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FLEXIBLE BUDGETING LECTURE

LEARNING OBJECTIVES
Student should be able to:
(1) Describe the differences between a static and flexible budget
(2) Develop flexible budgets and compute flexible-budget variances and sales-volume
variances
(3) Explain how flexible budgets can facilitate budgetary control.

Fixed/Static Budgets

The master budget prepared at the beginning of the budget period is known as the fixed or static
budget.
The term fixed means the following
(a) The budget is prepared on an estimated volume of production and an estimated volume of
sales, but no plans are made for the event that actual volume of production and sales may
differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (week, month,
quarter) are not achieved, a fixed budget is not adjusted (in retrospect) to the new levels
of activity.

Flexible Budgets

A flexible budget recognizes the existence of fixed, variable, and semi-variable costs.
Flexible budgets may be used in one of two ways:
(a) At the planning stage.
For example suppose a firm expects to sell 10,000 units of output during the year. The
fixed budget would be prepared on the basis of these expected volumes. However, if the
company thinks that output and sales might be as low as 8,000 units or as high as 12,000
units, it may prepare contingency flexible budgets, at volumes of, say 8,000, 9,000,
11,000 and 12,000 units.

There are a number of advantages of planning with flexible budgets:

(i) It is possible to find out well in advance the cost of redundancy payments, idle
time and so on associated with different levels of output.
(ii) Management can decide whether it is possible to find alternative uses for idle
capacity if output falls short of budget (could employees be asked to overhaul
their own machines for example, instead of paying an outside contractor?).
(iii) An estimate of the cost of overtime, subcontracting work or extra machine hire if
sales volume exceeds the fixed budget estimate can be made. From this, it can be
established whether there is a limiting factor which would prevent high volumes
of sales and output being achieved.

(b) At the Evaluation (Control) stage

At the end of each month (control period) or year, flexible budgets flexible budgets can
be used to compare actual results achieved with what results should have been under the
circumstances.
Flexible Budgets are essential tools in Budgetary Control because of the following:
(i) Management needs to be informed about how good or bad actual performance
has been. To provide a measure of performance, there must be a yardstick
(budget or standard) against which actual performance can be measured.
(ii) Every business is dynamic, and actual volumes cannot be expected to conform
exactly to the fixed budget. When actual volumes is different from budgeted
volumes comparing actual costs directly with the fixed budget cost is
meaningless.
(iii) For useful control information, it is necessary to compare actual results at the
actual level of activity achieved against the results that would have been expected
at this level of activity, which are shown by the flexible budget.

Flexible Budgeting uses the principle of Marginal Costing

In estimating future costs it is often necessary to begin by looking at cost behavior in the past. For
costs which are wholly fixed or wholly variable no problem arises. But you may be presented
with a cost which appears to have behaved in the past as a semi-variable cost. The techniques of
cost estimation covered in a previous lecture will have to be used to separate these cost into their
fixed and variable components before the flexible budget can be prepared.
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EXAMPLE

(a) Prepare a budget for 2001 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90%, and 100%, using the information listed below.

(i) The direct labour hourly rate is expected to be $3.75

(ii) 100% activity represents 60,000 direct labour hours.
(iii) Variable costs
Indirect Labour $0.75 per direct labour hour
Consumable supplies $0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
(iv) Semi-variable costs
Semi-variable costs 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
$
1996 64,000 20,800
1997 59,000 19,800
1998 53,000 18,600
1999 49,000 17,800
2000 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
(b) Calculate the budget cost allowance (ie expected expenditure) for 2001 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
$ $ $

Direct Labour 180,000 202,500 225,000

Other Variable Costs
Indirect Labour 36,000 40,500 45,000
Consumables 18,000 20,250 22,500
Canteen etc. 12,960 14,580 16,200
Total Variable Costs 246,960 277,830 308,700
($5.145 per hour.)

Semi-variable Costs 17,600 18,800 20,000

Fixed Costs
Depreciation 18,000 18,000 18,000
Maintenance 10,000 10,000 10,000
Insurance 4,000 4,000 4,000
Rates 15,000 15,000 15,000
Management Salaries 25,000 25,000 25,000
Budgeted Costs 336,560 368,630 400,700

Workings – Semi-variable costs.

Using the High/Low method:
$
Total Cost of 64,000 hrs 20,800
Total Costs of 40,000 hrs. 16,000
Variable Costs of 24,000 hrs. 4,800

Variable Cost per hour ($4,800/24,000) $0.20

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$
Total Cost of 64,000 hours 20,800
Variable Costs of 64,000 hours (x $0.20) 12,800
Fixed Costs 8,000

Semi-variable Costs are calculated as follows.

$
48,000 hours (48,000 x $0.20) + $8,000 17,600
54,000 hours (54,000 x $0.20) + $8,000 18,800
60,000 hours (60,000 x $0.20) + $8,000 20,000

(b) The budgeted Cost Allowance for 57,000 direct labour hours of work would be as follows:

$
Variable Costs (57,500 x $5.345) 304,665
Fixed Costs (72,000 + 8,000) 80,000
Total Budgeted Costs 384,665

Flexible Budgeting and Budgetary Control

Budgetary control is the practice of establishing budgets which identify areas of responsibility for
individual managers (for example production managers, purchasing managers and so on) and of
regularly comparing actual results against expected results.
The most important method of budgetary control is variance analysis, which involves the
comparison of actual results achieved during a control period with a FLEXIBLE BUDGET.
The differences between actual results and expected results are called 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
light of actual events.

The wrong approach to budgetary control is to compare actual results against a fixed
budget.
Consider the following example.
Toyo Ltd. manufactures a single product, the toy. Budgeted results and actual results for June
1999 are shown below.
Budget Actual results Variance
Production and sales (units) 2,000 3,000
$ $ $
Sales Revenue 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 1,400 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 18,100 23,200 5,100
Profit 1,900 6,800 4,900 (F)

In this example the variances are meaningless for purposes of control. Costs were higher than
budgeted because the volume of output was also higher; variable costs would be expected to
increase above the budgeted costs in the fixed budget. There is no information to indicate whether
control action is needed for any aspect of costs or revenue.
For control purposes, it is necessary to know answers to questions such as the following.
(i) Were actual costs higher than they should have been to produce and sell 3,000 toys?
(ii) Was actual revenue satisfactory from the sale of 3,000 toys?

The correct approach to budgetary control is as follows.

(1) Identify fixed and variable costs.
(2) Produce a flexible budget using marginal costing techniques.

In our previous example of Toyo Ltd, let us assume that we have the following estimates of cost
behavior.
(a) Direct Materials, Direct Labour and maintenance costs are variable
(b) Rent, Rates and Depreciation are fixed costs
(c) Other costs consist of fixed costs of $1,600 plus a variable cost of $1
per unit made and sold
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The Budgetary control analysis should be as follows.

Fixed Flexible
Budget Budget Actual 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
Direct Materials 6,000 9,000 8,500 500 (F)
Direct Labour 4,000 6,000 4,500 1500 (F)
Maintenance 1,400 1,500 1,400 100 (F)
Other Costs 3,600 4,600 5,000 400 (A)
Fixed Costs:
Rent and Rates 1,500 1500 1,600 100 (A)
Depreciation 2,000 2,000 2,200 200 (A)
Total Costs 18,100 24,600 23,200 1,400
Profit 1,900 5,400 6,800 1,400 (F)

We can analyze the above as follows.

(a) In selling 3,000 units the expected profits should have been, not the fixed budget profit of
$1,900 but the flexible budget profit of $5,400.Instead, the actual profit was $6,800 ie $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.
$
Direct Material cost variance 500 (F)
Direct Labour cost variance 1,500 (F)
Maintenance cost variance 100 (F)
Other costs variance 400 (A)
Fixed costs variances
Depreciation 200 (A)
Rent and Rates 100 (A)
1,400 (F)

Profits were therefore increased by $1,400 because costs were lower than anticipated.

A full variance analysis statement would be as follows.

$ $
Flexible budget profit 5,400
Variances
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and Rates 100 (A)
1,400 (F)
Actual Profits 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 corrective action is necessary or whether the
budget needs amending in light of actual events.

Factors to consider when preparing flexible budgets

The mechanics of flexible budgeting are, in theory, fairly straightforward. In practice,

however, there are a number of points that must be considered before figures are simply
flexed.
(a) The separation of costs into their fixed and variable elements is not always
straightforward.
(b) Account must be taken of the assumptions upon which the original fixed
budget was based. Such assumptions might include the constraints posed by
limiting factors, the rate of inflation, judgments about future uncertainty, the
demand for the organization’s products and so on.