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Limitations of Standard Costing and Flexible Budgeting
“We have been leaders in Picture Tube manufacturing from the last many years, however, it appears that frequent changes in government policies have been adversely  affecting us leading to a demand from the quality and production  personnel to abandon the age old budgeting and standard costing system which has been used so effectively in the past. The argument is simple that since we do not know in advance, as to what the demand in the market is going to be, we are in no position to budget production. Last year the budget forecasted a potential manufacture of 2000 17’ Picture Tubes; however, we ended up manufacturing nothing of that sort as there was no demand in the market. Blaming the marketing personnel is of no use as demand in the present day scenario is widely fluctuating specially with customers having multiple choices in both the Picture Tube sizes as well as quality parameters.  Critics argue that in the present business environment  there may be little use of budget related activities as they may not be able to provide us with any measure of our competitiveness in the industry. On the other hand, the accounting and finance personnel are vehemently opposed to the issue of abandoning the old concept as they feel that slight changes and modifications in the same may allow us to retain our effectiveness as well as help in enhancing efficiency. I understand that there was a proposal of changing our system to an Activity Based Costing methodology but the same was talked down upon because of the excessive costs involved.” Thyagrajan, the General Manager of Pele tube Electronics recalled issues, which were discussed during the last meeting chaired by President Shri Victor Nichole. 
Minutes of an internal meeting of managers of Peletube Eletronics ltd. 
DATE: November 09, 2012
TIME: 5.30 p.m.
VENUE: Peletube  Bhavan, Ghaziabad
PRESENT: Thyagrajan , General Manager; Devendra Bahadur, Sr Manager  (Marketing); Arvind Lakhotia ,  Sr Manager  (Finance); Shalab Kapur ,Dy General Manager  (Manufacturing); OP Singh  , Quality Control Manager 

Thyagrajan: Good evening to all of you. I have called this meeting to resolve an issue raised in the meeting held last month chaired by our honorable President Shri Victor Nichole. There was a proposal in the meeting of discarding the Budgeting and Standard Costing systems since, according to OP Singh, the reports generated by the same were inducing dysfunctional behaviour in our employees, so much so, that they would ultimately end up distancing us from our customers. The reasons, according to OP Singh were many and I would ask him to apprise you of the same. However, before we commence further with the meeting I would request you all to be futuristic in your approach as we are planning a quantum leap in our production in the coming years with talks in advanced stages with quite a few leading companies, which are engaged in the assembly of Televisions. Ideally, I would like to see a process built up so as to ensure timely production for timely deliveries along with minimal or even zero variances. Subsequent to achieving the same, we would perform both value engineering and value analysis for cost reduction purposes. However, since OP Singh raised the matter in the monthly meeting, I would request him to take a lead and share with all of your good selves the issues he has in mind, which he believes may be detrimental for Pele tube in the coming years.

OP Singh : Thank you Thyagrajan. In my opinion, Standard Costing and Budgeting have actually become a liability to our company. These systems are old and meant for an environment very unlike of what we are witnessing now. The basic objectives of these systems were that of controlling costs and evaluating performance of various Responsibility Centre managers. The environment prevailing during those times was not as competitive as now and we were amongst the very few organizations that had the capability of manufacturing Picture Tubes. A cost plus pricing approach was sufficient.  Competitors used our price as a benchmark for pricing Tubes produced by them. Our infrastructure was better than what was available with most organizations and to add to the advantage the promoters of our company had the latest technical knowhow available in the world: that too with first hand working experience. In fact, two of our promoters had been technically trained in the manufacturing process of Picture Tubes in the US. This led us to have a huge competitive advantage over others and in case you allow me to be blunt – we have milked our knowledge cow for perhaps too long a period. 
Thyagrajan : Yes , you are right. In fact, another founding Director of ours had worked in the UK with a Picture Tube manufacturing organization. During his tenure, he was responsible for the entire factory accounting and other commercial activities. I understand that Budgeting and Standard Costing systems implemented in our factory are similar to those implemented in that UK based company.  I believe that there have been a few changes in the system from what we did during the 1980s to what we do now. Perhaps Mr. Lakhotia may be able to tell us more as he has been associated with the company since its inception. 
Arvind Lakhotia : Change is a very subjective term . A change made in the Bill of Material is a change but also a result of intensive R&D effort. Similarly a change made in the relevant range assigned to any activity may , technically be termed as a change, however, it is most of the times due to the increase in efficiency, either concerted or otherwise, through a mere application of the learning curve. The word ‘improvement’ would be more appropriate in such situations. In this sense, I would not agree with respected Thyagrajan. In my opinion, there have been no changes in the systems we used in the 1980’s and the systems, which are in vogue today.  These systems have been giving excellent results since inception and similar systems are in fact being used the world over, even now. 
Thyagrajan: But OP Singh was so emphatic – in fact, according to him the system should be abandoned and replaced with an Activity Based Costing System.  Isn’t it , OP Singh? I distinctly remember your presentation during the meeting chaired by our President!
OP Singh : The system in vogue is managing events in isolation giving scant regard to the cross functional dynamics. I would go even further to claim that the systems are actually preventing management from taking proactive actions and in case this continues, it would certainly be detrimental in the long run. I for one believe that variations are bound to exist in any dynamic system and in case one wants to get a real picture, the measurement practices at our company need to be improved. I would give you specific examples but before that, it is essential to understand the complexities faced by our company today and appreciate the business environment changes, which have happened over the past many years.
As you are aware, we had established our plant in the early 80s and were pioneers in manufacturing Picture Tubes in India. There were only black and white Tubes made during those times and that too in a couple of sizes, 17” and 21”. Subsequently we diversified into the making of coloured Picture Tubes and added two more sizes, 19” and 27”. Later developments in the Television market pushed us into the making of Flat Surface tubes, which were in addition to the curved monitors made since long. We were able to survive because of the high quality human capital which existed in our organization who were good enough to adapt with the much needed technical changes happening globally. However, today, the paradigm is completely different with manufacturers from North America, Korea, Japan and China entering India to produce in our territories. In addition, with a drastic reduction in Custom Duties, both CKDs and SKDs can be imported at a very cheap rate .These when assembled turn out to be cheaper than what we produce at our plant; however, we have still managed to survive and profit because of the competitive advantage which I mentioned earlier. 
Let me come to specific instances, which I believe shall help everyone understand the point I want to make. Our Costing system computes a variance known as a production volume variance (PVV). An adverse PVV highlights the money, which we lose because of not utilizing the capacity to the full. An adverse variance is understood to be a lapse on the part of the production department. However, in the present circumstances where we have to produce only as per the demand in the market, the computation of PVV does not make sense. In case we continue doing so, the production personnel shall be forced to produce for stock, as they would be reluctant to have an adverse PVV reflecting negatively on their performance. The need of today is to produce in small quantities as per the market requirements and that to deliver the same on time. Capacity utilization is no longer the paradigm, especially post globalization where the competition is intense. Apart from locking up unnecessary funds in the Inventory, we also run the risk of obsolescence with frequent rapid changes being introduced in the product characteristics .    
Arvind Lakhotia : I agree with this, however, doing away with PVV may not be a solution. We can make PVV independent of performance appraisal and that be that. The computation of unutilized fixed expenses would certainly help in improving future performance. How do we know whether we can produce more than what we have in hand? PVV would be necessary. 
Shalab Kapur : Unutilized fixed expenses ! Uh!  This shall be of use in case we are measuring the fixed expenses properly. Let me give you an example. Salaries paid to the production personnel are a fixed cost in our budgeting and costing systems. A huge component of the PVV arises due to the same. However, with frequent changes in production schedules and the routing plans on the floor, a major portion of the production personnel’s time is devoted to Setup activities rather than actual production. The resources consumed during Setup are a part of the fixed salary component. Don’t you think it is wrong to call them fixed costs? This is one reason I advocate for an Activity Based Costing System. In case implemented, Setups would be treated as a distinct Cost Object and so the salary related to every Setup would become variable in nature. As we know, “the more we identify variability; the more precise we get in cost ascertainment”. 
Arvind Lakhotia : I agree with what Shalab is saying. In the present scenario, there is a need for redefining the fixed overheads. The finance department is already working in this regard with a proposal to identify resources consumed during a Setup and removing the same from the fixed cost component. Once this is done, the PVV would reflect the unutilized capacity in real terms. Setup costs would be concentrated upon separately with a view to control and gradually reduce the same. Removal of PVV as a parameter for performance appraisal plus the changes we propose in the computation of PVV shall help address the concern of Shalab. 
Devendra Bahadur: Perhaps we may be better off by removing the fixed cost component from the product cost. These costs are imputed, not traced and should be looked upon holistically. 
OP Singh : I am glad that we are working on this aspect. I agree with Devendra Bahadur that fixed costs are imputed and the same need not be a part of the product cost. Also, that Setups shall be treated as a separate Cost Object is welcome. The same would have been done in case we had an operational Activity Based Costing system. However, there are other issues that need to be taken care about. Let us take the example of the computation of Material Price Variance (MPV). The variance reflects the deviations in the raw material prices actually paid from the ones, which were established in the beginning of the year. This variance reflects performance of the Purchase department. Frequently, in order to get a favourable or a negligible adverse variance, the purchase people have resorted to buying in bulk as the same fetches them discount. However, this is against the basic need of our company. Buying in bulk may fetch us discounts but it also increases the risk of obsolescence of the raw material inventory. Imagine buying material for 17” Picture Tubes and having the same locked in Stores for years because of zero production. The inventory would go obsolete. Similarly, the use of MPV for performance appraisal can induce another type of dysfunctional behavior i.e. buying of poor quality raw material at cheaper prices, which would help reduce the MPV. Both these examples again focus on the limitations of Standard Costing and Flexible Budgeting.
Arvind Lakhotia : I agree with the first point you have made. Buying in bulk could reduce MPV but alongside, there is a risk of huge capital tied up in the inventory. This can be rectified at the time we establish standards. Perhaps the standard prices for material would have to be raised . However, I would not agree with the second point. According to me, in case the purchase department saves money by buying low quality stuff at cheaper rates to improve MPV, the same would be reflected in an extremely high adverse usage variance. In addition, the cost of quality would shoot up abnormally. We had understood this recently when the Solder purchased was not of good quality, because of which the usage variance at the floor had become extremely high. Variances are all interdependent and it is wrong to say that the costing and budgeting systems in our factory measure things in isolation. What is important is the way we interpret these variances.  We need to understand that our operations are volume related. Variances for volume related activities are controllable and in case we incorporate the kaizan approach while establishing benchmarks, we could have a continuously improving operational situation.  I would like to emphasise over here that the Finance department is looking into the matters raised by OP Singh and Shalab Kapur and the perceived anomalies shall be looked into and rectified very soon. We believe that all of us are working towards the same goal and hence any MIS implemented should be in line with the ultimate objective of our company. I am sure that you will agree that the rectifications, which I have proposed in today’s discussions, are acceptable and would go a long way in addressing the concerns.
Shalab Kapur : Yes, in case we exclude the fixed cost component from our cost sheets and treat them in totality , we would have made progress in the right direction. Also. there is a compelling need to change the standard prices of raw material since buying in small quantities shall certainly be more expensive than when we buy in bulk. Both these developments would go a long way in improving performance. I would recommend that we stop using variances as a stick to beat managers, rather we use them to improve future performance by rectifying past errors.
OP Singh : In a way, what Mr Lakhotia is proposing is to have a hybrid system which utilizes concepts of ABC and blend the same to the traditional approach. I have absolutely no problem with such a development but allow me to say that still the system would be historical in nature which by itself is a big shortcoming for decision making . I am sure you will accept that what we need is real time information rather than a historical analysis. 
Arvind Lakhotia : We are already in the process of  implementing Integrated Accounting . This type of a system is actually designed to provide real time information.  Once this is done, the Cost Accounting section would not need to wait for the Trial Balance to be prepared by us in Accounting for computing variances , specially those which concern Overheads. 
Thyagrajan : Thank you gentlemen. I think we have had an intellectually stimulating session with Mr Lakhotia proposing certain changes in the existing costing and budgeting systems in our company. Perhaps we should meet again, once the existing system is improved upon and see how the MIS generated is different and hopefully better. Thank you all for being in the meeting.


1. Do you agree with the statement that variance analysis induces dysfunctional behaviour?
2. Do you think variances should be used for performance appraisal?  
3. Should Pele tube Electronics abandon its existing Costing and Budgeting system?
4. How is Activity Based Costing different from traditional Costing?

Click To Answer

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