Flexible Budgeting

Chapter 18
 Manufacturing Overhead Costs
◦ Are not traceable to individual products.

They are a pool of many different kind of costs

with different relationship to productive activity
(variable vs. fixed).

Different individuals responsible for different

type of overhead costs.
 Overhead Budgets
Since overhead costs are not traceable to
products we can’t set standards for them.

Flexible Budgets – not based on only one level

of activity, but covers a range of activity.

Static Budget – based on a particular level of

activity.
 Static Budget Versus Flexible Budget
Electricity - $.50 per machine hour

Static Budget Flexible Budget

Activity
(machine hours) 7,500 6,000 7,500 9,000
Budgeted
electricity cost $3,750 $3,000 $3,750 $4,500
A static budget is A flexible budget
based on only one includes several
anticipated activity possible activity
level. levels.

Notice that the static budget and the flexible budget are
the same (in this example) when machine activity is
7,500 machine hours.
Flexible Budgeting
Hmm! Comparing
costs at different
levels of activity
Static budgets are prepared for a is like comparing
single, planned level of activity. apples with oranges.

Performance evaluation is difficult

when actual activity differs from
the activity originally budgeted.

Consider the following

condensed example
from Barton, Inc. . . .
Flexible Budgeting
Prepared for an expected activity of
10000 units but actual activity for the
period was only 8000 units
Original Actual
Budget Results Variances
Units of Activity 10,000 8,000
Variable costs
Indirect labor $ 40,000 $ 34,000
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,000
Total overhead costs $ 89,000 $ 77,300
Flexible Budgeting
Original Actual
Budget Results Variances
Units of Activity 10,000 8,000 2,000 U
Variable costs
U =labor
Indirect Unfavorable variance $– Barton,
$ 40,000 34,000
Indirect Inc. was unable
materials to achieve the
30,000 25,500
Power budgeted level of activity. 3,800
5,000
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,000
Total overhead costs $ 89,000 $ 77,300
Flexible Budgeting
Original Actual
Budget Results Variances
Units of Activity 10,000 8,000 2,000 U
Variable costs
Indirect labor $ 40,000 $ 34,000 $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
F = Favorable variance: actual costs
Fixed costs
are less than 12,000
Depreciation budgeted costs. 12,000 0
Insurance
Since cost variances2,000
are favorable,2,000
have 0
we done costs
Total overhead a good$job controlling
89,000 $ costs?
77,300 $11,700 F
 Static Budgets and
Performance Reports
I do know that
I don’t think I can actual activity is below
answer this question budgeted activity which
using a static budget. is unfavorable.
But shouldn’t variable costs
be lower if actual activity
is below budgeted activity?
Static Budgets and Performance
Reports
The relevant question is . . .
“How much of the favorable cost variance is
due to lower activity, and how much is due to
good cost control?”

To answer the question,

we must
the budget to the
actual level of activity.
 Shortcomings of the Traditional Master
Budget Process
Departmental orientation
◦ Plan from resources to outputs
◦ Does not recognize interdependencies among departments
Static budgets
◦ Developed for a single level of activity
◦ Based on incremental adjustments
Results orientation
◦ Disconnects the process from its output
◦ Cost-cutting accomplished by across-the-board cuts

11
Flexible Budgeting
Show expenses that should
have occurred at the actual
level of activity.

May be prepared for any activity

level in the relevant range.

Reveal variances due to cost

control or lack of cost control.
Managers can locate possible
problem areas by examining the
variances revealed on a
performance report that compares
budgeted costs for the actual level
of activity to the actual costs for
the same level.
 Flexible Budget
 Based on the reasoning that every business is dynamic
in nature.

 Attempts to cover the relevant range of expected level

of activity and its impact on costs (and therefore, on
profits).

 ForExample, it can be prepared for an expected range

of activity, say, 15000-20000;

 Suppose, the budgeted production is 18000 units;

however, the output slips to 16000 units; the manager
can use flexible budget at 16000 (level of activity) to
measure the performance more appropriately.
 Preparation of Flexible Budget
 Deciding of range of level of activity (Relevant
Range);

 Analysis of the cost behavior for each item of the

cost; classify them as ‘Variable’, ‘Fixed’ and ‘Mixed’.

 Selecting Measurement Unit for the Level of

Activity, normally production units are chosen;

 Preparation of budget for each chosen level of

activity; each level of activity is associated with the
corresponding costs.
Flexible Budgets
for Planning and Control
Static budgets Flexible budgets
Master budget Variable budget
Vital for planning Provides expected
Less useful for control costs for a range of
Developed around a activity
single level of activity Provides budgeted
Budgeted activity level costs for the actual
rarely equals actual activity level
activity

15
Flexible Budgets

Central Concept

If you can tell me what your activity was

for the period, I will tell you what your
costs and revenue should have been.
 Flexible Budgeting
To a budget for different activity
levels, we must know how costs behave
with changes in activity levels.
 Total variable costs change
in direct proportion to
changes in activity. le
b
ar ia
 Total fixed costs remain V
unchanged within the Fixed
relevant range.

23-17
Flexible Budgeting

Let’s prepare
budgets for
Barton, Inc.
Flexible Budget
What are the three steps to prepare a
flexible budget?
Determine a relevant range over which production is expected to
vary during the coming period.

Analyze the projected manufacturing costs for the coming

period.

Using the per-unit costs for each element, prepare a budget

showing what costs are expected to be incurred at several
points within the relevant range.
Original Budget
Prepared for an expected activity of
10000 units but actual activity for the
period was only 8000 units
Original Actual
Budget Results Variances
Units of Activity 10,000 8,000
Variable costs
Indirect labor $ 40,000 $ 34,000
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,000
Total overhead costs $ 89,000 $ 77,300
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000 10,000 12,000
Variable costs
Indirect labor 4.00
Indirect material 3.00
Power 0.50
Total variable cost $ 7.50

Fixed costs
Depreciation $12,000
Insurance 2,000
Total fixed cost
Total overhead costs
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000
Variable costs are10,000
expressed as12,000
a
Variable costs constant amount per hour.
Indirect labor 4.00 In the $
original
32,000 budget, indirect labor was
$40,000 for 10,000 hours resulting in a rate
Indirect material 3.00 24,000
of $4.00 per hour.
Power 0.50 4,000
Total variable cost $ 7.50 $ 60,000

Fixed costs Fixed costs are expressed as a

Depreciation $12,000 total amount that does not
Insurance 2,000 change within the relevant
Total fixed cost range of activity.
Total overhead costs
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 $ 32,000 $ 40,000 $ 48,000
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 $ 104,000
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 $ 32,000 $ 40,000 $ 48,000
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total variable
Total overhead cost = $7.50 per unit × budget
costs level in units
$ 74,000 $ 89,000 $ 104,000
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000 10,000 12,000
Variable costs Fixed costs are expressed as a total
IndirectThere
labor is no 4.00 amount$that does not
32,000 change within
$ 40,000 the
$ 48,000
Note: flex relevant
Indirect material 3.00 24,000 range 30,000
of activity. 36,000
inPower
the fixed costs. 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 $ 104,000
 Flexible Budgeting
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Units of Activity 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 $ 32,000 $ 40,000 $ 48,000
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 $ 104,000
Flexible Budgeting
Performance Report
 Flexible
budget  Managerial
performance report performance report
◦ Compare budgeted costs ◦ Flexible budget variances
given the actual level of – Actual results vs.
activity to the actual costs flexible budget
for the same level – Examines efficiency
◦ Locate possible problem ◦ Volume variances
areas by examining the – Static budget vs. flexible
flexible budget variances budget
– Examines effectiveness
◦ Examines efficiency
Flexible Budget
Performance Report
Now let’s prepare a
budget performance
report
at 8,000 actual mach
ine
hours
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Units of Activity 8,000
Variable costs
Indirect labor $ 4.00 $ 34,000
Indirect material 3.00 25,500
Power 0.50 3,800
Total variable costs $ 7.50 $ 63,300
Fixed Costs
Depreciation $12,000 $ 12,000
Insurance 2,000 2,000
Total fixed costs $ 14,000
Total overhead costs $ 77,300
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Flexible budget is prepared
Units of Activity
for the same activity level 8,000 8,000 0
(8,000 hours) as actually
Variable costs
achieved.
Indirect labor $ 4.00 $ 34,000
Indirect material 3.00 25,500
Power 0.50 3,800
Total variable costs $ 7.50 $ 63,300
Fixed Costs
Depreciation $12,000 $ 12,000
Insurance 2,000 2,000
Total fixed costs $ 14,000
Total overhead costs $ 77,300
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Units of Activity 8,000 8,000
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000
Indirect material 3.00 24,000 25,500
Power 0.50 4,000 3,800
Total variable costs $ 7.50 $ 60,000 $ 63,300
Fixed Costs
Depreciation $12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000
Total fixed costs $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 77,300
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Units of Activity 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed Costs
Depreciation $12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000 $ 14,000 0
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Units of Indirect
Activity labor and indirect 8,000 8,000 0
material
Variable have large unfavorable
costs
variances
Indirect because$ actual
labor 4.00costs $ 32,000 $ 34,000 $ 2,000 U
are more than the flexible
Indirect material 3.00 24,000 25,500 1,500 U
budget costs.
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
FixedThese
Costsvariances are due to cost
control issues because we have
Depreciation $12,000 $ 12,000 $ 12,000 0
removed the activity differences
Insurance 2,000 2,000 2,000 0
by flexing the original budget
Total fixed costs $ 14,000 $ 14,000 0
from 10,000 units down to the
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U
actual activity of 8,000 units.
 Flexible Budgeting
Performance Report
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Units of Activity 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Power has a favorable variance
Indirect material 3.00 24,000 25,500 1,500 U
because the actual cost is less
Power 0.50 4,000 3,800 200 F
than the flexible budget cost.
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed Costs
Depreciation $12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000
Fixed costs remain unchanged so the$total
14,000 0
Total overhead costs $ 74,000
overhead variance is $3,300 $ 77,300
unfavorable. $ 3,300 U
Now we have a better indication on overhead
cost control at Barton.
Flexible Budget
Performance Report
Remember the ques
tion:
“How much of the to
ta
variance is due to ac l
tivity
and how much is du
e to
cost control?”
Flexible Budgeting
How much of the $11,700 is due to activity
and how much is due to cost control?
Original Actual
Budget Results Variances
Units of Activity 10,000 8,000 2,000 U
Variable costs
Indirect labor $ 40,000 $ 34,000 $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,000 0
Total overhead costs $ 89,000 $ 77,300 $11,700 F
Flexible Budget
Performance Report
Overhead Variance Analysis
Static Let’s place Actual
Overhead the flexible Overhead
Budget at at
budget for
10,000 Hours 8,000 Hours
8,000 hours
$ 89,000 here. $ 77,300

Difference between original static budget

and actual overhead = $11,700 F.
 Flexible Budget
Performance Report
Overhead Variance Analysis
Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
$ 89,000 $ 74,000 $ 77,300

Activity Cost control

This $15,000F variance is This $3,300U flexible

due to lower activity. budget variance is due
to poor cost control.
Flexible Budget
Performance Report
There are two primary
reasons for unfavorable
variable overhead variances:
What causes 1. Spending too much for
the cost resources.
control variance?
2. Using the resources
inefficiently.
 Flexible Budget
 Based on the reasoning that every business is dynamic in
nature.

 Attempts to cover the relevant range of expected level of

activity and its impact on costs (and therefore, on profits).

 For Example, it can be prepared for an expected range of

activity, say, 15000-20000;

 Suppose, the budgeted production is 18000 units; however,

the output slips to 16000 units; the manager can use flexible
budget at 16000 (level of activity) to measure the
performance more appropriately.
Preparation of Flexible Budget
 Deciding of range of level of activity (Relevant
Range);

 Analysis of the cost behavior for each item of the

cost; classify them as ‘Variable’, ‘Fixed’ and ‘Mixed’.

 Selecting Measurement Unit for the Level of

Activity, normally production units are chosen;

 Preparation of budget for each chosen level of

activity; each level of activity is associated with the
corresponding costs.
 Additional quantity for ABC product is in demand from market. Present sale of Rs
60,000 pm utilizes only 60% plant capacity.
Sales manager assures that by reducing 10% price, increase in sale is possible by about
25% to 30%. Following data are available:
Selling Price Rs 10 per unit
Variable Cost Rs 3 per unit
Semi variable cost Rs 6000 fixed plus Rs 0.50 per unit
Fixed cost Rs 20,000 at present level estimated to be Rs 24,000 at 80% output. *
Class Problem 1

Prepare
1.Operating profits at 60%, 70% & 80% levels at current selling price and at proposed
selling price.
2.Percentage increase in present output required to maintain the present profit at the
proposed selling price.
*Assume Fixed Cost to be Rs 20000 at 70% output also
Class Problem 2
 Case Discussion

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