Flexible Budgets for Planning and Control
Master budget amounts, while vital for planning, are less useful for control. The reason for this is because the anticipated level of activity rarely equals the actual level of activity. Therefore, the costs and revenues associated with the anticipated level of activity cannot be readily compared with actual costs and revenues for a different level of activity.
Static Budgets
Master budgets are developed around a particular level of activity; they are static budgets. Because the revenues and costs prepared for static budgets depend on a level of activity that rarely equals actual activity, they are not very useful when it comes to preparing performance reports. To illustrate, let’s return to the ABT, Inc., example used in developing the master budget. Suppose that ABT provides quarterly performance reports. Recall that ABT anticipated sales of 2 million in the first quarter and had budgeted production of 2.4 million units to support that level of sales. Now, let’s suppose that sales activity was greater than expected in the first quarter; 2.6 million concrete blocks were sold instead of the 2 million budgeted in the sales budget; and, because of increased sales activity, production was increased over the planned level. Instead of producing 2.4 million units, ABT produced 3 million units. A performance report comparing the actual production costs for the first quarter with the original planned production costs is given in Exhibit 8-7.
Master budget amounts, while vital for planning, are less useful for control. The reason for this is because the anticipated level of activity rarely equals the actual level of activity. Therefore, the costs and revenues associated with the anticipated level of activity cannot be readily compared with actual costs and revenues for a different level of activity.
Static Budgets
Master budgets are developed around a particular level of activity; they are static budgets. Because the revenues and costs prepared for static budgets depend on a level of activity that rarely equals actual activity, they are not very useful when it comes to preparing performance reports. To illustrate, let’s return to the ABT, Inc., example used in developing the master budget. Suppose that ABT provides quarterly performance reports. Recall that ABT anticipated sales of 2 million in the first quarter and had budgeted production of 2.4 million units to support that level of sales. Now, let’s suppose that sales activity was greater than expected in the first quarter; 2.6 million concrete blocks were sold instead of the 2 million budgeted in the sales budget; and, because of increased sales activity, production was increased over the planned level. Instead of producing 2.4 million units, ABT produced 3 million units. A performance report comparing the actual production costs for the first quarter with the original planned production costs is given in Exhibit 8-7.
According to the report, unfavorable variances occur for direct materials, direct labor, supplies, indirect labor, and rent. However, there is something fundamentally wrong with the report. Actual costs for production of 3 million concrete blocks are being compared with planned costs for production of 2.4 million. Because direct materials, direct labor, and variable overhead are variable costs, we would expect them to be greater at a higher activity level. Thus, even if cost control were perfect for the production of 3 million units, unfavorable variances would be produced for all variable costs. To create a meaningful performance report, actual costs and expected costs must be compared at the same level of activity. Since actual output often differs from planned output, some method is needed to compute what the costs should have been for the actual output level.flexible-Budgets
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