This chapter introduces flexible budgets. The most common budgets prepared on a flexible basis focus on total production costs, or some measure of profitability, such as an income statement budget. Flexible budgets are useful for performance evaluation of cost and profit centers. The evaluation process involves comparing budgeted amounts with actual performance to determine and evaluate variances.

 


Budgetary Control


Cost and profit center managers are responsible for controlling their respective areas of operations. The specific components of which they have control depend on which type of center for which a manager is responsible.

 

A budgeted amount is often called a ‘benchmark’ and is an amount against which actual results are compared. Any difference between actual activity and budgeted amounts is called a budget variance. Some variances are favorable, while others are unfavorable. Favorable variances may not always indicate 'good' situations, and unfavorable variances are not always the result of something 'wrong'. These variances are highlighted on a performance report and labeled as favorable or unfavorable, depending on the effect on profit. Variances which result in profit being less than what was budgeted as considered unfavorable. Variances which result in profit being greater than what was budgeted as considered favorable. The analysis of variances is a key tool used in evaluating managers.

 


Budget Variances


Budget variances exist for three primary reasons. First, the budget may have errors in its creation. This can be due to a number of reasons including math computations, relying on wrong data, failing to consider inflation, etc. Second, conditions may have changed. Economic conditions impact consumer demand, cost of materials, competitive pricing of goods, etc. For example, the change in oil prices in recent years caused airlines and trucking companies to have significant variances because the fuel prices used in the budgets were less than the actual cost. Third, a manager's job performance may have been very good or very bad.

 


Investigating Variances


The management by exception approach requires that only budget variances that are 'material' in amount be investigated. Materiality is a term from your financial accounting class that implies that if the dollar amount is large enough to impact someone's decision, then it should be considered significant to disclose. Both favorable and unfavorable variances are investigated if they exceed the materiality threshold. The threshold is the maximum amount of a variance and can be measured in dollars as a designated amount or as a percentage of the budgeted cost. For instance, assume a budgeted cost of $50,000 for labor with a materiality threshold of 1%. The 1% indicates the level for which all variances exceeding that amount should be investigated. As such, management should investigate all favorable and unfavorable variances that are at least $500. The threshold amount used will vary by company.

 

Why do companies investigate variances? To determine the cause of the variance so it can be remedied if needed, or used as a model to improve other areas of the company.

 


Static Budgets


Budgets that are prepared as part of the master budget are based on a predetermined level of sales volume. All budgets prepared prior to the beginning of the accounting period are designed for the level of activity at which the company plans to operate. This type of budget is a static budget, because the level of activity is static or fixed on a single level of sales. Static budgets are useful in planning future operations. However, very few companies perform at the exact level of activity that was originally planned in the master budget.

 

For example, assume RavCo's static budget allows $4 per widget for variable production costs based on 300 units expected to be produced, for a total cost allowed of $1,200. During June, the manager produced 350 widgets and incurred costs of $1,320. Comparing the actual costs to the static budget amount, it appears the manager spent $120 more than allowed ($1,320 - $1,200). Because static budgets do not consider the fact that the company may have operated at a different level of activity, they do not accurately reflect how well a manager performed when compared with actual activity. 

 


Flexible Budgets


A flexible budget can be prepared for any level of activity within the relevant range. To be effective as a tool in evaluating performance, it should be based on the actual activity level once it is known--at the end of an accounting period. Any budget used for performance evaluation purposes should reflect the same volume of units sold or produced as the number actually achieved. The use of units sold or produced depends on the nature of the budget. If the budget is for production costs, the number of units produced should be used. If it is an income statement budget, the number of units sold is used to determine the flexible budget.

The focus in this chapter is primarily on performance evaluation of cost center managers. Cost center managers are responsible primarily for costs within their division or department. In the case of manufacturing companies, production cost budgets are very important to ensure that costs remain within budget. In preparing flexible budgets for product costs, costs are separated based on behavior---variable costs and fixed costs---because variable unit costs and total fixed are easy predictors of future costs. The following are used to determine flexible budget costs:

Flexible budget variable cost = Budgeted variable cost per unit x Actual number of units

 

Flexible budget fixed cost = Same as static budget amount allowed

 

Recall that the static budget for RavCo allowed $4 per widget for variable production costs. At the estimated static production level of 300 units, a total cost of $1,200 was estimated in the static budget. When actual production is 350 widgets, a flexible budget will allow $4 of variable costs for each unit produced, or a total of $1,400 (350 x $4). With an actual cost incurred of $1,320, the variance is now favorable as $80 less was spent on variable production costs compared to the flexible budgeted amount.

 

Flexible budgets consider the fact that the company often operates at a different level of activity, and more accurately reflect how well a manager performs when compared with actual activity.   Because a flexible budget adjusts budgeted allowances to actual levels of activity, it is the preferred method in evaluating performance.

 


Performance Report 


A performance report is a comparative analysis of a budgeted amounts with the actual amounts, and the resultant variances. It is most effective when a flexible budget is used to compare with actual, though some companies like to see the differences between the originally planned activity as well. Variances are displayed as dollar amounts and each is labeled with an 'F' is favorable, or a 'U' if unfavorable.

 


Walk Through Problem 


Assume that Max, Inc. created its original production cost budget assuming 1,000 units of product would be produced. Management prepared a performance report based on the static budget, as follows:

 

  Unit Costs Allowed Static Actual    
  Budget Activity Variances  
Units produced   1,000 900    
Variable costs:          
  Direct labor $2.00 $2,000 $1,800       $200  F
  Direct materials $1.50 1,500 1,400         100  F
  Factory supplies $0.25 250 260           10  U
Total variable costs   3,750 3,460         290  F
Fixed costs:          
  Depreciation   2,000 2,100         100 U
  Occupancy costs   800 760           40  F
Total fixed costs   2,800 2,860           60 U
Total overhead costs   $6,550 $6,320       $230  F

At the end of the month, it was determined that actual production was only 900 units. Determine if the manager has been evaluated fairly by preparing a performance report that contains a flexible budget performance report. Identify which variances should be investigated assuming the company has a 1% materiality threshold.

Solution

The static budget variances are not very meaningful because the manager produced fewer units than expected in the budget. The format of the flexible budget performance report is the same as a static, expect that static budget column amounts are replaced with the flexible budget amounts, which results in new variances. The variable flexible budget amounts are determined by multiplying the unit costs allowed by the actual activity. The flexible budget allowed for direct labor is $2 times 900 units, or $1,800. The amount allowed for direct materials is  $1.50 times 900, or $1,350, and for factory supplies, the cost allowed is $0.25 times 900, or $225. Fixed costs allowed are the same in total at every level of activity.

 

  Unit Costs Allowed Flexible Actual Variances  
  Budget Activity
Units produced   900 900    
Variable costs:          
  Direct labor $2.00 $1,800 $1,800       $    0  F
  Direct materials $1.50 1,350 1,400           50  U
  Factory supplies $0.25 225 260           35  U
Total variable costs   3,375 3,460         $85  F
Fixed costs:          
  Depreciation   2,000 2,100       $100 U
  Occupancy costs   800 760           40  F
Total fixed costs   2,800 2,860       $  60 U
Total overhead costs   $6,175 $6,320       $145  U

 

Now it appears the production manager incurred more costs than he was allowed to spend at 900 units of activity, creating an unfavorable variance of $145.

 

Any cost with a variance that exceeds the company's minimum threshold level should be investigated. Max's 1% materiality threshold is multiplied by the total flexible budget amount of $6,175, to arrive at a dollar threshold of $61.75. Every variance that is $61.75 or greater should be investigated, regardless if favorable or unfavorable. Only one of Max's variances is large enough to be investigated---the depreciation cost. Investigation begins with an inquiry of the manager responsible for controlling the respective costs. 


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