cost-driving variable. This enables the firm to easily evaluate its performance at the end of the budget period.
Time costing, on the other hand, is appropriately applied in situations where the items of cost have a relatively constant period of operation per day within the budget period. For instance, workers working for eight hours a day, a machine operating for ten hours a day, etcetera. Activity based costing, as mentioned above, is most appropriately applied by firms that deal with a large number of products and incur high amounts of overheads. The main difference between time costing and ABC is that the latter takes into consideration the proportion of usage of cost drivers in production while the former does not.
Reference List
Averkamp, H. (2011). Activity Based Costing. Web.
Bentz, W. (n.d.). Flexible Budgeting: Activity Rates. Web.
Caplan, D. (n.d.). Management Accounting: Concepts and Techniques. Web.
Emblemsvag, J. (2010). ABC. Web.