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. Read on…
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. Move on…
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.
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.