Static and Flexible Budget Example

Assume that Max, Inc. created its original income production cost budget assuming
1,000 units would be produced. At the end of the month, it was determined that actual
production was only 900 units. If we compare the static budget which allows total costs
of $6,550 with the actual amounts incurred of $6,320, it appears the manager is $230
under budget, creating a favorable variance.

  Static Actual    
    Budget Amounts Variances  
Units produced Unit costs 1,000 900 100 U
Variable costs:          
  Direct labor $2.00 $2,000 $1,800       $200 F
  Direct materials $1.50 1,500 1,400         100 F
  Factory supplies   $0.25 250 260           10 U
Total variable costs   $3,750 $3,460       $290 F
Fixed costs:          
  Depreciation   $2,000 $2,100       $100 U
  Occupancy costs   800 760           40 F
Total fixed costs   $2,800 $2,860       $  60 U
Total overhead costs   $6,550 $6,320       $230 F

These variances are not very meaningful because the manager produced fewer units.
We should prepare a flexible budget that shows the amount of costs allowed at the 900
units that were actually produced. The format is the same. We replace the static budget
column with the flexible budget amounts and calculate the new variances.

  Flexible Actual    
    Budget Amounts Variances  
Units produced Unit costs 900 900 -  
Variable costs:          
  Direct labor $2.00 $1,800 $1,800       $    0 F
  Direct materials $1.50 1,350 1,400           50 U
  Factory supplies   $0.25 225 260           35 U
Total variable costs   $3,375 $3,460         $85 F
Fixed costs:          
  Depreciation   $2,000 $2,100       $100 U
  Occupancy costs   800 760           40 F
Total fixed costs   $2,800 $2,860       $  60 U
Total overhead costs   $6,175 $6,320       $145 U
 
Now it appears the production manager spent more than he was allowed to spend at
900 units of activity. If any of the 5 cost amounts have variances that exceed the
company's minimum threshold level for investigation of variances, we would need to
determine the manager in charge, determine why the variances exist, and hopefully,
find remedies for any in need. 
 
 
Planning With Flexible Budgets
Some companies use flexible budgets as an aid in planning. This is done by selecting
several activity levels and creating side-by-side budgets that show the costs allowed for
each of these levels of activity. This helps managers who don't want to wait until the end
of the period to see how much they were allowed to spend for the level they achieved.
For example, we might create comparative budgets for 920, 940, 960 and 980 units so
that a manager that produces units between those levels would have a better idea of
how he compares to the benchmarks at those levels.
 

MANAGEMENT ACCOUNTING: CONCEPTS AND

TECHNIQUES
 

By Dennis Caplan

PART 2: MICROECONOMIC FOUNDATIONS OF

MANAGEMENT ACCOUNTING
 
CHAPTER 5:  FLEXIBLE BUDGETING

Chapter Contents:

-                     Introduction

-                     Pro Forma Analysis at Guess Who Jeans

-                     Static Budget Variance at Guess Who Jeans

-                     Flexible Budget Variance at Guess Who Jeans

Introduction:

A budget is a plan for the future. Hence, budgets are planning tools, and they are usually
prepared prior to the start of the period being budgeted. However, the comparison of the budget
to actual results provides valuable information about performance. Therefore, budgets are both
planning tools and performance evaluation tools.

Usually, the single most important input in the budget is some measure of anticipated output. For
a factory, this measure of output is the number of units of each product produced. For a retailer,
it might be the number of units of each product sold. For a hospital, it is the number of patient
days (the number of patient admissions multiplied by the average length of stay).

The static budget is the budget that is based on this projected level of output, prior to the start of
the period. In other words, the static budget is the “original” budget. The static budget variance
is the difference between any line-item in this original budget and the corresponding line-item
from the statement of actual results. Often, the line-item of most interest is the “bottom line”:
total cost of production for the factory and other cost centers; net income for profit centers.

The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the
period. A flexible budget adjusts the static budget for the actual level of output. The flexible
budget asks the question: “If I had known at the beginning of the period what my output volume
(units produced or units sold) would be, what would my budget have looked like?” The
motivation for the flexible budget is to compare apples to apples. If the factory actually produced
10,000 units, then management should compare actual factory costs for 10,000 units to what the
factory should have spent to make 10,000 units, not to what the factory should have spent to
make 9,000 units or 11,000 units or any other production level.

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.

The following steps are used to prepare a flexible budget:

1.                  Determine the budgeted variable cost per unit of output. Also determine the
budgeted sales price per unit of output, if the entity to which the budget applies
generates revenue (e.g., the retailer or the hospital).

2.                  Determine the budgeted level of fixed costs.

3.                  Determine the actual volume of output achieved (e.g., units produced for a factory,
units sold for a retailer, patient days for a hospital).

4.                  Build the flexible budget based on the budgeted cost information from steps 1 and 2,
and the actual volume of output from step 3.

Flexible budgets are prepared at the end of the period, when actual output is known. However,
the same steps described above for creating the flexible budget can be used prior to the start of
the period to anticipate costs and revenues for any projected level of output, where the projected
level of output is incorporated at step 3. If these steps are applied to various anticipated levels of
output, the analysis is called pro forma analysis. Pro forma analysis is useful for planning
purposes. For example, if next year’s sales are double this year’s sales, what will be the
company’s cash, materials, and labor requirements in order to meet production needs?

 
Pro Forma Analysis at Guess Who Jeans:

Following are pro forma monthly income statements for Guess Who Jeans, a small, start-up
fashion jeans manufacturer. The pro forma analysis was prepared at the beginning of the month
and considered three alternative sales levels. The company has no variable marketing costs.
 

GUESS WHO JEANS

PRO FORMA ANALYSIS

FOR THE UPCOMING MONTH

Income Budgeted Pro Forma Analysis for

amount
Statement per unit Alternative Output Levels
     
line-item
10,000 units 20,000 units 30,000 units
Revenue $40 $400,000 $800,000 $1,200,000

         

Variable costs:        

  Materials 15 150,000 300,000 450,000

  Labor 10 100,000 200,000 300,000

  Overhead 5 50,000 100,000 150,000

    Total 30 300,000 600,000 900,000

         

Contribution margin $10 100,000 200,000 300,000

       

Fixed costs:      

  Manufacturing      

     Overhead 100,000 100,000 100,000

  Marketing costs 50,000 50,000 50,000

    Total fixed costs 150,000 150,000 150,000

        

Operating income ($50,000) $50,000 $150,000

Since by definition, fixed costs are not expected to change as volume of output changes within
the relevant range, fixed costs remain the same at all three projected levels of output. Revenue
and variable costs vary with output in a linear fashion. Hence, when output increases 100% from
10,000 units to 20,000 units, revenue, each line-item for variable costs, and contribution margin
all increase 100%.

Static Budget Variance at Guess Who Jeans:

Guess Who management decides that 10,000 units is the most likely output volume, and sets the
static budget based on this sales and production level. After the end of the month, company
personnel prepare the following table, showing the static budget, actual results, and the static
budget variance.
 

GUESS WHO JEANS

STATIC BUDGET VARIANCE

FOR THE MONTH JUST ENDED

Income Budgeted Static Actual Static

amount per
Statement unit  Budget Results Budget

line-item (A) (B) Variance

10,000 units 16,000 units (A) – (B)

Revenue $40 $400,000 $670,000 $270,000

         

Variable costs:        

  Materials 15 150,000 230,000 (80,000)

  Labor 10 100,000 167,000 (67,000)

  Overhead 5 50,000 84,000 (34,000)

    Total 30 300,000 481,000 (181,000)

         

Contribution margin $10 100,000 189,000 89,000

       

Fixed costs:      

  Manufacturing Overhead 100,000 105,000 (5,000)

  Marketing costs 50,000 49,000 1,000.

    Total fixed costs 150,000 154,000 (4,000)

       

Operating income ($50,000) $35,000 $85,000

   

In the variance column, positive numbers are favorable variances (good news), and negative
numbers are unfavorable (bad news).

The static budget variance shows a large favorable variance for revenue, and large unfavorable
variances for variable costs. These large variances are due primarily to the fact that the static
budget was built on an output level of 10,000 units, while the company actually made and sold
16,000 units. The revenue variance might also be due to an average unit sales price that differed
from budget. The variable cost variances might also be due to input prices that differed from
budget (e.g., the price of fabric), or input quantities that differed from the per-unit budgeted
amounts (e.g., yards of fabric per pair of pants). 

There are also small variances for fixed costs. These costs should not vary with the level of
output (at least within the relevant range). However, many factors can cause actual fixed costs to
differ from budgeted fixed costs that are unrelated to output volume. For example, property tax
rates and the fixed salaries of front office personnel can change, and depreciation expense can
change if unexpected capital acquisitions or dispositions occur.

The Flexible Budget Variance at Guess Who Jeans:

In order to better understand the causes of the large revenue and variable cost variances in the
static budget variance column, Guess Who personnel prepare the following flexible budget.

GUESS WHO JEANS

 FLEXIBLE BUDGET VARIANCE

FOR THE MONTH JUST ENDED

Income Budgeted Flexible Actual Flexible

amount per
Statement unit  Budget Results Budget

line-item (A) (B) Variance

16,000 units 16,000 units (A) – (B)

Revenue $40 $640,000 $670,000 $30,000

         

Variable costs:        

  Materials 15 240,000 230,000 10,000

  Labor 10 160,000 167,000 (7,000)

  Overhead 5 80,000 84,000 (4,000)

    Total 30 480,000 481,000 (1,000)

         

Contribution margin $10 160,000 189,000 29,000

       

Fixed costs:      

  Manufacturing Overhead 100,000 105,000 (5,000)

  Marketing costs 50,000 49,000 1,000.

    Total fixed costs 150,000 154,000 (4,000)

       

Operating income $10,000 $35,000 $25,000

 
  

Once again, positive variances are favorable (good news), and negative variances are
unfavorable (bad news).

From this table, Guess Who management sees that even after adjusting for sales volume, revenue
was higher than would have been expected. The favorable $30,000 variance must be due entirely
to an average sales price that was higher than planned (almost $42 per pair compared to the
original budget of $40 per pair).

Materials costs were lower than would have been expected for a sales volume of 16,000 units.
This favorable variance could be due to lower fabric prices, or to more efficient utilization of
fabric (less waste than expected), or a combination of these two factors. Labor and overhead
were higher than expected, even after adjusting for the sales volume of 16,000 units. This
unfavorable flexible budget variance implies that either wage rates were higher than planned, or
labor was not as efficient as planned, or both. Similarly, the components of variable overhead
were either more expensive than budgeted, or were used more intensively than budgeted. For
example, electric rates might have been higher than planned, or more electricity was used than
planned per unit of output. 

The fixed cost variances are identical in this table to the previous table. In other words, the
flexible budget and flexible budget variance provide no additional information about fixed costs
beyond what can be learned from the static budget variance.

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