FLEXIBLE BUDGETING

SESSION 1-5: FLEXIBLE BUDGETS

1-5.1 INTRODUCTION
Usually, a firm prepares a budget for a single expected level of activity such as production or sale.
It does not change the budget even if the level of activity differs from the expected. Such a budget
is called static or fixed budget. Since the actual level of activity may significantly differ from the
expected, the static budget has limited use for cost control purpose. Besides, it also fails to analyze
the reasons for the difference between the actual and expected levels of activity. It also causes
difficulty in forecasting the operation for the firms dealing in continuous and job order production.
Therefore, another type of budgeting was developed to overcome the limitations of static budget,
which is known as flexible budgeting.

The concept of responsibility accounting requires the use of flexible budgets for control purposes.
Many of the costs under a manager‘s control are variable and will therefore change if the level of
activity is different from that in the budget. It would be unreasonable to criticize a manager for
incurring higher cost if these were a result of a higher than plan volume of activity.

Conversely, if the level of activity is low, costs can be expected to fall and the original budget must
be amended to reflect this. A variance report based on a flexible budget therefore compares actual
costs with the costs budgeted for the level of activity actually achieved. It does not explain any
change in budgeted volume, which should be reported on separately

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.

1-5.2 MEANING OF FLEXIBLE BUDGET

To understand the flexible budget, you must first understand a static budget. A static budget is
prepared by management before a given accounting period. This budget tells management what
income and costs to expect during the upcoming accounting period. Unlike a static budget, a
flexible budget is prepared at the end of the accounting period to show what the static budget should
have looked like. Dennis Caplan, of Oregon State University's College of Business, defines the
flexible budget as the one that would have been prepared ―if I had known at the beginning of the
period‖ what I know now.

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed
to change as volume of activity changes (ACCA, BPP 2010). A flexible budget (variable budget)
is a budget that adjusts for changes in sales volume and other cost-driver activities. A flexible
budget is one which is revised while it is current to take account of changing circumstances-
typically price levels and output levels. Divergences from a flexed budget thus reflect only

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operational efficiencies. A flexible budget calculates budgeted revenues and budgeted costs based
on the actual output in the budget period. A budget that is designed to cover a range of activity and
that can be used to develop budgeted costs at any point within that range to compare to actual costs
incurred. A flexible budget is prepared for a variety of activity levels taking into account the
variable and fixed costs of the organization.

Although usually prepared after the fact, sometimes flexible budgets are prepared at the beginning
of an accounting period to allow management to experiment with different numbers. When this
happens, the flexible budget is often called a “pro forma budget.”

The flexible budget variance is the difference between any line-item in the flexible budget and
the corresponding line-item from the statement of actual results.

1-5.3 CHARACTERISTICS OF FLEXIBLE BUDGET

The important characteristics of flexible budget can be pointed as follows:
a) Flexible budget covers a range of activities
b) Flexible budget is easy to change according to variations of production and sales levels.
c) Flexible budget facilitates performance measurement and evaluation.
d) It takes into account the changes in the volume of activity.
e) Flexible budget replaces a static budget for control.

1-5.4 PREPARING A FLEXIBLE BUDGET

Preparing a flexible budget is simple and very much like preparing a static budget. To prepare a
flexible budget, you must look back at the static budget to determine what per-unit fixed and
variable costs were used to prepare it. Then find out how many units were actually manufactured
during the period. Combine the fixed and variable costs used on the static budget with the actual
number of units produced to create the flexible budget. Creating the flexible budget in a spreadsheet
next to the original static budget will allow you to easily compare the two. Outline of the steps are
as follows:
1. Determine the cost behaviour patterns, which mean deciding whether costs are fixed,
variable or semi-variable.
2. Calculate the budget cost allowance for each cost item: Budget cost allowance = budgeted
fixed cost* + (number of units × variable cost per unit)**
* nil for variable cost **
nil for fixed cost
Semi-variable costs therefore need splitting into their fixed and variable components so that
the budget cost allowance can be calculated.
3. Determine the relevant range of activity or the actual volume of output achieved
4. Build the flexible budget based on the budgeted cost information and the actual volume of
output.
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Example 1
Flexible Budget Ltd manufactures one uniform product only, and activity levels in the assembly
department vary widely from month to month. The following statement shows the departmental
overhead budget based on an average level of activity of 20,000 units production per four-week
period and the actual results for four weeks in October.

Budget average for Actual for 1 to 28 October

four-week period
GH¢ GH¢

Indirect labour-variable 20,000 19,540

Consumables-variable 800 1,000

Other variables -overheads 4,200 3,660

Depreciation-fixed 10,000 10,000

Other fixed overheads 5,000 5,000

40,000 39,200

Production units 20,000 17,600

You are required:

a) To prepare a columnar flexible four-week budget for at 16,000, 20,000 and 24,000 unit levels
of production;
b) To prepare two performance reports based on production of 17,600 units by the department in
October, comparing actual with:
i) average four-week budget; and
ii) flexible four-week budget for 17,600 units of production ;
c) To state which comparison (b)(i) or (b)(ii) would be more helpful in assessing the foreman‘s
effectiveness and why.

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SOLUTION

Solution 1-(a)

Production level 16000units 20000units 24000units

Variable costs: GH¢ GH¢ GH¢

Indirect labour 16,000 20,000 24,000

Consumables 640 800 960

Other overheads 3,360 4,200 5,040

Fixed costs:

Depreciation 10,000 10,000 10,000

Other overheads 5,000 5,000 5,000

35,000 40,000 45,000

Solution-(b-i)
Average four week Actual results Variances
budget fav/(adv)

Production level 20,000units 17,600units

Variable costs: GH¢ GH¢ GH¢

Indirect labour 20,000 19,540 460

Consumables 800 1,000 (200)

Other overheads 4,200 3,660 540

Fixed costs:

Depreciation 10,000 10,000 -

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 Other overheads 5,000 5,000 -

40,000 39,200 800

Solution-(b-ii)
Flexed four-week Actual results Variances
budget fav/(adv)

Production level 17,600units 17,600units -

Variable costs: GH¢ GH¢ GH¢

Indirect labour 17,600 19,540 (1,940)

Consumables 704 1000 (296)

Other overheads 3,696 3,660 36

Fixed costs:

Depreciation 10,000 10,000

Other overheads 5,000 5,000

37,000 39,200 (2,200)

Solution c
The flexed budget provides more useful data for comparison because:
i) The fixed original budget makes no distinction between fixed and variable cost;
ii) Hence no data is available concerning the appropriate level of costs at the actual production
level;
iii) This would lead to the conclusion that the foreman had done well, when in fact costs had
not fallen nearly as much as anticipated for the actual production;
iv) Responsibility for the production shortfall is not known.

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1-5.5 FLEXIBLE BUDGETS AND PERFORMANCE EVALUATION
A static budget is prepared for only one level of activity. This one level of activity has associated
revenues, associated expenses, and produces a level of planned net income. Often times, though,
an organization‘s level of activity differs from the planned level, producing greater expenses but
also greater revenues to cover those revenues. If managers‘ performances are measured only in
how they control expenses as compared to a static budget, this would be an unfair comparison if
the level of activity was either greater or smaller than planned.

To provide managers a more fair comparison when actual activity levels vary from planned levels,
flexible budgets were developed. A flexible budget provides an estimate of what costs (expenses)
should be for any level of activity within a specified range. When a flexible budget is used in
performance evaluation, actual costs are compared to what costs should have been for the actual
level of activity for the period, rather than to the budgeted costs for the original budget. Therefore
Managers‘ performance in controlling costs should be measured against the flexible budget amount
for the actual level of activity.

Solved Example 2:
As the Management Accountant of Mind Power Co. Ltd, you have been provided with the
following operating statement, which represents an attempt to compare the actual performance of
‗brainstorm‘ for the quarter that has just ended with the budget.

Budget Actual results Variance

GH¢ GH¢ GH¢
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)
Other costs 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Maintenance 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)

Production and sales of the ‗brainstorm‘ (units) 5,000 7,000

The estimates of cost behaviour for the company are as follows:

i. Direct materials, direct labour and other costs are variable. ii. Maintenance costs consist
of fixed costs of GH¢1,600 plus a variable cost of GH¢0.4 per unit made and sold.
iii. Rent and rates and depreciation are fixed costs.

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Required
a) Using a flexible budgeting approach, redraft the operating statement so as to provide a
more realistic indication of the variances, and comment briefly on the possible reasons
(other than inflation) why they have occurred.
b) Briefly explain why the original operating statement was of little use to management.

Solution
Standard cost card
GH¢
Direct material (6000/5000) 1.2
Direct labour (4000/5000) 0.8
Other costs (1000/5000) 0.2
Maintenance cost 0.4

Budgeted selling price = 20000/5000 = GH¢ 4

Maintenance cost, Budget Allowance = GH¢ 1,600 + (.4 ×7000)

= 1,600 + 2,800
= GH¢ 4,400 a.
FIXED FLEXIBLE ACTUAL VARIANCE
BUDGET BUDGET RESULT (FAV./ADV.)
Units produced and sold 5000 7000 7000
GH¢ GH¢ GH¢ GH¢
Sales Revenue (A) Variable 20,000.00 28,000.00 30,000.00 2,000.00
Costs:
Direct Material 6,000.00 8,400.00 8,500.00 (100.00)
Direct Labour 4,000.00 5,600.00 4,500.00 1,100.00
Other costs 1,000.00 1,400.00 1,400.00 -
Semi-Variable Cost: -
Maintenance Cost 3,600.00 4,400.00 5,000.00 (600.00)
Fixed Cost: -
Depreciation 2,000.00 2,000.00 2,200.00 (200.00)
Rent & Rates 1,500.00 1,500.00 1,600.00 (100.00)
Total Cost (B) 18,100.00 23,300.00 23,200.00 100.00

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 Profit (A-B) 1,900.00 4,700.00 6,800.00 2,100.00

The variances have changed and the major reason is the equal units that have been used to calculate
the flexible budget. This tends to reason that the major cause of the change is volume. This is
because when we take the original budget statement we realize that there is a comparison of
―unlike items‖ so labour cost for instance showed a negative variance. Meanwhile the flexible
budget has demonstrated a positive variance for such cost element.

b. why the original operating statement was of little use to management

• The fixed operating statement or budget did not demonstrate a clear distinction between
variable, fixed or semi variable cost elements.
• Also, the original budget seems to compare ―unlike items‖ which mainly is the production
and sales units. In situations of this nature, a manager is expected to spend more where actual
output of (7000 units) is more than the budgeted of (5000 units).
• The budget statement failed to point out who was responsible for the output increases. This
could be the fault of either the production or the sales manager.

1-5.6 BENEFITS OF FLEXIBLE BUDGET

A flexible budget is both a planning and control device: it can be used before the start of the period
to predict costs at different output levels...it can also be used after the fact to determine what costs
should have been incurred to achieve a certain level of output. The usefulness or importance of a
flexible budget depends very much on the accuracy of the classification of expenses into fixed,
semi-fixed and variable ones. The important advantages of flexible budget are as follows:
a) Uncertainty Analysis: Flexible budgets allow management to consider several scenarios
when looking at a future time period. When the future activity level cannot be reasonably
estimated, management can run the flexible budget for several activity levels. This allows
management to create a best case and worst case scenario to use for planning company
resources. Management reasonably expects the actual numbers to fall in between these two
scenarios. The flexible budget provides a range of total budget dollars.
b) Improved Performance Evaluation: Companies use budgets to evaluate the performance of
department managers. However, certain factors are often out of the manager's control.
The primary factor out of the manager's control involves production levels. When customer
demand increases, production levels must increase to accommodate. Increased production
levels increase the expenses upon which the manager is evaluated. A flexible budget
considers the impact of the additional production and adjusts the budget numbers
accordingly. This allows the company to evaluate the manager's performance more fairly.
c) Useful Variance Analysis: When activity levels change, the variable manufacturing costs
change as well. Variance analysis compares the actual cost to the budgeted cost. When
budget numbers remain the same and the costs increase, the variance increases, too. A

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 flexible budget considers cost increases due to increased activity levels, eliminating the
impact.
d) A flexible budget enables the management to analyze the deviation of actual output from
expected output.
e) The management can compare actual costs at the actual volume with the budgeted costs at
the actual volume.
f) The flexible budget provides a correct basis for comparison between actual and expected
costs for an actual activity.
g) Flexible budget helps to fulfill the objectives of cost control as it shows where the actual
performance deviated from the planned performance. 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.

1-5.7 CRITICISM OF FLEXIBLE BUDGET

Critics of flexible budgets sometimes argue that it is an approach which allows managers to revise
targets after the event to ensure that those targets have been met. It thus degrades the budget as an
instrument of control

Some critics also argue that there are too many variables: When one variable in a flexible budget
is subject to changes, other variables in the budget can also change, too. For example, if a flexible
budget allows for changes in the volume of sales, then changes in sales will change the budget for
related costs, such as upkeep of equipment and labour. So, even if there is only a single variable in
a flexible budget, other items may be left opaque as well

PRACTICE QUESTION
Brackendale Ltd - Case study description
When the standards for the year ahead were set, it was expected that monthly output of units
manufactured would be 10,000 units. By the time July was reached, output had fallen to 8,000
units per month because of a decrease in market share of sales. The next table reports the original
budget and the actual outcome for the month of July.

The original budget is based on a standard direct material cost of £4 per kg of raw material, a
standard direct labour cost of £5 per hour and a standard variable cost rate of £3 per direct labour
hour. Each unit of output requires 0.5 kg of raw materials and 12 minutes of labour time. The
actual cost of direct materials was found to be £4.40 per kg, the actual cost of direct labour was
found to be £5.50 per hour and the actual variable overhead cost rate was £2.80 per direct labour
hour. 3,800 kg of materials were used and the actual labour hours worked were 2,000.

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Original budget and actual costs for July
Original budget Actual for July
Units manufactured 10,000 8,000
£ £
Direct material 20,000 16,720
Direct labour 10,000 11,000
Variable overhead 4,800 5,600
Fixed overhead 7,000 7,500
Total direct costs 41,800 40,820

Required
Copy and complete the table below

Hint: Insert flexible budget before calculating variances

Calculation of variances using a flexible budget: Summary statement of variances

Original Flexible Actual for Variance

budget Budget July
(1) (2) (3) (2) (3)
Units manufactured 10,000 8,000 8,000
£ £ £ £
Direct material 20,000 16,720
Direct labour 10,000 11,000
Variable overhead 6,000 5,600
Fixed overhead

Total direct costs

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