Managerial Accounting

Chapter-6

Flexible Budgets

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Static Budget & Flexible Budget

A Static Budget is a budget that is based on only one level of activity (ie. one particular level of predicted sales) or on only one cost driver. All the master budgets are static budgets, because managers prepare a master budget for only one level of a given type of activity. A Flexible Budget (sometimes called variable budget) is a budget that adjusts for changes in sales volume and other cost-driver activities.

The flexible budget is identical to the master budget in format, but managers may prepare it for any level of activity.
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Static Budget & Performance Evaluation

The Dominion Company manufactures and sells a wheeled, collapsible suitcase carrier that is popular with airline flight crews. The product has some variations, but we will assume for our purposes that it is a single product bearing one selling price. Assume that the cost driver is sales volume (that is, units sold) and the projected sales volume is 9,000 units. Thus, we base the master budget on projected sales of 9,000 units, as shown in column 2 of the table below. The master budgets called for production and sales of 9,000 units, but Dominion actually produced and soled only 7,000 units. There are no beginning or ending inventories, so the units made in June were sold in June. We could compare the actual results with the original budgeted amounts, even though, sales volume turned out to be only 7,000. The actual results appear in column 1 of table below. Differences or variances between actual results and the master budgets are in column 3.
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Static Budget & Performance Evaluation

Dominion Company Performance Report Using a Master Budget [ For the Month Ended June 30, 20X1 ]
Particulars A. Units produced and sold B. Selling Price per unit C. Sales D. Variable costs Variable manufacturing costs Shipping costs (Selling) Administrative costs Total variable costs E. Contribution margin [C-D] F. Fixed expenses Fixed manufacturing costs Fixed selling and admin costs Total fixed costs G. Operating income (loss) [E-F]
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Actual (1) 7,000 $ 31 $ 217,000

$ 151,270 5,000 2,000 $ 158,270 $ 58,730 $ 37,300 33,000 $ 70,300 $ (11,570)

Master budget Master Budget Variances (2) (3) 9,000 2,000 U $ 31 $ 279,000 $ 62,000 U
$ 189,000 5,400 1,800 $ 196,200 $ 82,800 $ 37,000 33,000 $ 70,000 $ 12,800 $ 37,730 F 400 F 200 U $ 37,930 F $ 24,070 U $ 300 U $ 300 U $ 24,370 U

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Flexible Budgets & Performance Evaluation

A more helpful benchmark for analysis is the flexible budget. The flexible-budget approach says, Give me any activity level, and Ill provide a budget tailored to that particular level. When Dominion's sales turn out to be 7,000 units instead of 9,000, managers can use the flexible budget to prepare a new budget based on this new cost-driver level. We can then see what the total variable costs should be based on a sales level of 7,000 and compare this amount to the actual result. For performance evaluation, we would prepare flexible budget at the actual level of activity achieved. In contrast, we keep the master budget fixed or static to serve as the original benchmark for evaluating performance. It shows revenues and costs at only the originally planned levels of activity. Many companies routinely flex their budgets to help evaluate recent financial performance.
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Flexible Budget Formulas for Preparing Flexible Budgets

Dominion Company Flexible Budgets [ For the Month Ended June 30, 20X1 ] Flexible Budget Flexible Budget for Various Levels Particulars Formula of Sales/Production Activity Units 7,000 8,000 9,000 Sales $ 31.00 $217,000 $248.000 $279,000 Variable Costs Variable manufacturing costs $ 21.00 $147,000 $168,000 $189.000 Shipping costs (selling) .60 4.200 4.800 5,400 Administrative .20 1,400 1,600 1,800 Total variable costs $ 21.80 $152.600 $174,400 $196,200 Contribution margin $ 9.20 $ 64,400 $ 73.600 $ 82,800 Fixed costs per month Fixed manufacturing costs $37,000 $ 37,000 $ 37,000 $ 37,000 Fixed selling and admin costs 33.000 33.000 33.000 33.000 Total fixed costs $70,000 $ 70,000 $ 70.000 $ 70.000 Operating income (loss) $ (5,600) $ 3,600 $ 12,800
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Activity-Based Flexible Budgets

Dominion Company's flexible budget as stated above is based on a single cost driver - units of product. This is an appropriate approach to flexible budgeting when "units of product" is both a plausible and reliable cost driver for all of a companys costs. But companies that have an activity-based costing system prepare an activity-based flexible budget by budgeting costs for each activity and related cost driver. The table below shows an activity-based flexible budget for the Dominion Company. There are four activities: processing, setup, marketing, and administration.

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Activity-Based Flexible Budgets

Dominion Company Activity-Based Flexible Budgets [ For the Month Ended June 30, 20X1

Budget Formula Sales ACTIVITY Processing Cost-driver level Variable costs Fixed costs Total costs of processing activity
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$ 31.00

Units 7,000 8,000 9,000 $ 217,000 $ 248,000 $ 279,000

Cost driver: Number of Machine Hours

$ 10.50 $ 13,000

14,000 $ 147,000 13,000 $ 160,000

16,000 18,000 $ 145,000 $ 189,000 13,000 13,000 $ 181,000 $ 207,000

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Activity-Based Flexible Budgets

Setup Cost-driver level Variable costs Fixed costs Total costs of setup activity
Marketing Cost-driver level Variable costs Fixed costs Total costs of marketing activity
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Cost driver: Number of Setups

$ 500 $12,000

21 $ 10,500 12,000 $ 22,500

24 27 $ 12,000 $ 13,500 12,000 12,000 $ 24,000 $ 25,500

Cost driver: Number of orders

350 $ 12.00 $ 4,200 $15,000 15,000

400 450 $ 4,800 $ 5,400 15,000 15,000

$ 19,200

$ 19,800 $ 20,400

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Activity-Based Flexible Budgets

Administration
Cost driver: Number of units

Cost-driver level Variable costs Fixed costs

Total costs of processing activity Total costs Operating Income (loss)

$ 0.20 $18,000

7,000 $ 1,400 $18,000

$ 19,400

8,000 $ 1,600 $18,000

9,000 $ 1,800 $18,000

$ 19,600 $ 19,800 $267,700 $ 11,300

$221,100 $244,400 $ (4,100) $ 3,600

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Notes on Activity-Based Flexible Budgets

Within each activity, costs depend on an appropriate cost driver. Compare the traditional flexible budgets and the activity-based flexible budgets. Note that the 8,000-unit columns in traditional flexible budgets and activity-based flexible budgets are the same, but at other volumes the costs diverge. The key difference is that some manufacturing costs that are fixed with respect to units are variable with respect to the costdriver "setups. That is, the fixed manufacturing costs ($37,000) in traditional flexible budgets include setup costs that are largely fixed with respect to "units produced" but that vary with respect to the "number of setups. An example is the cost of supplies used to set up the production run. Each time employees perform a setup, they use supplies. Therefore, the cost of supplies varies directly with the number of setups. However, production itself uses no setup supplies, so there is little change in the cost of supplies over wide ranges of units produced. This basic difference is why the total budgeted costs differ using the two approachesand why activity-based flexible budgets provide more accurate measures of cost behavior. When should a company use activity-based flexible budgets? A company uses activity-based flexible budgets when a significant portion of its costs vary with cost drivers other than units of production.
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End of Chapter 6

McGraw-Hill/Irwin

Copyright 2008, The McGraw-Hill Companies, Inc.