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Flexible budget
- 1. Flexible Budgets and Performance Analysis Chapter 10 © 2010 The McGraw-Hill Companies, Inc.
- 2. Learning Objective 1 Prepare a flexible budget. McGraw-Hill/Irwin Slide 2
- 3. Characteristics of Flexible Budgets Hmm! Comparing static planning budgets Planning budgets with actual costs are prepared for is like comparing a single, planned apples and oranges. level of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity. McGraw-Hill/Irwin Slide 3
- 4. Characteristics of Flexible Budgets May be prepared for any activity level in the relevant range. Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons. Help managers control costs. Improve performance evaluation. Let’s look at Larry’s Lawn Service. McGraw-Hill/Irwin Slide 4
- 5. Deficiencies of the Static Planning Budget Larry’s Lawn Service provides lawn care in a planned Larry’s Lawn Service provides lawn care in a planned community where all lawns are approximately the same size. community where all lawns are approximately the same size. At the end of May, Larry prepared his June budget based on At the end of May, Larry prepared his June budget based on mowing 500 lawns. Since all of the lawns are similar in size, mowing 500 lawns. Since all of the lawns are similar in size, Larry felt that the number of lawns mowed in a month would Larry felt that the number of lawns mowed in a month would be the best way to measure overall activity for his business. be the best way to measure overall activity for his business. Larry’s Budget McGraw-Hill/Irwin Slide 5
- 6. Deficiencies of the Static Planning Budget Larry’s Planning Budget Larry's Lawn Service For the Month Ended June 30 Revenue/Cost Planning Formulas Budget Number of lawns (Q) 500 Revenue ($75Q) $ 37,500 Expenses: Wages and salaries ($5,000 + $30Q) $ 20,000 Gasoline and supplies ($9Q) 4,500 Equipment maintenance ($3Q) 1,500 Office and shop utilities ($1,000) 1,000 Office and shop rent ($2,000) 2,000 Equipment Depreciation ($2,500) 2,500 Insurance ($1,000) 1,000 Total expenses 32,500 Net operating income $ 5,000 McGraw-Hill/Irwin Slide 6
- 7. Deficiencies of the Static Planning Budget Larry’s Actual Results Larry's Lawn Service For the Month Ended June 30 Actual Results Number of lawns 550 Revenue $ 43,000 Expenses: Wages and salaries $ 23,500 Gasoline and supplies 5,100 Equipment maintenance 1,300 Office and shop utilities 950 Office and shop rent 2,000 Equipment Depreciation 2,500 Insurance 1,200 Total expenses 36,550 Net operating income $ 6,450 McGraw-Hill/Irwin Slide 7
- 8. Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget Larry's Lawn Service For the Month Ended June 30 Revenue/Cost Planning Actual Formulas Budget Results Variances Number of lawns (Q) 500 550 Revenue ($75Q) $ 37,500 $ 43,000 $ 5,500 F Expenses: Wages and salaries ($5,000 + $30Q) $ 20,000 $ 23,500 $ 3,500 U Gasoline and supplies ($9Q) 4,500 5,100 600 U Equipment maintenance ($3Q) 1,500 1,300 200 F Office and shop utilities ($1,000) 1,000 950 50 F Office and shop rent ($2,000) 2,000 2,000 - Equipment Depreciation ($2,500) 2,500 2,500 - Insurance ($1,000) 1,000 1,200 200 U Total expenses 32,500 36,550 4,050 U Net operating income $ 5,000 $ 6,450 $ 1,450 F McGraw-Hill/Irwin Slide 8
- 9. Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget F = Favorable variance that occurs when actual Larry's Lawn Service For the Month Ended June 30 revenue is greater than budgeted revenue. Revenue/Cost Planning Actual Formulas Budget Results Variances Number of lawns (Q) 500 550 Revenue ($75Q) $ 37,500 $ 43,000 $ 5,500 F Expenses: Wages and salaries ($5,000 + $30Q) $ 20,000 $ 23,500 $ 3,500 U U = Unfavorable variance that 4,500 Gasoline and supplies ($9Q) occurs when 5,100 600 U Equipment costs are ($3Q) actual maintenance greater than budgeted costs. 1,500 1,300 200 F Office and shop utilities ($1,000) 1,000 950 50 F Office and shop rent ($2,000) 2,000 2,000 - Equipment Favorable($2,500) F = Depreciation variance that occurs when 2,500 2,500 - Insurance ($1,000) 1,000 1,200 200 U actual costs are less than budgeted costs. Total expenses 32,500 36,550 4,050 U Net operating income $ 5,000 $ 6,450 $ 1,450 F McGraw-Hill/Irwin Slide 9
- 10. Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget Larry's Lawn Service For the Month Ended June 30 Revenue/Cost Planning Actual Formulas Budget Results Variances Number of lawns (Q) 500 550 Revenue ($75Q) $ 37,500 $ 43,000 $ 5,500 F Expenses: Wages and salaries Since these variances are $ 20,000 Gasoline and supplies ($5,000 + $30Q) ($9Q) $ 23,500 unfavorable, 5,100 4,500 has $ 3,500 600 U U Equipment maintenance poor job controlling costs? Larry done a ($3Q) 1,500 1,300 200 F Office and shop utilities ($1,000) 1,000 950 50 F Office and shop rent ($2,000) 2,000 2,000 - Equipment Depreciation variances are favorable, has Since these ($2,500) 2,500 2,500 - Insurance ($1,000) 1,000 1,200 200 U Larry done a good job controlling costs? Total expenses 32,500 36,550 4,050 U Net operating income $ 5,000 $ 6,450 $ 1,450 F McGraw-Hill/Irwin Slide 10
- 11. Deficiencies of the Static Planning Budget I don’t think I Actual activity is above can answer the planned activity. questions using a static budget. So, shouldn’t the variable costs be higher if actual activity is higher? McGraw-Hill/Irwin Slide 11
- 12. Deficiencies of the Static Planning Budget The relevant question is .. .. .. The relevant question is “How much of the cost variances is due to higher “How much of the cost variances is due to higher activity, and how much is due to cost control?” activity, and how much is due to cost control?” To answer the question, To answer the question, we must we must the budget to the the budget to the actual level of activity.. actual level of activity McGraw-Hill/Irwin Slide 12
- 13. How a Flexible Budget Works To a budget we need to know that: Total variable costs change in direct proportion to changes in activity. Total fixed costs remain able unchanged within the Vari relevant range. Fixed McGraw-Hill/Irwin Slide 13
- 14. How a Flexible Budget Works Let’s prepare a budget for Larry’s Lawn Service. McGraw-Hill/Irwin Slide 14
- 15. Preparing a Flexible Budget Larry’s Flexible Budget Larry's Lawn Service For the Month Ended June 30 Revenue/Cost Flexible Formulas Budget Number of lawns (Q) 550 Revenue ($75Q) $ 41,250 Expenses: Wages and salaries ($5,000 + $30Q) $ 21,500 Gasoline and supplies ($9Q) 4,950 Equipment maintenance ($3Q) 1,650 Office and shop utilities ($1,000) 1,000 Office and shop rent ($2,000) 2,000 Equipment Depreciation ($2,500) 2,500 Insurance ($1,000) 1,000 Total expenses 34,600 Net operating income $ 6,650 McGraw-Hill/Irwin Slide 15
- 16. Quick Check What should the total wages and salaries cost What should the total wages and salaries cost be in a flexible budget for 600 lawns? be in a flexible budget for 600 lawns? a. $18,000 a. $18,000 b. $20,000. b. $20,000. c. $23,000. c. $23,000. d. $25,000. d. $25,000. McGraw-Hill/Irwin Slide 16
- 17. Quick Check What should be the total wages and salaries What should the the total wages and salaries be total wages and salaries cost the total wages and salaries cost be in in flexible budget for 600 lawns? cost in a flexible budget for 600 lawns? cost a a flexible budget for 600 lawns? be in a flexible budget for 600 lawns? a. $18,000 a. $18,000 b. $20,000. b. $20,000. c. $23,000. c. $23,000. d. $25,000. d. $25,000. Total wages and salaries cost = $5,000 + ($30 per lawn × 600 lawns) = $5,000 + $18,000 = $23,000 McGraw-Hill/Irwin Slide 17
Notes de l'éditeur
- Chapter 10: Flexible Budgets and Performance Analysis This chapter explores how budgets can be adjusted so that meaningful comparisons to actual costs can be made.
- Learning objective number 1 is to p repare a flexible budget.
- A planning budget is prepared before the period begins and is valid for only the planned level of activity. If the actual level of activity differs from what was planned, it would be misleading to evaluate performance by comparing actual costs to the static, unchanged planning budget.
- A flexible budget provides estimates of what revenues and costs should be for any level of activity, within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons.
- Larry’s Lawn Service provides lawn care in a planned community where all lawns are approximately the same size. At the end of May, Larry prepared his June budget based on mowing 500 lawns. Since all of the lawns are similar in size, Larry felt that the number of lawns mowed in a month would be the best way to measure overall activity for his business.
- Larry identified 7 major expenses for his business. In addition, Larry estimated a cost formula for revenue and for each expense in terms of the number of lawns mowed. Revenue, along with each of the 7 major expense categories, and their relationship to the number of lawns (Q) is as follows: Revenue, $75 per lawn (Q) Wages and salaries, $5,000 + $30 per lawn (Q) Gasoline and supplies, $9Q Equipment maintenance, $3Q Some expenses are not directly related to the number of lawns mowed. They are the fixed costs: office and shop utilities, $1,000; office and shop rent, $2,000; equipment depreciation, $2,500; and insurance, $1,000. Larry’s static planning budget is based on an activity level of 500 lawns.
- Assume that Larry’s actual results for the month of June are as shown. Notice that Larry actually mowed 550 lawns.
- If Larry wanted to, he could compare his actual results to the planning budget as shown on the slide. Notice that a variance is computed for revenue and each expense item. The planning budget column and actual results column have apple and orange icons to emphasize that the amounts in both columns are based on different levels of activity ( 500 vs. 550 lawns ).
- Revenue variances are labeled favorable when actual revenues exceed budgeted revenues, and they are labeled unfavorable when actual revenues are less than budgeted revenues. Expense variances are labeled favorable when actual expenses are less than budgeted expenses, and they are labeled unfavorable when actual expenses exceed budgeted expenses.
- Has Larry done a poor job controlling those costs with unfavorable variances? Has he done a good job controlling the costs with favorable variances?
- The answer is unclear because the actual activity level (550 lawns) does not equal the planned activity level (500 lawns).
- This raises an additional question, namely – How much of the cost variances is due to higher activity, and how much is due to cost control? To answer this question, we must “flex” the budget.
- Flexing a budget involves two key assumptions about cost behavior. First, total variable costs change in direct proportion to changes in activity; and second, total fixed costs remain unchanged within a specified activity range.
- Let’s continue the Larry’s Lawn Service example by preparing a flexible budget at the actual level of activity.
- Larry’s flexible budget for an activity level of 550 lawns mowed is as shown on this slide. The key to preparing a flexible budget is to state each variable cost as a function of activity. For example, gasoline and supplies are equal to $9 per lawn, and the variable portion of wages and salaries is $30 per lawn. While variable costs are expressed per unit of activity, fixed costs are not. The fixed costs are not sensitive to changes in the activity level. Notice, the “Q” in all revenue and cost formulas is 550 lawns mowed. So, for example: Revenue of $41,250 is computed by multiplying $75 × 550. Wages and salaries of $21,500 is computed by multiplying $30 × 550 plus $5,000 in fixed salaries. Can you compute the flexible budget amount for wages and salaries at a different level of activity? The question on the following screen will ask you to do that.
- Here’s the question. What should be the total wages and salaries cost in a flexible budget for 600 lawns?
- Total wages and salaries is the sum of the $5,000 of fixed portion plus the $18,000 of variable portion. The variable portion is computed by multiplying $30 per lawn times 600 lawns.