FLEXIBLE BUDGETS

Budgets and standards are similar in the following ways:

1. Budgets and standards are very similar and interrelated, but there are important differences
between them.
2. A budget is an overall plan and a standard cost is a unit cost. Standard costs may be used for
budgeting.
3. They both involve looking to the future and forecasting what is likely to happen given a certain set
of circumstances.
4. They are both used for control purposes. A budget aids control by setting financial targets or limits
for a forthcoming period. Actual achievements or expenditures are then compared with the
budgets and action is taken to correct any variances where necessary. A standard also achieves
control by comparison of actual results against a predetermined target.
5. As well as being similar, budgets and standards are interrelated. For example, a standard unit
production cost can act as the basis for a production cost budget. The unit cost is multiplied by the
budgeted activity level to arrive at the budgeted expenditure on production costs.
6. There are, however, important differences between budgets and standards.

Budget Standard cost

Gives planned total aggregate costs for a Shows the unit resource usage for a single task, for
function or cost centre example the standard labour hours for a single unit of
production
Can be prepared for all functions, even Limited to situations where repetitive actions are
where output cannot be measured performed and output can be measured
Expressed in money terms Need not be expressed in money terms. For example, a
standard rate of output does not need a financial value
put on it

FLEXIBLE BUDGETS
Comparison of a fixed budget with the actual results for a different level of activity is of little use
for control purposes. Flexible budgets should be used to show what cost and revenues should
have been for the actual level of activity.
A flexible budget is a budget which, by recognizing different cost behaviour patterns, changes as
volume of activity (output and sales) changes.

PREPARING A FLEXIBLE BUDGET

Step 1
The first step in the preparation of a flexible budget is the determination of cost behaviour
patterns, which means deciding whether costs are fixed, variable or semi-variable.
Step 2
The second step in the preparation of a flexible budget is to calculate the budget cost allowance
for each cost item.
Budget cost allowance = budgeted fixed cost* + (number of units x variable cost per unit)

Semi-variable costs therefore need splitting into their fixed and variable components so that the
budget cost allowance can be calculated. One method for splitting semi-variable costs is the
high/low method.

Example: Preparing a flexible budget

Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
department flexed at the activity levels of 80%, 90% and 100%, using the information listed below.
The direct labour hourly rate is expected to be $3.75.
100% activity represents 60,000 direct labour hours.

Variable costs

Indirect labour $0.75 per direct labour hour

Consumable supplies 10% of direct labour cost

Canteen and welfare services 6% of direct and indirect labour costs

Semi-variable costs are expected to relate to the direct labour hours in the same manner as for
the last five years.

Direct labour Semi-variable

Year hours costs

$
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 (estimate) 16,000 (estimate)
(v) Fixed costs
$
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
Inflation is to be ignored.
Calculate the budget cost allowance (i.e. expected expenditure) for 20X6
assuming that 57,000 direct labour hours are worked.

Solution
(a)
80% level 90% level 100% level
48,000 hrs 54,000 hrs 60,000 hrs
$'000 $'000 $'000
Direct labour 180.00 202.50 225.0
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc. 12.96 14.58 16.2
Total variable costs ($5.145 per hour) 246.96 277.83 308.7
Semi-variable costs (W) 17.60 18.80 20.0
Fixed costs
Depreciation 18.00 18.00 18.0
Maintenance 10.00 10.00 10.0
Insurance 4.00 4.00 4.0
Rates 15.00 15.00 15.0
Management salaries 25.00 25.00 25.0
Budgeted costs 336.56 368.63 400.7

Working
Using the high/low method:

$
Total cost of 64,000 hours 20,800
Total cost of 40,000 hours 16,000
Variable cost of 24,000 hours 4,800
Variable cost per hour ($4,800/24,000) $0.20

$
Total cost of 64,000 hours 20,800
Variable cost of 64,000 hours (x $0.20) 12,800
Fixed costs 8,000
Semi-variable costs are calculated as follows. $
60,000 hours(60,000 x $0.20) + $8,000 = 20,000
54,000 hours(54,000 x $0.20) + $8,000 = 18,800
48,000 hours(48,000x $0.20) + $8,000 = 17,600

The budget cost allowance for 57,000 direct labour hours of work would be as follows

$
Variable costs (57,000 x $5.145) 293,265
Semi-variable costs ($8,000+ (57,000 x $0.20) 19,400
Fixed costs 72,000
384,665

Flexible budgets and performance management

Budgetary control involves drawing up budgets for the areas of responsibility for individual
managers (production managers, purchasing managers, and so on) and regularly comparing
actual results against expected results. The differences between actual results and expected
results are reported as variances and these are used to provide a guideline for control action by
individual managers.
Note that individual managers are held responsible for investigating differences between
budgeted and actual results, and are then expected to take corrective action or amend the plan
in the light of actual events.
The wrong approach to budgetary control is to compare actual results against a fixed budget.
Suppose that a company manufactures a single product, Z. Budgeted results and actual results for
June 20X2 are shown below.
Budget Actual results Variance
Production and sales of the cloud (units) 2,000 3,000
$ $ $
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100
Profit (a) – (b) 1,900 6,800 4,900 (F)
Here the variances are meaningless for control purposes. Costs were higher than budget because
the output volume was also higher; variable costs would be expected to increase above the costs
budgeted in the fixed budget. There is no information to show whether control action is needed
for any aspect of costs or revenue.

For control purposes, it is necessary to know the following.

 Were actual costs higher than they should have been to produce and sell 3,000 Zs?

 Was actual revenue satisfactory from the sale of 3,000 Zs?

The correct approach to budgetary control is as follows.

 Identify fixed and variable costs

 Produce a flexible budget using marginal costing techniques

Let's suppose that we have the following estimates of cost behaviour for the company.

 Direct materials, direct labour and maintenance costs are variable.

 Rent and rates and depreciation are fixed costs.

 Other costs consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and
sold.

Now that the cost behaviour patterns are known, a budget cost allowance can be
calculated for each item of expenditure. This allowance is shown in a flexible budget
as the expected expenditure on each item for the relevant level of activity. The
budget cost allowances are calculated as follows.
(a) Variable cost allowances = original budgets x (3,000 units/2,000 units)
e.g. material cost allowance= $6,000 x 3/2 = $9,000
(b) Fixed cost allowances = as original budget
Semi-fixed cost allowances = original budgeted fixed costs
+ (3,000 units x variable cost per unit)

e.g. other cost allowances = $1,600 + (3,000 x $1) = $4,600

The budgetary control analysis should be as follows.
Fixed Flexible Actual Budget
budget budget results variance
(a) (b) (c) (b) - (c)
Production and sales (units) 2,000 3,000 3,000
$ $ $ $
Sales revenue 20,000 30,000 30,000 0
Variable costs
Direct materials 6,000 9,000 8,500 500 (F)
Direct labour 4,000 6,000 4,500 1,500 (F)
Maintenance 1,000 1,500 1,400 100 (F)
Semi-variable costs
Other costs 3,600 4,600 5,000 400 (A)
Fixed costs
Depreciation 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)
Note. (F) denotes a favourable variance and (A) an adverse or unfavourable variance.
We can analyze the above as follows.
In selling 3,000 units the expected profit should not have been the fixed budget
profit of $1,900, but the flexible budget profit of $5,400. Instead, actual profit was
$6,800 i.e. $1,400 more than we should have expected. One of the reasons for the
improvement is that, given output and sales of 3,000 units, costs were lower than
expected (and sales revenue exactly as expected).

$
Direct materials cost variance 500 (F)
Direct labour cost variance 1,500 (F)
Maintenance cost variance 100 (F)
Other costs variance 400 (A)
Fixed cost variances
Depreciation Another
200 (A)
Rent and rates reason
100 (A) for
the
1,400 (F)
improvement
in profit above the fixed budget profit is the sales volume (3,000 Zs were sold instead of
2,000).
$ $
Sales revenue increased by 10,000
Variable costs increased by:
Direct materials 3,000
Direct labour 2,000
Maintenance 500
Variable element of other costs 1,000
Fixed costs are unchanged 6,500
Profit increased by 3,500

Profit was therefore increased by $3,500 because sales volumes increased.

A full variance analysis statement would be as follows.
$ $
Fixed budget profit 1,900
Variances
Sales volume 3,500 (F)
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance cost 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and rates 100 (A)
4,900 (F)
Actual profit 6,800
If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary or whether the
plan needs amending in the light of actual events.
Question Budget preparation
The budgeted and actual results of Crunch Co for September were as follows. The company uses a
marginal costing system. There was no opening or closing stocks.
Fixed budget Actual
Sales and production 1,000 units 700 units
$ $ $ $
Sales 20,000 14,200
Variable cost of sales
Direct materials 8,000 5,200
Direct labour 4,000 3,100
Variable overhead 2,000 1,500
14,000 9,800
Contribution 6,000 4,400
Fixed costs 5,000 5,400
Profit/(loss) 1,000 (1,000)

Required
Prepare a budget that will be useful for management control purposes.

Answer

We need to prepare a flexible budget for 700 units.

Budget Flexed Actual Variances
budget
per
1,000 units unit 700 units 700 units
$ $ $ $ $
Sales 20,000 (20) 14,000 14,200 200 (F)
Variable costs
Direct material 8,000 (8) 5,600 5,200 400 (F)
Direct labour 4,000 (4) 2,800 3,100 300 (A)
Variable production
overhead 2,000 (2) 1,400 1,500 100 (A)

14,000 (14) 9,800 9,800

Contribution 6,000 4,200 4,400
Fixed costs 5,000 (N/A) 5,000 5,400 400 (A)
Profit/(loss) 1,000 (800) (1,000) 200 (A)

By flexing the budget in the question above we removed the effect on sales revenue of the
difference between budgeted sales volume and actual sales volume. However, there is still a
variance of $200 (F). This means that the actual selling price must have been different to the
budgeted selling price, resulting in a $200 (F) selling price variance.
Factors to consider when preparing flexible budgets
The mechanics of flexible budgeting are, in theory, fairly straightforward but in practice there are a
number of points to consider before figures are simply flexed.
Splitting mixed costs is not always straightforward.

 Fixed costs may behave in a step-line fashion as activity levels increase/decrease.

 Account must be taken of the assumptions on which the original fixed budget was based.
Such assumptions might include the constraint posed by limiting factors, the rate of
inflation, judgments about future uncertainty, the demand for the organization’s products,
and so on.
 By flexing a budget, a manager is effectively saying 'If I knew then what I know now, this is
the budget I would have set'. It is a useful concept but can lead to some concern, as
managers can become confused and frustrated if faced with continually moving targets.

The need for flexible budgets

 We have seen that flexible budgets may be prepared in order to plan for variations in the
level of activity above or below the level set in the fixed budget. It has been suggested,
however, that since many cost items in modern industry are fixed costs, the value of
flexible budgets in planning is dwindling.
 In many manufacturing industries, plant costs (depreciation, rent, and so on) are a very
large proportion of total costs, and tend to be fixed costs.
 Wage costs also tend to be fixed, because employees are generally guaranteed a basic
wage for a working week of an agreed number of hours.
 With the growth of service industries, labour (wages or fixed salaries) and overheads will
account for most of the costs of a business, and direct materials will be a relatively small
proportion of total costs.
 Flexible budgets are nevertheless necessary and, even if they are not used at the planning
stage, they must be used for budgetary control variance analysis.