Management Accounting

Methods of Preparing Flexible Budget

1. Where the budget is prepared before the budget period begins, determine the normal level of activity. The budget is flexed to the normal level;
2. Prepare budgets for all important levels of activity. When the actual level is known then the budget is prepared by interpolating between the budgets of the activity levels immediately below or above the actual level; and
3. Where the budget is prepared at the end of the budget period, determine the actual level of activity. The budget is flexed to the actual level.

Preparing a Flexible Budget

A flexible budget is one in which you develop different scenarios, based on different assumptions, in order to judge whether changes that you are able to make might be beneficial. In the case of the proposed café, we can experiment with different types of assumptions and examine other ways of doing things. For example, using the first draft budget for the café, we can show the effect of increasing the sales by 50 per cent and 100 per cent. If sales were increased by 100 per cent, the existing oven would not cope with the extra volume of food required. A new oven would have to be purchased to cope with a 100 per cent increase in sales. The additional capital expenditure would be:

Acquisition of new oven                                RM18000

Fitting and installation of new oven               RM2300

Estimated length of life of new oven              8 years

Residual value of oven after 8 years’             RM1500

If sales increase by 50 per cent, the staff costs for cooking and preparation would remain unchanged, but additional staff would be required for waiting on the tables. This would cost an extra RM250 per month. If sales increased by 100 per cent, then the increase in the monthly cost of staff would be RM350.

In order to calculate a flexible budget for a full year and forecast the annual profit or loss the following approach could be followed:

1. The period we are asked to look at is a full year, so we need to estimate both    revenue (sales) and expenses (costs) for a 12 month period.
2. We are asked to forecast the annual profit or loss.
3. We are asked first to assume a 50 per cent increase in sales for the full year and, second, a 100 per cent increase in sales for a full year.
4. If we buy an extra oven to cope with extra demand that will involve capital expenditure and our budget estimates will have to include an increased allowance for ‘depreciation’.

Activity Flexible Budgeting

Activity flexible budgeting is the prediction of what activity costs will be as activity output changes. Variance analysis within an activity framework makes it possible to improve traditional budgetary performance reporting. It also enhances the ability to manage activities.

In a functional-based approach, budgeted costs for the actual level of activity are obtained by assuming that a single unit-based driver (unit of product or direct labour hours) droves all costs. A cost formula is developed for each cost item as functions of units produced or direct labour hours. However, costs vary with respect to more than one driver and the drivers are not highly correlated with direct labour hours, then the predicted costs can be misleading.

The solution, of course, is to build flexible budget formulas for more than one driver. Cost estimation procedures can be used to estimate and validate the cost formulas for each activity. In principle, the variable cost component for each activity should correspond to resources acquired as needed, and the fixed cost component should correspond to resources acquired in advance of usage. This multiple formula approach allows managers to predict more accurately what costs ought to be for different levels of activity usage, as measured by the activity output measure. These costs can then be compared with the actual costs to help assess budgetary performance. The budgeted amounts for the other items differ significantly from the traditional amounts because the activity output measures differ.

Flexible Budgets and Performance Reports

A flexible budget is a tool that is extremely useful in cost control. In contrast to a static budget, the flexible budget is characterized as follows:

1. It is geared toward a range of activity rather than a single level of activity.
2. It is dynamic in nature rather than static. By using the flexible budget formula, a series of budgets can be easily developed for various levels of activity.

The static budget is geared for only one level of activity and is relatively ineffective in cost control. Flexible budgeting distinguishes between fixed and variable costs, thus allowing for a budget that can be automatically adjusted to the particular level of activity actually attained. Thus, variances between actual cost and budgeted costs are adjusted for volume ups and downs before differences due to price and quantity factors are computed.

 The primary use of the flexible budget is to give accurate measurements of performance by comparing actual costs for a given output with the budgeted costs for the same level of output.

Performance Evaluation with a Flexible Budget

The use of a flexible budget for cost performance reporting makes the budget estimates and actual results comparable since they both are based on the same level of activity. Table 3 presents a flexible budget performance report for the production department of Bendigo Manufacturing Ltd. Instead of achieving favourable financial results that might be reported with the fixed budget shown earlier, the department actually incurred an adverse variance of RM32950. Both the budget column and the actual column in the report are based on the same production level of 20000 units. The flexible budget performance report represents a much more realistic evaluation of the departmental cost performance than the fixed budget performance report.

The variances shown in table 4 have meaning since they relate to the cost performance only. Production differences have been eliminated by adjusting the flexible budget to the level of 20000 units. The performance report provides management with a realistic indication of the areas that should be investigated further in order to control the production cost. For example, direct materials cost and direct labour cost exceeded the budget estimates by RM10000 (10%) and RM20000 (8.3%) respectively. Corrective action will be required if future profitability goals are to be achieved.

The dynamic nature of a flexible budget permits management to adjust it to any level as long as the same cost behavior patterns prevail. In the case of Bendigo Manufacturing Ltd, the actual level of activity was the same as one of the levels in the original flexible budget (20000 units). Even if the actual activity level is not found in the flexible budget, management easily can adjust the budget to that level. For example, if Bendigo Manufacturing Ltd had produced 22400 units, the budget would be adjusted to that level and the results would be compared with the associated actual costs. The variable cost rates (totaling RM19.50 per unit) would be multiplied by 22400 to determine the total variable costs, and the fixed costs would be the same as they were for the production of 25000 units (RM94400). The total budgeted manufacturing costs for 22400 units would be RM531200.

 

Flexible Budget for Factory Overhead

A flexible budget can be prepared for factory overhead to avoid the limitations of a fixed budget. A distinction between variable and fixed costs is made and the budget is prepared for a range of production levels so that management can evaluate the impact of attaining an activity level different from the one planned. The production activity levels are based on the same measure of standard production used to apply the overhead. Whenever the standard production performance is different from that planned, management can easily adjust to the change by revising the original budget. The budgeted fixed overhead costs for the standard production level attained will be the same as those in the original budget, but the budgeted variable overhead cost will change.

A factory overhead flexible budget for the Parramatta Manufacturing Co. Ltd is shown in table 5. The budget represents the January portion of the annual flexible budget used by the firm to calculate a predetermined overhead rate and to provide a comparative basis for cost performance evaluation with variance analysis. Standard direct labour hours are used to measure the level of production and range from 7000 to 10000 for the budget period. Four production levels are budgeted as percentages of maximum capacity at 70%, 80%, 90%, and 100%. Maximum capacity is the measure of the highest production level a firm can achieve with its existing physical facilities and organizational structure. The variable overhead costs change at a rate of RM2 per standard direct labour hour within the budgeted range of activity. The fixed costs remain constant at RM45000. As a result, the total factory overhead at any level of activity can be calculated with the following formula:

        Factory overhead = RM45000 + (RM2 x Standard direct labour hours)

Since a range of production activity is considered in the flexible budget, a single level of production must be selected for the calculation of the predetermined overhead rate. The choice of a specific production level is important because different overhead rates are calculated for different levels of production. These differences are caused by the fact that the fixed costs per standard direct labour hour decrease as the number of hour’s increases. The following schedule illustrates the effect of cost behavior on the calculation of a predetermined overhead rate from the flexible budget of Parramatta Manufacturing Co. Ltd:

Table 5 Factory overhead flexible budget

As a result, the total overhead rate decreases from RM8.43 per hour to RM6.50 per hour as the capacity increases from 70% to 100%. If the correct production level is not selected at the beginning of the period, the wrong amount of overhead will be applied to work in process even if the actual cost performance is equal to its related budget estimates. For example, if Parramatta Manufacturing Co. Ltd selects its predetermined overhead rate from the maximum capacity level, the fixed portion of the rate will be RM4.50. If the firm works only 8000 standard direct labour hours, the fixed overhead applied will be RM36000 (8000×RM4.50) despite the fact that the budgeted fixed costs were RM45000. The variable costs do not cause the same problem since they automatically adjust to the level of 8000 standard direct labour hours, with the applied amount and budgeted amount being equal at RM16000 (8000×RM2). The following four concepts of capacity can be considered for the choice of a production level within a flexible budget:

1. Maximum capacity: The highest level of production activity possible if optimal operating conditions exist with no delays, materials shortages or maintenance problems.
2. Practical capacity: Maximum capacity less reasonable allowances for departures from an optimal performance.
3. Expected capacity: Level of production activity expected for a specific year, given the firm’s operating conditions and market demand for its products.
4. Normal capacity: The average annual production activity that will satisfy the market demand over a relatively long time, such as a three to five year period.

Why do Companies need Flexible Budget?

1. The supply and cost of raw materials, electricity, and natural gas may change unexpectedly;
2. Competitive pressures from imports and substitute materials may intensify;
3. The market demand for steel products may change;
4. Change to foreign trade policy may alter current importing and exporting practices;
5. New government regulations could significantly increase environmental compliance costs; and
6. Uncertainties regarding the global economy may affect customer demand.

Question b

Classification of Costs by behavior

Costs may or may not vary with the level of activity. The level of activity usually refers to the volume of production or number or value of items sold. A manager must have knowledge about a company’s cost behavior so that may predict the impact of their decision on profit and in controlling costs. The preparation of a flexible budget requires an understanding of basic cost-behavior patterns. They are:

 

Variable Costs

A variable cost is one that changes in response changes in the level of activity.  Variable costs vary in direct proportion to the volume of activity, that is, doubling the level of activity wills double the total variable cost. Total variable costs are linear and a unit variable cost is constant i.e. total variable costs decrease as the production decreases and vice versa, variable cost per unit remains fixed. For examples: Direct Material Costs, Direct Labour Cost, Direct Expenses, and Variable Overheads.

Variable costs remain the same per unit as activity levels rise or fall. The total expenditure on variable costs of course rises or falls. Variable costs have two types, they are as follows:

1. Linear variable cost or engineered cost: When the relationship between variable cost and output can be shown as a straight line oh the graph, they are termed as linear variable cost. A variable cost is called as engineered cost because an optimum relationship can be carefully determined by work measurement technique between input and output. Direct material cost and direct labour cost are good examples of engineered cost.

2.  Non-linear or curvilinear variable cost: When the relationship between variable cost and output can be shown as a curved line on a graph, it is said to be curvilinear. The non-linear variable cost may be of two types. They are convex-linear variable cost and concave-linear variable cost. The convex-linear variable cost it is a cost where each extra unit of output causes a less than proportionate increase in cost. The concave-linear variable cost it is a cost where each extra unit of output causes a more than proportionate increase in cost. Differential piece rate system of wage payment is a good example for this type of cost.

1. Practical Example

Thus, variable cost per unit remains fixed and does not change with the changes in the volume of output.

2. Graphical Representation

Fixed Costs

Total fixed costs are those costs which do not vary with the change in the volume of production up to a given range. Fixed costs per unit vary with the change in the volume of production. Thus, fixed cost per unit goes on decreasing as the total number of output produced increases i.e. fixed cost per unit decreases as the production increases and vice versa. For examples: Rent and Insurance of Building, Plant & Machinery & Furniture, Salary of manager etc.

Fixed costs remain the same regardless of activity levels. The salary of the chief executive is a fixed cost. Fixed costs, on the other hand, rise per unit if the activity level falls, because the number of units that must bear them has fallen. Similarly, if the activity levels rise fixed cost per unit will be fall.

Fixed costs have two types, they are as follow:

1. Committed cost: These costs are related to the provision of a capacity to do business. The amount of committed cost is fixed by decisions which were made in the past and is not subject to management control in the present on a short run basis. Since there is no direct relationship between committed costs and either the planned or actual utilization of existing facilities, the amount will remain constant over the whole range of operating activity.

2. Programmed or managed cost: These costs are related to the utilization of the capacity provided.

There have five categories of fixed costs:

1. The time period classification: Those types of cost which are not likely to change significantly in the short term, usually a year. In the long term all costs may change or become avoidable.
2. The volume classification:  Costs which are fixed for small, but not large changes in output or capacity.
3. The joint classification: Where a cost is incurred jointly with another cost and is only capable of being altered jointly. For example, if an organization leases a showroom which has a warehouse attached then the fixed cost element applies to both parts of the asset acquired whether or not they are both wanted.
4. The policy classification: These are costs which are fixed by management policy and bear no causal relationship to volume or time. They are usually items which are dealt with by appropriation budgets, e.g. expenditure on advertising, research and development. These types of costs are sometimes known as programmed fixed costs and typically are reviewed annually.
5. The avoidable classification: These are costs which are fixed in the normal sense i.e. they do not vary with activity, but they are avoidable if particular decisions or events occur. For example, the rent and rates for a branch office would normally be classed as fixed yet they are avoidable if the branch was shut down.

1. Practical Example

2. Graphical Representation

A summary of both variable and fixed cost behavior is present in below table.

Mixed (Semi-Variable) Cost

Semi-variable costs are those costs of which one part remains fixed up to a given range and the other part varies with the change in the volume of production but not in the same proportion. Semi-variable costs are costs that vary but do not vary in direct proportion to the level of activity because some of these costs are a mixture of fixed and variable costs. Semi-variable costs are also known as semi-fixed costs. For example, the delivery costs, which include the petrol or diesel of a delivery fleet, will vary the number of kilometers driven. Other related costs, however, such as road tax, insurance and maintenance are generally fixed over a given period.

When managers have identified a semi-var5iable cost they will need to know how much of it is fixed and how much is variable. Only when they have determined this they will be able to estimate the cost to be incurred at relevant activity levels. Past record of costs and their associated activity levels are usually used to carry out the analysis. The three most common methods used to separate the fixed and variable elements are as follows:

1. The high-low method: This method picks out the highest and lowest activity levels from the available data and investigates the change in cost which has occurred between them. The highest and lowest points are selected to try to use the greatest possible range of data. This improves the accuracy of the result.
2. The scatter graph method: This method takes account of all available historical data and it is very simple to use. However, it is prone to inaccuracies that arise due to subjectivity and the likelihood of human error.
3. The least squares method of regression analysis

1. Practical Example

Sales representatives are often paid a salary plus a commission and sales.

2. Graphical Representation

                

                           

                                   

Summary

This coursework look at flexible budget and the types of costs involved in a flexible budget. A flexible budget can be developed by expressing revenues and variable costs on a budgeted per output unit basic and then multiplying these amounts by the appropriate output level. Alternatively, the flexible budget can be developed, first by computing standard costs for its inputs, then summing those amounts to obtain the standard cost per output unit, and finally by multiplying these standard costs per output unit by the appropriate output level.

In contrast, flexible budgets are prepared for different levels of activity. Comparison is more meaningful because the flexible budget is flexed to actual level of activity.

The master budget is typically static; that is, it is developed in detail for one level of activity. A flexible budget recognizes that variable costs and revenues are expected to differ from the budget if the actual activity differs from what was budgeted. A flexible budget can be thought of as the costs and revenues that would have been budgeted if the activity level had been correctly estimated in the master budget. The general relationship between the actual results, the flexible budget, and the master budget follows: a) Actual- Actual costs and revenues based on actual activity. b) Flexible budget- Cost and revenues that would have been budgeted if actual activity had been budgeted. c) Master budget- Budgeted costs and revenues based on budgeted activity.

In flexible budgeting, costs must be separated into fixed, variable and semi-variable (fixed) cost. The measurement of activity may be expressed in units produced or labour hours or machine hours or number of units sold. We have seen that the distinction between fixed and variable costs is only valid within a relevant range of activity. Whatever measure is chosen there must be a high correlation with cost, especially variable cost under consideration.

A variable cost is a cost that changes in total in proportion to changes of a cost driver. Unit variable cost is expected to stay the same regardless of the change in level of activity within the relevant range. A fixed cost is a cost that does not change in total despite changes of a cost driver. Unit fixed cost will vary with any change in level of activity. Semi-variable (fixed) has both a variable and a fixed cost component.

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