Question
3 Cortinas Retail Clothing （CRC）: Company information
CRC started as a clothing retailer 20 years ago with one store.The business expanded steadily and had 10 stores after 18 years of trading.Since then, the rate of expansion has increased rapidly with an average of four stores opening per year.
CRC is planning to open its first large out of town store soon and is also considering the acquisition of a food retailing business.Both of these will be supplied with items using CRC’s existing central warehouse.

Introduction of RFID system
At the beginning of the 20X5 accounting year, to cope with this rapid growth, CRC acquired a RFID （radio frequency identification device）system at its single central warehouse.This was to help manage inventory more effectively and speed up the processes for receiving items from suppliers and despatching them to stores.
Items are still moved manually by staff in the CRC warehouse where there is little automation compared to competitors.There has been some resistance from staff to the RFID system, which they find difficult to use.CRC is currently trying to reduce the number of suppliers it has to help increase efficiency in the warehouse.

Budgeting system
The budget setting process has remained unchanged since CRC was formed.All managers prepare draft budgets using spreadsheets and submit them to the CRC board for approval.Managers use the previous year results as a starting point when drafting the budgets and increase the variable costs in line with any anticipated growth in volumes.
For example, when preparing the budget for the year ending 30 June 20X6, the manager of the central warehouse used the actual costs of running the warehouse from the previous year and increased them all by the same percentage.This was to reflect an anticipated increase in volumes in 20X6 over 20X5.Managers are appraised on their performance against the approved budgets.
CRC has needed all its financial resources to fund its expansion and so it has only old and basic IT systems which are not enterprise resource planning systems, unified databases or networked systems.

It has been suggested to the CRC board that the current system of budgeting is no longer suitable and that the business should move to activity-based budgeting （ABB）.The CEO has asked you to evaluate the potential introduction of ABB at CRC.
Central warehouse activity in July 20X5
The board has never seen an activity-based budget before and is unsure how it could be used to explain variances between actual and budgeted performance in the central warehouse.As an example, they would like to see how an activity-based budget for the year ending 30 June 20X6 could be used to explain variances from the actual results for the month of July 20X5.
The two key activities which drive costs in the central warehouse are receipts of items into the goods inwards section and despatches of items from the goods outwards section.A receipt into good inwards involves accepting a delivery of items from a supplier, tagging those items and putting them away in the warehouse.Receipts from suppliers contain variable numbers of individual items.Despatches of items from goods outwards are to CRC’s own retail stores.Cost driver rates for these two activities will be used to set monthly cost budgets for the warehouse.

The board asked an analyst to prepare an activity-based budget for the central warehouse for the year ending 30 June 20X6.The analyst has collected relevant information on the costs for the year needed to prepare the activity-based budget and has begun the work （Appendix 1）.
The total annual cost relating to goods inwards needs to be determined.This should be used to calculate the budgeted cost of each receipt into goods inwards, in order to explain the variance between the budgeted cost and the actual cost of receipts of goods inwards for the month of July 20X5.The analyst has already correctly included the costs of the warehouse manager’s salary and the lease of the RFID system into the incomplete activity-based budget in Appendix 1.
The board has asked you to complete the analyst’s work.
To enable you to complete your calculations, you are told that in July 20X5 there were 650 receipts into goods inwards.
These receipts contained 100,000 items, which is the same as the budgeted number of items for the month.The actual total cost of activities driven by receipts into goods inwards for the month was $18,000.
It is now 1 September 20X5.

Required:
（a）Evaluate whether CRC should move from its current budgeting system to ABB.
（13 marks）
（b）Complete the analyst’s work in Appendix 1 as required by the board and explain the variance between the budgeted cost and the actual cost for each receipt into goods inwards for July 20X5.（12 marks）
（25 marks）

Appendix 1
Analyst’s incomplete activity-based budget for the central warehouse for YE 30 June 20X6.

Analyst’s notes
Relevant information on costs in the central warehouse for the year ending 30 June 20X6
1.The cost of the warehouse manager’s salary relates to all sections of the warehouse and cannot be apportioned directly to goods inwards or goods outwards.
2.The cost for the RFID system is invoiced by a lease company.60% of this cost is allocated to goods inwards and the remainder relates to goods outwards.
3.The cost of RFID tagging is the wages cost for specially trained staff, known as taggers.Their only job is to attach RFID tags to items when they are received, before the items are put away in the warehouse.All items received are RFID tagged and the costs of tagging are allocated entirely to the cost of goods inwards.Each tagger can attach 35,000 tags per month and is paid an annual salary of $24,000.The cost of each individual RFID tag is negligible.
4.There were 12 full-time warehouse staff throughout the year to 30 June 20X5 who were each paid an annual salary of $22,500.Two more staff will be recruited at the beginning of the new budget year.50% of the warehouse staff work in goods inwards and 50% in goods outwards.

5.The cost of heating and lighting relates to all sections of the warehouse and cannot be apportioned directly to goods inwards or goods outwards.The actual heating and lighting cost for last year was $10,000 and the warehouse manager has proposed a budget of $10,500 for the coming year.The general cost of inflation though is expected to be zero.
6.The annual number of receipts into goods inwards expected is 9,000, containing a total of 1,200,000 items.
These are expected to occur evenly over the year.

Answer
3 （a）Advantages of the current budgeting system CRC managers use the previous year results as a starting point when drafting their budgets and increase the variable costs according to any anticipated growth in volumes.This is an example of incremental budgeting.
An advantage of incremental budgeting is that it is quick and easy to prepare.The budgeting system at CRC has remained unchanged for a long time and it is unlikely managers will have experience in any other method of budget setting.While CRC was growing steadily, and relatively slowly at approximately one new store approximately every two years （approximately 18 years/10 stores）, the use of incremental budgeting may have been appropriate.But as CRC is now entering new locations, such as out of town shopping centres and possibly food retailing, incremental budgeting is unlikely to be appropriate.
Incremental budgets can also be flexed according to anticipated activity levels.The manager of the central warehouse has done this, rather simplistically, by increasing costs of running the warehouse to reflect the anticipated increase in volumes in 20X6.

Disadvantages of current budgeting system
The use of incremental budgets can encourage slack.This includes incorporating extra costs into the budget to make it more achievable, or spending up to the budgeted amount to ensure that a larger budget is set next year.This may be particularly so at CRC, as managers are appraised based on achieving their budget.The manager of the central warehouse appears to be building in slack by increasing the budget for heating and lighting when the general rate of inflation is zero.This will make it more likely that the manager will receive a positive appraisal next year as it will be easier to achieve the budget.
Incremental budgeting does not encourage CRC to look for new and innovative ways of doing things.The level of automation in the warehouse is lower than in competitors and CRC appears to have just increased the budget for more staff to manually handle items in response to increased volumes.The introduction of the RFID system is, though, an example of the use of technology to increase efficiency in the warehouse.
Incremental budgeting is only appropriate where costs are already well controlled and operations are efficient.Otherwise, poorly controlled costs and inefficiencies are just incorporated into the next period’s budget.Staff resistance to the introduction of the RFID system, and their difficulties in using it, suggest that this might not be the case.

Advantages of activity-based budgeting （ABB）
The principle of ABB is that it is activities, such as the goods inwards and goods outwards in the central warehouse, which drive costs.By understanding what drives the cost, such as the number of receipts from suppliers and the number of despatches to stores, CRC can take action to control the drivers of the costs and eliminate activities which are not value adding.ABB is particularly useful where overhead costs form a large part of total costs.
ABB can help identify critical success factors which CRC must do well, such as being able to put items away in the warehouse quickly and accurately and to retrieve them efficiently.This is more likely to be done right first time as ABB focuses on the whole of an activity.
ABB is useful as CRC is changing the nature of its operations.It is undergoing rapid expansion by opening four new stores a year.There is also likely to be a change in the nature of its business, with the opening of its first out of town store and possible acquisition of a food retailing business.The incremental approach to budgeting may no longer be appropriate given the scale and nature of these changes.ABB may be more suitable as the business becomes more complex.

Disadvantages of activity-based budgeting （ABB）
One of the main disadvantages of ABB is the time and resources which are needed to implement it, for example, by identifying activities and their costs drivers.In the short term, overheads may not be controllable which will reduce the benefits of implementing ABB.
CRC has used all its financial resources to fund its expansion and has only old and basic IT systems compared to its competitors.Its current systems are not enterprise resource planning systems （ERPS）, unified databases or networked systems.Significant investment in CRC’s IT systems will be needed to collect and process large volumes of data on cost drivers and activities which would be required to implement ABB.There may also be resistance to the change from staff, who may also require extensive training, as they will be unfamiliar with the ABB approach.
Conclusion
CRC should adopt ABB, mainly as a response to the significant changes in the business and its increasing complexity.

The out of town store and the food retailing business will both be supplied from CRC’s existing central warehouse.The nature of these businesses may be different from the existing business.For example, out of town stores may require despatches each containing a larger number of items from the goods outwards section.Food retailers may require smaller, more frequent despatches to prevent spoilage.The current approach of incremental budgeting, in the central warehouse at least, is unlikely to be appropriate.The benefits of implementing ABB do, however, need to be compared to the financial cost and disruption of doing so.

（b）Activity-based budget for the central warehouse for YE 30 June 20X6

Answer
Comments on variance analysis
The total expected cost for receipts into goods inwards for July 20X5 was $19,825 （$30·50 budgeted cost per receipt x 650 receipts）.The actual cost was $18,000 giving a favourable variance of $1,825.It cannot be identified, on the basis of the information available, the cause of the $1,825 variance, as the breakdown of the $18,000 actual cost would be required.
100,000 items were processed in July 20X5 which is the same as the budgeted amount.However, the number of receipts budgeted was 750 （9,000/12）, whereas the actual number of receipts was only 650, equivalent to $27·69 （$18,000/650）per receipt.This is a favourable variance of $2·81 per receipt.
It appears that the favourable variance may be due to the receipt of larger quantities of items from suppliers in each delivery.If some of the goods inwards costs are variable with the number of items this would result in a cost saving.This could be because of the reduction in the number of suppliers, with fewer suppliers individually supplying more items.

W1 – RFID tagging
Expected volume of items received in the month = 100,000
Each member of staff can tag 35,000 items per month, so 2·86 （100/30）staff are required – say 3
Annual wages cost is 3 x $24,000 = $72,000
W2 – Warehouse staff wages
Number of staff required in budget year = 14 （12 + 2）
Total warehouse staff wages = 14 x $22,500 = $315,000
Of which $157,500 （50% of $315,000）relate to each of goods inwards and goods outwards
W3 – Heating and lighting
As inflation is zero the cost included in the budget should be $10,000.