The budget that (1) provides expected costs for a range of activity or (2) provides budgeted costs for the actual level of activity is called a flexible budget. Flexible budgeting can be used in planning by showing what costs will be at various levels of activity. When used this way, managers can deal with uncertainty by examining the expected financial results for a number of plausible scenarios. Spreadsheets are particularly useful in developing this type of flexible budget.
The flexible budget can be used after the fact, for control, to compute what costs should have been for the actual level of activity. Once expected costs are known for the actual level of activity, a performance report that compares those expected costs to actual costs can be prepared. When used for control, flexible budgets help managers compare “apples to apples” in assessing performance. To illustrate the power of flexible budgeting, let’s prepare a budget for ABT for three different activity levels (the number of concrete blocks produced). Since the flexible budget gives the expected cost at various levels of activity, we must know the cost behavior patterns of each budget item. Recall that the cost behavior pattern can be expressed as the sum of the fixed cost and a variable rate multiplied by activity level. The variable rates for direct materials ($0.26 per unit), direct labor ($0.12 per unit), supplies ($0.03), indirect labor ($0.07), and power ($0.02) are given in Schedule 6. Finally, we know from Schedule 5 that fixed overhead is budgeted at $320,000 per quarter. Exhibit 8-8 displays a flexible budget for production costs when 2.4, 3, and 3.6 million concrete blocks are produced.
The flexible budget can be used after the fact, for control, to compute what costs should have been for the actual level of activity. Once expected costs are known for the actual level of activity, a performance report that compares those expected costs to actual costs can be prepared. When used for control, flexible budgets help managers compare “apples to apples” in assessing performance. To illustrate the power of flexible budgeting, let’s prepare a budget for ABT for three different activity levels (the number of concrete blocks produced). Since the flexible budget gives the expected cost at various levels of activity, we must know the cost behavior patterns of each budget item. Recall that the cost behavior pattern can be expressed as the sum of the fixed cost and a variable rate multiplied by activity level. The variable rates for direct materials ($0.26 per unit), direct labor ($0.12 per unit), supplies ($0.03), indirect labor ($0.07), and power ($0.02) are given in Schedule 6. Finally, we know from Schedule 5 that fixed overhead is budgeted at $320,000 per quarter. Exhibit 8-8 displays a flexible budget for production costs when 2.4, 3, and 3.6 million concrete blocks are produced.
Notice in Exhibit 8-8 that total budgeted production costs increase as the activity level increases. Budgeted costs change because of variable costs. Because of this, a flexible budget is sometimes referred to as a variable budget. Exhibit 8-8 reveals what the costs should have been for the actual level of activity (3 million blocks). A revised performance report that compares actual and budgeted costs for the actual level of activity is given in Exhibit 8-9 on the following page.The revised performance report in Exhibit 8-9 paints a much different picture thanthe one in Exhibit 8-7. By comparing budgeted costs for the actual level of activity with actual costs for the same level, flexible budget variances are generated. Managers can locate possible problem areas by examining these variances. According to the ABT flexible budget variances, expenditures for direct materials are excessive. (The other unfavorable variances seem relatively small.) With this knowledge, management can search for the causes of the excess expenditures and prevent the same problems from occurringin the future.
Budgets can be used to examine the efficiency and effectiveness of a company. Efficiency is achieved when the business process is performed in the best possible way, with little or no waste. The flexible budget provides an assessment of the efficiency of a manager. This is so because the flexible budget compares the actual costs for a given level of output with the budgeted costs for the same level. Effectiveness means that a manager achieves or exceeds the goals described by the static budget. Thus, efficiency examines how well the work is done, and effectiveness examines whether or not the right work is being accomplished. Any differences between the flexible budget and the static budget are attributable to differences in volume. They are called volume variances. A 5-column performance report that reveals both the flexible budget variances and the volume variances can be used. Exhibit 8-10 provides an example of this report using the ABT data.
As the report in Exhibit 8-10 reveals, production volume was 600,000 units greater than the original budgeted amount. Thus, the manager exceeded the output goal. This volume variance is labeled favorable because it exceeds the original production goal. (Recall that the reason for the extra production was because the demand for the product was greater than expected. Thus, the increase in production over the original amount was truly favorable.) On the other hand, the budgeted variable costs are greater than expected because of the increased production. This difference is labeled unfavorable because the costs are greater than expected; however, the increase in costs is because of an increase in production. Thus, it is totally reasonable. For this particular example, the effectiveness of the manager is not in question; thus, the main issue is how well the manager controlled costs as revealed by the flexible budget variances. Also read characteristics of good budgetary system
As the report in Exhibit 8-10 reveals, production volume was 600,000 units greater than the original budgeted amount. Thus, the manager exceeded the output goal. This volume variance is labeled favorable because it exceeds the original production goal. (Recall that the reason for the extra production was because the demand for the product was greater than expected. Thus, the increase in production over the original amount was truly favorable.) On the other hand, the budgeted variable costs are greater than expected because of the increased production. This difference is labeled unfavorable because the costs are greater than expected; however, the increase in costs is because of an increase in production. Thus, it is totally reasonable. For this particular example, the effectiveness of the manager is not in question; thus, the main issue is how well the manager controlled costs as revealed by the flexible budget variances. Also read characteristics of good budgetary system
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