budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools.
Usually, the single most important input in the budget is some measure of anticipated output. For a factory, this measure of output is the number of units of each product produced. For a retailer, it might be the number of units of each product sold. For a hospital, it is the number of patient days (the number of patient admissions multiplied by the average length of stay).
The static budget is the budget that is based on this projected level of output, prior to the start of the period. In other words, the static budget is the “original” budget. The static budget variance is the difference between any line-item in this original budget and the corresponding line-item from the statement of actual results. Often, the line-item of most interest is the “bottom line”: total cost of production for the factory and other cost centers; net income for profit centers.
The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the period. A flexible budget adjusts the static budget for the actual level of output. The flexible budget asks the question: “If I had known at the beginning of the period what my output volume (units produced or units sold) would be, what would my budget have looked like?” The motivation for the flexible budget is to compare apples to apples. If the factory actually 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.
The flexible budget variance is the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results.
The following steps are used to prepare a flexible budget:
1. Determine the budgeted variable cost per unit of output. Also determine the budgeted sales price per unit of output, if the entity to which the budget applies generates revenue (e.g., the retailer or the hospital).
2. Determine the budgeted level of fixed costs.
3. Determine the actual volume of output achieved (e.g., units produced for a factory, units sold for a retailer, patient days for a hospital).
4. Build the flexible budget based on the budgeted cost information from steps 1 and 2, and the actual volume of output from step 3.
Flexible budgets are prepared at the end of the period, when actual output is known. However, the same steps described above for creating the flexible budget can be used prior to the start of the period to anticipate costs and revenues for any projected level of output, where the projected level of output is incorporated at step 3. If these steps are applied to various anticipated levels of output, the analysis is called pro forma analysis. Pro forma analysis is useful for planning purposes. For example, if next year’s sales are double this year’s sales, what will be the company’s cash, materials, and labor requirements in order to meet production needs?
A flexible budget can help managers to make more valid comparisons. It is designed to show the expected revenue and the allowed expenditure for the actual number of units produced and sold. Comparing this flexible budget with the actual expenditure and revenue it is possible to distinguish genuine efficiencies. The question is: how to prepare a flexible budget? This post provide a simple overview of how a flexible budget is prepared.
Before a flexible budget can be produced, managers must identify which costs are fixed and which are variable. The allowed expenditure on variable costs can then be increased or decreased as the level of activity changes. “Fixed costs” are those costs which will not increase or decrease over a given range of activity. The allowance for these items will therefore remain constant. Let us continue with the example…
Management have identified that the following budgeted costs are fixed:
Direct labor = $8,400
Overheads = $53,000
It is now possible to identify the expected variable cost per unit produced and sold:
Now that managers are aware of the fixed costs and the variable costs per unit it is possible to ‘flex’ the original budget to produce a budget cost allowance for 1,000 units produced and sold.
The budget cost allowance for each item is calculated as follows:
Cost allowance = budgeted fixed cost + (number of units produced and sold x variable cost per unit)
For the costs which are wholly fixed or wholly variable the calculation of the budget cost allowance is fairly straightforward. The remaining costs are semi-variable, which means that they are partly fixed and partly variable.
The budget cost allowance for direct labor is calculated as follows:
Cost allowance for direct labor = $8,400 + (1,000 units x $4) = $12,400
The budgeted sales price per unit is $120,000 / 1,200 = $100 per unit.
If it is assumed that sales revenues follow a linear variable pattern (because the sales price remains constant) the full flexible budget can now be produced.
To make sure that you followed it, let’s do further example.
Following the example of the calculation of the budget cost allowance for direct labor, calculate a revised budget cost allowance for all costs for an activity of 1,000 units and produce a revised variance statement for April.
Firstly, we need to compute the cost allowance for the overhead. Here we go:
Cost allowance for overhead = $53,000 + (1,000 units x $7) = $60,000
Next, we can make “flexible budget comparison” for April as below:
This revised analysis shows that in fact the profit was $7,610 higher than would have been expected from a sales volume of 1,000 units.
The largest variance is a $10,000 favorable variance on sales revenue. This has arisen because a higher price was charged than budgeted.
Could the higher sales price have been the cause of the shortfall in sales volume?
Although the answer to this question is not available from this information, without a flexed budget comparison it was not possible to tell that a different selling price had been charged. This is an example of variances which may be interrelated – a favorable variance on sales price may have caused an adverse variance on sales volume.
The cost variances in the flexible budget comparison are mainly adverse. These overspendings were not revealed when a fixed budget was used and managers may have been under the false impression that costs were being adequately controlled. You may be wondering what has happened to the remainder of the $6,990 adverse profit variance shown in our original budget comparison at the beginning of this example. This could be analyzed as follows:
Difference in budgeted profit -
causedby volume shortfall ($26,200 - $11,600) = ($14,600)
Profit variance from flexible budget comparison = $7,610
Total profit shortfall, per original budget comparison = ($6,990)
This shows clearly that the adverse variance was caused by the volume shortfall, and not by differences in the expected cost and revenues from the sales that were made.
Using Flexible Budgets for Planning
Although flexible budgets can be useful for control purposes they are not particularly useful for planning. The original budget must contain a single target level of activity so that managers can plan such factors as the resource requirements and the product pricing policy. This would not be possible if they were faced with a range of possible activity levels.
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