Flexible budgets

HP CH:11
Fixed budgets versus FLEXIBLE budgets
 A fixed budget is a budget which is set for a single
activity level.
 A flexible budget is a budget which recognises different
cost behaviour patterns and is designed to change as
volume of activity changes.

Master budgets are based on A fixed budget is a 'budget set

planned volumes of production
and sales but do not include any
provision for the event that
actual volumes may differ from
the budget. In this sense they
may be described as fixed
budgets.
prior to the control period
and not subsequently changed in
response to changes in activity,
costs or revenue. It may serve
as a benchmark in
performance evaluation.' --
CIMA Official Terminology
Preparation of FLEXIBLE BUDGETS
 Step 1: The first step in the preparation of a flexible
budget is the determination of cost behaviour patterns,
which means deciding whether costs are fixed, variable or
semi-variable.
 Fixed costs are easy to spot. They remain constant as activity
levels change.
 For non-fixed costs, divide each cost figure by the related
activity level.
 If the cost is a variable cost, the cost per unit will remain
constant.
 If the cost is a semi-variable cost, the unit rate will reduce as
activity levels increase.
 Step 2: The second step in the preparation of a flexible
budget is to calculate the budget cost allowance for
each cost item.
 Budget cost allowance = budgeted fixed cost* +
(number of units × variable cost per unit)**
 Semi-variable costs therefore need splitting into their fixed and
variable components so that the budget cost allowance can be
calculated.

* nil for variable cost

** nil for fixed cost
Budget FLEXING
 Budget flexing involves 'flexing variable costs from
original budgeted levels to the allowances permitted for
actual volume achieved while maintaining fixed costs
at original budget levels'. --CIMA Official Terminology
Splitting semi-variable costs

One method for splitting semi-variable costs is the high/low method, which we
covered earlier.
Example1
The cost of factory power has behaved as follows in past years.
Units of output Cost of factory
produced power$
20X1 7,900 38,700
20X2 7,700 38,100
20X3 9,800 44,400
20X4 9,100 42,300
Budgeted production for 20X5 is 10,200 units.
Ignoring inflation, the cost of factory power which will be
incurred is estimated to be $ ______
The cost of factory power is estimated
to be $ 45,600
Workings Notes
Units $
20X3 (highest output) 9,800 44,400
20X2 (lowest output) 7,700 38,100
2,100 6,300
The variable cost per unit is therefore $6,300/2,100 = $3.

The level of fixed cost can be calculated by looking at any output level.
$
Total cost of factory power in 20X3 44,400
Less: Variable cost of factory power (9,800 × $3) 29,400
Fixed cost of factory power 15,000
An estimate of costs is 20X5 is as follows. $
Fixed cost 15,000
Variable cost of budgeted production (10,200 × $3) 30,600
Total budgeted cost of factory power 45,600
 Example 2
(a) Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production department flexed
at the activity levels of 80%, 90% and 100%, using the information listed below.
(i) The direct labour hourly rate is expected to be $3.75.
(ii) 100% activity represents 60,000 direct labour hours.
(iii) Variable costs :
Indirect labour $0.75 per direct labour hour
Consumable supplies $0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
(iv) Semi-variable costs are expected to relate to the direct labour hours in the same manner as for the last five
years.
Year Direct labour Semi-variable
hours costs $
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 16,000
(v) Fixed costs $
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
(vi) Inflation is to be ignored.

(b) Calculate the budget cost allowance (i.e. expected expenditure) for 20X6 assuming that 57,000 direct labour hours
are worked.
(a)

80% level 90% level 100% level

48,000 hrs 54,000 hrs 60,000 hrs
($'000) ($'000) ($'000)
Direct labour 48*3.75 = 180 54*3.75 = 202.5 60*3.75 = 225
Other variable costs
Indirect labour 36 40.5 45
Consumable supplies 18 20.25 22.5
Canteen etc 12.96 14.58 16.2
Total variable costs (308.7/60 = $5.145 per hour) 246.96 277.83 308.7
Budgeted costs 336.56 368.63 400.7
Semi-variable costs ( see Working Note) 17.6 18.8 20
Fixed costs
Depreciation 18 18 18
Maintenance 10 10 10
Insurance 4 4 4
Rates 15 15 15
Management salaries 25 25 25
(Working Note)

Using the high/low method:

$
High Total cost of 64,000 hours 20,800
Low Total cost of 40,000 hours 16,000
Variable cost of 24,000 hours 4,800
Variable cost per hour ($4,800/24,000) $0.20
$
Total cost of 64,000 hours 20,800
Variable cost of 64,000 hours (× $0.20) 12,800
Fixed costs 8,000
Semi-variable costs are calculated as follows.
$
60,000 hours (60,000 × $0.20) + $8,000 20,000
54,000 hours (54,000 × $0.20) + $8,000 18,800
48,000 hours (48,000 × $0.20) + $8,000 17,600
(b)

The budget cost allowance for 57,000 direct labour hours of work would be as follows.

Variable costs (57,000 × $5.145) 293,265

Semi-variable costs ($8,000 + (57,000 × $0.20)) 19,400

Fixed costs 72,000

Total Cost 384,665
Flexible budgets and CONTROL
 Control involves comparing a flexible budget (based on
the actual activity level) with Actual results.
 The differences between the flexible budget figures and
the actual results are budget variances.
Example 3
Suppose Western Co. manufactures a single product, the CL. Budgeted results
and actual results for June 20X2 are shown below.
Production and sales of Budget Actual results
the CL (units) 2,000 3,000 Variance
$ $ $
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100
Profit (a) – (b) 1,900 6,800 4,900 (F)
 (a) In this example, the variances are meaningless for
purposes of control. Costs were higher than budget because
the volume of output was also higher; variable costs
would be expected to increase above the budgeted costs in
the fixed budget. There is no information to show
whether control action is needed for any aspect of costs
or revenue.
 (b) For control purposes, it is necessary to know the
answers to questions such as the following.
 (i) Were actual costs higher than they should have been to produce
and sell 3,000 CLs?
 (ii) Was actual revenue satisfactory from the sale of 3,000 CLs?
The correct approach to control
 The correct approach to control is as follows.
 • Identify fixed and variable costs.
 • Produce a flexible budget based on the actual activity level.
In the previous example of Western Co, let us suppose that we have the
following estimates of cost behaviour.

(a) Direct materials, direct labour and maintenance costs are variable.

(b) Rent and rates and depreciation are fixed costs.

(c) Other costs consist of fixed costs of $1,600 plus a variable cost of $1
per unit made and sold.
The control analysis should therefore be based on a flexible budget as follows.

Fixed Flexible Actual Budget

budget budget results variance
(a) (b) (c) (c)–(b)
Production and sales (units) 2,000 3,000 3,000
$ $ $ $
Sales revenue 20,000 30,000 30,000 0
Variable costs
Direct materials 6000/2000= 3 6,000 9,000 8,500 500 (F)
Direct labour 4000/2000=2 4,000 6,000 4,500 1,500 (F)
Maintenance 1000/2000=0.50 1,000 1,500 1,400 100 (F)
Semi-variable costs
3,600 4,600 5,000 400 (A)
Other costs =1600+3000*$1
Fixed costs
Depreciation 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)
(1,900 – 5400) (24,600 – 23,200)

(18,100-23,200)

Notice that the total variance has not altered. It is still $4,900 (F) as per previous slide. The flexible
budget comparison merely analyses the TOTAL VARIANCE into TWO SEPARATE COMPONENTS.
 Variances are calculated by comparing actual results and
the flexible budget, not actual results and the original
budget.
Example 4
WL Co. manufactures and sells a single product, R. Since the R is highly perishable, no inventories are
held at any time. WL Co's management uses a flexible budgeting system to control costs. Extracts from
the flexible budget are as follows.
Output and sales (units) 4,000 5,500
Budget cost allowances $ $
Direct material 16,000 22,000
Direct labour 20,000 24,500
Variable production overhead 8,000 11,000
Fixed production overhead 11,000 11,000
Selling and distribution overhead 8,000 9,500
Administration overhead 7,000 7,000
Total expenditure 70,000 85,000
Production and sales of product R amounted to 5,100 units during period 5.
The total budget cost allowances in the flexible budget for period 5 will be:
(a) Direct material $ ______________
(b) Direct labour $ _______________
(c) Variable production overhead $ _____________
(d) Fixed production overhead $ _____________
(e) Selling and distribution overhead $ _____________
(f) Administration overhead $ ___________________
(g) Production and sales of product R in period 6 amounted to 5,500 units. Budgeted output for
the period was 4,000 units. Actual total expenditure was $82,400.
(i) The total expenditure variance for period 6 was $ ________ favourable/adverse
(ii) The volume variance for period 6 was $ __________ favourable/adverse
(a) Direct material is a variable cost of $16,000/4,000 = $4 per unit
Budget cost allowance for 5,100 units = 5,100 × $4 = $20,400
(b) Direct labour is a semi-variable cost which can be analysed using the high-low
method.
Output
Units $
High 5,500 24,500
Low 4,000 20,000
Change 1,500 4,500
Variable cost per unit = $4,500/1,500 = $3
Substituting in high output, fixed cost = $24,500 – (5,500 × $3) = $8,000
Budget cost allowance for 5,100 units: $
Variable cost = 5,100 × $3 15,300
Fixed cost 8,000
23,300
(c) Variable production overhead per unit = $8,000/4,000 = $2 per unit
Budget cost allowance for 5,100 units = 5,100 × $2 = $10,200
(d) Fixed production overhead cost allowance is fixed at $11,000.
(e) Selling and distribution is a semi-variable cost which can be analysed using the high-low method.
Output
Units $
High 5,500 9,500
Low 4,000 8,000
Change 1,500 1,500
Variable cost per unit = $1,500/1,500 = $1
Substituting in high output, fixed cost = $9,500 – (5,500 × $1) = $4,000
Budget cost allowance for 5,100 units: $
Variable cost = 5,100 × $1 5,100
Fixed cost 4,000
9,100
(f) Administration overhead cost allowance is fixed at $7,000.
(g) The budgeted and actual output volumes correspond to the two activity levels provided in the
question data. The total budget cost allowance for each activity level can be used as the basis for
the variance calculations.
(i) Expenditure variance = budget cost allowance for 5,500 units – actual expenditure for
5,500 units
= $85,000 – $82,400
= $2,600 favourable
(ii) Volume variance = budget cost allowance for original budget of 4,000 units – budget
cost allowance for actual volume of 5,500 units
= $70,000 – $85,000 = $15,000 adverse
Example 5

The following extract is taken from the production cost budget of Zebra Co:
Production units 4,000 6,000
Production cost $35,529 $41,280
$47,040
The budget cost allowance for an activity level of 8,000 units is $ _____
The following extract is taken from the production cost budget of Zebra Co:
Production units 4,000 6,000
Production cost $35,529 $41,280
The budget cost allowance for an activity level of 8,000 units is $___________

Change
Production units 4,000 6,000 2,000
Production cost $35,520 $41,280 $5,760

Variable cost per unit =5760/2,000 = $2.88

Fixed costs = $35,520 – (4,000 × $2.88) = $24,000
Therefore, budget cost allowance for activity level of 8,000 units = $24,000 +
(8,000 × $2.88) = $47,040