Chapter 7 Chuaco Flexible Budget and Performance Analysis

BATAAN PENINSULA STATE UNIVERSITY
MAIN CAMPUS
Capitol Compound, Tenejero, City of Balanga 2100 Bataan
GRADUATE SCHOOL
P Phone Number: (047) 237-6658 www.bpsu.edu.ph
Chapter 7: Flexible Budget and Performance Analysis (Part 1)
Learning Objectives:
After studying Chapter 9, you should be able to:
1. Prepare a flexible budget
2. Prepare a report showing activity variances
3. Prepare a report showing revenue and spending variance
4. Prepare a performance report that combines activity variances and
revenue and spending variances
5. Prepare a flexible budget with more than one cost driver
6. Understand common errors made in preparing performance reports based
on budgets and actual results
The Inevitability of Forecasting Errors
While companies derive numerous benefits from planning for the future, they
must be able to respond when actual results deviate from the plan. For
example, just two months after telling Wall Street analysts that it would
breakeven for the first quarter of 2005, General Motors (GM) acknowledged
Our Vision Our Mission
A leading university in the Philippines recognized for its proactive To develop competitive graduates and empowered community members by providing relevant, innovative
contribution to Sustainable Development through equitable and inclusive and transformative knowledge, research, extension and production programs and services through
programs and services by 2030. progressive enhancement of its human resources capabilities and institutional mechanism.
MAIN CAMPUS
GRADUATE SCHOOL
that its actual sales were far less than its original forecast and the company
would lose $850 million in the quarter. For the year, GM acknowledged that
projected earnings would be 80% lower than previously indicated. The
company’s stock price dropped by $4.71.

When a company’s plans deviate from its actual results, managers need to
understand the reasons for the deviations.
1. How much is caused by the fact that actual sales differ from budgeted
sales?
2. How much is caused by the actions of managers?
General Motors (GM)
 the actual level of sales is far less than the budget, so some actual costs
are likely to be less than originally budgeted.
 These lower costs do not signal managerial effectiveness.
This chapter explains how to analyze the sources of discrepancies between
budgeted and actual results.

Budgeting
 It involves a lot of time and effort and the results of the budgeting process
should not be shoved into a filing cabinet and forgotten.

MAIN CAMPUS
GRADUATE SCHOOL
 To be useful, budgets should provide guidance in conducting actual operations
and should be part of the performance evaluation process.
 However, managers need to be very careful about how budgets are used.
Budgeting Process in Government and For Profit Organizations
 Government- budgets often establish how much will be spent and indeed,
spending more than was budgeted may be a criminal offense.
 Profit-Organizations-actual spending will rarely be the same as the spending
that was budgeted at the beginning of the period. The reason is that the actual
level of activity (such as unit sales) will rarely be the same as the budgeted
activity; therefore, many actual costs and revenues will naturally differ from
what was budgeted.
Issue 1
1. Should a manager be penalized for spending 10% more than budgeted for a
variable cost like direct materials if unit sales are 10% higher than budgeted?
Answer: Of course not. In this chapter we will explore how budgets can be
adjusted so that meaningful comparisons to actual costs can be made
Learning Objective No.1 Prepare a Flexible Budget

Characteristics of a Flexible Budget
Planning Budget
MAIN CAMPUS
GRADUATE SCHOOL
 is prepared before the period begins and is valid for only the planned level of
activity.
 A static planning budget is suitable for planning but is inappropriate for
evaluating how well costs are controlled.
 If the actual level of activity differs from what was planned, it would be
misleading to compare actual costs to the static, unchanged planning budget.
 If activity is higher than expected, variable costs should be higher than
expected; and if activity is lower than expected, variable costs should be lower
than expected.
 Flexible budgets take into account how changes in activity affect costs.
Flexible budget
 is an estimate of what revenues and costs should have been, given the actual
level of activity for the period.
 A flexible budget, also called a variable budget, is an estimate of what
revenues and costs should have been , given the actual level of activity for the
period
 In other words, a flexible budget uses the revenues and expenses produced in
the current production as a baseline and estimates how the revenues and
expenses will change based on changes in the output. This is why it’s often
called a variable budget.
MAIN CAMPUS
GRADUATE SCHOOL
 When a flexible budget is used in performance evaluation, actual costs are
compared to what the costs should have been for the actual level of a activity
during the period rather than to the static planning budget. This is a very
important distinction.
 If adjustments for the level of activity are not made, it is very difficult to
interpret discrepancies between budgeted and actual costs.
Why do companies need flexible budgets?
 The difficulty of accurately predicting future financial performance can be
readily understood by reading the annual report of any publicly traded
company.
Why do companies need flexible budget?
 Flexible Budgets Help Avoid Overspending
 Flexible Budgets Let You React to Opportunities
 Flexible Budgets Can Adjust Costs and Margins
 Flexible Budgets Rely on Current Data
Nucor Corporation
 a steel manufacturer headquartered in Charlotte, North Carolina, cites
numerous reasons why its actual results may differ from expectations, including
the following: (1) the supply and cost of raw materials, electricity, and natural gas
MAIN CAMPUS
GRADUATE SCHOOL
may change unexpectedly; (2) the market demand for steel products may change;
(3) competitive pressures from imports and substitute materials may intensify; (4)
uncertainties regarding the global economy may affect customer demand; (5)
changes to U.S. and foreign trade policy may alter current importing and exporting
practices; and (6) new government regulations could significantly increase
environmental compliance costs.
 Each of these factors could cause static budget and cost differ from
actual results
(Source: Nucor Corporation 2004 annual report, p. 3.)
Deficiencies of the Static Planning Budget

To tell the difference between Static Planning Budget and Flexible Budget, let’s
take the case of Rick’s Hairstyling Salon.

Rick’s Hairstyling Salon
 is an upscale hairstyling salon located in Beverly Hills that is owned and
managed by Rick Manzi. The salon has very loyal customers—many of whom
are associated with the film industry.
 Rick has been attempting to get better control of his revenues and costs, and
at the urging of his accounting and business adviser, Victoria Kho, he has
begun to prepare monthly budgets.
MAIN CAMPUS
GRADUATE SCHOOL
 Victoria Kho is an accountant in independent practice who specializes in
small service-oriented businesses like Rick’s Hairstyling. At the end of
February, Rick prepared the March budget that appears in Exhibit 9–1.
Exhibit 9.1 Static Planning Budget vs. Flexible Budget
 Rick believes that the number of customers served in a month is the best
way to measure the overall level of activity in his salon.
MAIN CAMPUS
GRADUATE SCHOOL
 He refers to these visits as client-visits. A customer who comes into the
salon and has his or her hair styled is counted as one client-visit.
 Note that the term revenue is used in the planning budget rather than sales.
Revenue is used throughout the chapter because some organizations have
sources of revenue other than sales. (Donations, sales are counted as
revenue in nonprofit organizations)
8 Major Categories of Cost in Rick’s Hairstyling Salon
1. Wages and salaries
2. Hairstyling supplies
3. Client gratuities- flowers, candies and glasses of champagne that Rick gives
his customers while they are in the salon.
4. Electricity
5. Rent
6. Liability insurance
7. Employee health insurance
8. Miscellaneous
Rick had already estimated a cost formula for each cost.

Example of Cost Formula for Each Cost
 Cost formula for Electricity should be $1,500 + $0.10q, where q equals the
number of client-visits
MAIN CAMPUS
GRADUATE SCHOOL
 Electricity is a mixed cost with a $1,500 fixed element and a $0.10 per
client-visit variable element.
 Once the budgeted level of activity was set at 1,000 client-visits, it was easy
to compute the budgeted amount for each line item in the budget. For example,
using the cost formula, the budgeted cost for electricity was set at $1,600
( $1,500 + $0.10 x 1,000).
 At the end of March, Rick found that his actual profit was $21,230 as shown in
the income statement in Exhibit 9–2.
Exhibit 9.2 Actual Results-Income Statement
MAIN CAMPUS
GRADUATE SCHOOL
 It is important to realize that the actual results are not determined by
plugging the actual number of client-visits into the revenue and cost
formulas. The formulas are simply estimates of what the revenues and costs
should be for a given level of activity.
 What actually happens usually differs from what is supposed to happen.
 Referring back to Exhibit 9–1, the budgeted net operating income was
$16,800, so the actual profit was substantially higher than planned at the
beginning of the month. This was, of course, good news, but Rick wanted to
know more.
 Business was up by 10%—the salon had 1,100 client-visits instead of the
budgeted 1,000 client-visits. Could this alone explain the higher net income?
The answer is no.
 An increase in net operating income of 10% would have resulted in net
operating income of only $18,480 (1.1 X $16,800), not the $21,230 actually
earned during the month.
 What is responsible for this better outcome? Higher prices? Lower costs?
Something else? Whatever the cause, Rick would like to know the answer and
then hopefully repeat the same performance next month.
 In an attempt to analyze what happened in March, Rick prepared the
report comparing actual to budgeted costs that appears in Exhibit 9–3.

MAIN CAMPUS
GRADUATE SCHOOL
Exhibit 9.3 Comparison of Static Planning Budget to Actual Results
 Most of the variances in this report are labeled unfavorable (U) rather
than favorable (F) even though net operating income was actually higher than
expected.
 For example, wages and salaries show an unfavorable variance of
$4,900 because the budget called for wages and salaries of $102,000, whereas
the actual wages and salaries expense was $106,900.
MAIN CAMPUS
GRADUATE SCHOOL
 The problem with the report, as Rick immediately realized, is that it
compares revenues and costs at one level of activity (1,000 client-visits) to
 revenues and costs at a different level of activity (1,100 client-visits). This is
like comparing apples to oranges.
 Because Rick had 100 more client-visits than expected, some of his costs
should be higher than budgeted.
 From Rick’s standpoint, the increase in activity was good and should be
counted as a favorable variance, but the increase in activity has an apparently
negative impact on most of the costs in the report.
 Rick knew that something would have to be done to make the report more
meaningful, but he was unsure of what to do. So he made an appointment to meet
with Victoria Kho to discuss the next step.
Managerial Accounting in Action: The Issue

How a Flexible Budget Works
Flexible budget
MAIN CAMPUS
GRADUATE SCHOOL
 approach recognizes that a budget can be adjusted to show what costs should
be for the actual level of activity. To illustrate how flexible budgets work, Victoria
prepared the report in Exhibit 9–4 that shows what the revenues and costs
should have been given the actual level of activity in March.
Exhibit 9.4 Flexible Budget based on Actual Activity
Flexible Budget Variances

To answer Rick’s questions concerning the discrepancies between budgeted and
actual costs, we will need to break down the variances shown in Exhibit 9–3 into
two types of variances”

1.Activity variances ;and
2. revenue and spending variances.
Learning Objective 2: Prepare a report showing activity variances.
Activity Variances
MAIN CAMPUS
GRADUATE SCHOOL
 The discrepancy between the budgeted profit and the actual profit is due to
the fact that the actual level of activity in March was higher than expected.
 How much of this discrepancy was due to this single factor? The report in
Exhibit 9–5 is designed to answer this question.
 Exhibit 9.5 shows that the planning budget from the beginning of the period is
compared to the flexible budget based on the actual level of activity for the
period.
Exhibit 9.5 Activity Variances from Comparing the Planning Budget to the
Flexible Budget Based on Actual Activity
MAIN CAMPUS
GRADUATE SCHOOL
 The planning budget shows what should have happened at the budgeted
level of activity whereas the flexible budget shows what should have
happened at the actual level of activity.
 Therefore, the differences between the planning budget and the flexible
budget show what should have happened solely because the actual level of
activity differed from what had been expected.
MAIN CAMPUS
GRADUATE SCHOOL
Client Visits
 Planning budget based on 1,000 client-visits= Revenue is $180,000 ( $180
per client-visit X 1,000 client-visits).
 Flexible budget based on 1,100 client visits= Revenue is $198,000 ($180
per client-visit X 1,100 client-visits).
 Because the salon had 100 more client-visits than anticipated in the budget,
actual revenue should have been higher than budgeted revenue by $18,000
( $198,000- $180,000).
 This activity variance is shown on the report as $18,000 F (favorable)
Electricity Cost
 Planning budget based on 1,000 client-visits shows electricity cost of
$1,600 ( $1,500 + $0.10 per client-visit X 1,000 client-visits)
 Flexible budget based on 1,100 client-visits shows electricity costs of
$1,610 ( $1,500 + $0.10 per client-visit X 1,100 client-visits).
 Because the salon had 100 more client-visits than anticipated in the budget,
actual electricity costs should have been higher than budgeted costs by $10
( $1,610 - $1,600).
MAIN CAMPUS
GRADUATE SCHOOL
 The activity variance for electricity is shown on the report as $10 U
(unfavorable). Note that in this case, the label “unfavorable” may be a little
misleading. Costs should be $10 higher for electricity simply because business
was up by 100 client-visits; therefore, is this variance really unfavorable if it was a
necessary cost of serving more customers?
 Caution: Don’t assume that unfavorable variances always indicate bad
performance and favorable variances always indicate good performance.
Activity Variance
 difference in the level of activity between the planning budget from the
beginning of the period and the actual level of activity
 Example: the activity variance for revenue is $18,000 F, the activity variance
for electricity is $10 U, and so on.
 The most important activity variance appears at the very bottom of the report;
namely, the $13,710 F (favorable variance for net operating income).
 This variance says that because activity was higher than expected in the
planning budget, the net operating income should have been $13,710 higher.
We caution against placing too much emphasis on any other single variance
MAIN CAMPUS
GRADUATE SCHOOL
 in this report. As we have said above, one would expect some costs to be
higher as a consequence of more business. It is somewhat misleading to
think of these unfavorable variances as indicative of poor performance.
Favorable Activity Variance for Net Operating Income
 Activity was up by 10%. A 10% increase in net operating income from the
$16,800 in the planning budget would result in net operating income of
$18,480 ( 1.1 X $16,800; however, the flexible budget shows much higher net
operating income of $30,510.
 Why? The short answer is: Because of the presence of fixed costs. When
we apply the 10% increase to the budgeted net operating income to estimate
the profit at the higher level of activity, we implicitly assume that the revenues
and all of the costs increase by 10%.
 Note that when the activity level increases by 10%, three of the costs—rent,
liability insurance, and employee health insurance—do not increase at all.
These are all purely fixed costs. So while sales do increase by 10%, these
costs do not increase. This results in net operating income increasing by more
than 10%.
 A similar effect occurs with the mixed costs which contain fixed cost elements
—wages and salaries, electricity, and miscellaneous.
MAIN CAMPUS
GRADUATE SCHOOL
 While sales increase by 10%, these mixed costs increase by less than 10%,
resulting in an overall increase in net operating income of more than 10%.
 Because of the existence of fixed costs, net operating income does not
change in proportion to changes in the level of activity. There is a
leverage effect.
 The percentage changes in net operating income are ordinarily larger
than the percentage increases in activity.

Chapter 7 Chuaco Flexible Budget and Performance Analysis

Hochgeladen von

Dokumentinformationen

Originalbeschreibung:

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Chapter 7 Chuaco Flexible Budget and Performance Analysis

Hochgeladen von

Copyright:

Verfügbare Formate

BATAAN PENINSULA STATE UNIVERSITY

Chapter 7: Flexible Budget and Performance Analysis (Part 1)

After studying Chapter 9, you should be able to:

1. Prepare a flexible budget

2. Prepare a report showing activity variances

3. Prepare a report showing revenue and spending variance

4. Prepare a performance report that combines activity variances and

revenue and spending variances

5. Prepare a flexible budget with more than one cost driver

6. Understand common errors made in preparing performance reports based

on budgets and actual results

The Inevitability of Forecasting Errors

projected earnings would be 80% lower than previously indicated. The

company’s stock price dropped by $4.71.

understand the reasons for the deviations.

2. How much is caused by the actions of managers?

General Motors (GM)

are likely to be less than originally budgeted.

 These lower costs do not signal managerial effectiveness.

This chapter explains how to analyze the sources of discrepancies between

budgeted and actual results.

should not be shoved into a filing cabinet and forgotten.

and should be part of the performance evaluation process.

Budgeting Process in Government and For Profit Organizations

spending more than was budgeted may be a criminal offense.

 Profit-Organizations-actual spending will rarely be the same as the spending

what was budgeted.

adjusted so that meaningful comparisons to actual costs can be made

Learning Objective No.1 Prepare a Flexible Budget

Our Vision Our Mission

 A static planning budget is suitable for planning but is inappropriate for

evaluating how well costs are controlled.

misleading to compare actual costs to the static, unchanged planning budget.

 If activity is higher than expected, variable costs should be higher than

level of activity for the period.

 A flexible budget, also called a variable budget, is an estimate of what

called a variable budget.

Our Vision Our Mission

interpret discrepancies between budgeted and actual costs.

Why do companies need flexible budgets?

 The difficulty of accurately predicting future financial performance can be

readily understood by reading the annual report of any publicly traded

Why do companies need flexible budget?

 Flexible Budgets Help Avoid Overspending

 Flexible Budgets Let You React to Opportunities

 Flexible Budgets Can Adjust Costs and Margins

 Flexible Budgets Rely on Current Data

 a steel manufacturer headquartered in Charlotte, North Carolina, cites

practices; and (6) new government regulations could significantly increase

environmental compliance costs.

(Source: Nucor Corporation 2004 annual report, p. 3.)

Deficiencies of the Static Planning Budget

take the case of Rick’s Hairstyling Salon.

 is an upscale hairstyling salon located in Beverly Hills that is owned and

are associated with the film industry.

begun to prepare monthly budgets.

Our Vision Our Mission

small service-oriented businesses like Rick’s Hairstyling. At the end of

Exhibit 9.1 Static Planning Budget vs. Flexible Budget

way to measure the overall level of activity in his salon.

Our Vision Our Mission

Revenue is used throughout the chapter because some organizations have

sources of revenue other than sales. (Donations, sales are counted as