Flexible Budgets and Performance Analysis

1. Flexible Budgets andPerformance Analysis Chapter 10 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.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.

2. Learning Objective 1 Learning objective number 1 is to prepare a flexible budget. Learning objective number 1 is to prepare a flexible budget.

3. Characteristics of Flexible Budgets Planning budgetsare prepared fora single, plannedlevel of activity. 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 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.

4. Characteristics of Flexible Budgets 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. 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.

5. Deficiencies of the Static Planning Budget 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’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.

6. Deficiencies of the Static Planning Budget 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. 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.

7. Deficiencies of the Static Planning Budget Assume that Larry’s actual results for the month of June are as shown. Notice that Larry actually mowed 550 lawns.Assume that Larry’s actual results for the month of June are as shown. Notice that Larry actually mowed 550 lawns.

8. Deficiencies of the Static Planning Budget 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). 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).

9. Deficiencies of the Static Planning Budget 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. 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.

10. Deficiencies of the Static Planning Budget Has Larry done a poor job controlling those costs with unfavorable variances? Has he done a good job controlling the costs with favorable variances?Has Larry done a poor job controlling those costs with unfavorable variances? Has he done a good job controlling the costs with favorable variances?

11. Deficiencies of the Static Planning Budget The answer is unclear because the actual activity level (550 lawns) does not equal the planned activity level (500 lawns). The answer is unclear because the actual activity level (550 lawns) does not equal the planned activity level (500 lawns).

12. The relevant question is . . . “How much of the cost variances is due to higher activity, and how much is due to cost control?” To answer the question,we mustthe budget to theactual level of activity. Deficiencies of the Static Planning Budget 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. 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.

13. How a Flexible Budget Works To a budget we need to know that: Total variable costs changein direct proportion to changes in activity. Total fixed costs remainunchanged within therelevant range. 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.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.

14. Preparing a Flexible Budget 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. 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.

15. Learning Objective 2 Learning objective number 2 is to prepare a report showing activity variances.Learning objective number 2 is to prepare a report showing activity variances.

16. Activity Variances An activity variance arises solely due to the difference in the level of activity included in the planning budget and the actual level of activity .An activity variance arises solely due to the difference in the level of activity included in the planning budget and the actual level of activity .

17. Activity Variances The activity variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The level of activity in the flexible budget (550 lawns) is 10% higher than the level of activity in the planning budget (500 lawns). The planning budget shows revenue and cost amounts at the original planned level of activity while the flexible budget shows revenue and cost amounts at the actual level of activity. The differences (variances) between the planning budget for 500 lawns and the flexible budget for 550 lawns are due solely to the activity increase. Revenue in the flexible budget is 10% higher than the planning budget because revenue varies proportionally to changes in the activity level. The higher activity level results in a favorable activity variance for revenue. The variable costs in the flexible budget (gasoline and supplies and equipment maintenance) are 10% higher than the planning budget because variable costs vary proportionally to changes the activity level. The mixed cost (wages and salaries) in the flexible budget is less than 10% higher than the planning budget because the fixed cost component of the mixed cost does not change when the activity level changes. The higher activity level results in unfavorable activity variances for these costs. The fixed costs in the flexible budget are the same as the planning budget because they do not change in response to changes in the activity level within the relevant range. The activity variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The level of activity in the flexible budget (550 lawns) is 10% higher than the level of activity in the planning budget (500 lawns). The planning budget shows revenue and cost amounts at the original planned level of activity while the flexible budget shows revenue and cost amounts at the actual level of activity. The differences (variances) between the planning budget for 500 lawns and the flexible budget for 550 lawns are due solely to the activity increase. Revenue in the flexible budget is 10% higher than the planning budget because revenue varies proportionally to changes in the activity level. The higher activity level results in a favorable activity variance for revenue. The variable costs in the flexible budget (gasoline and supplies and equipment maintenance) are 10% higher than the planning budget because variable costs vary proportionally to changes the activity level. The mixed cost (wages and salaries) in the flexible budget is less than 10% higher than the planning budget because the fixed cost component of the mixed cost does not change when the activity level changes. The higher activity level results in unfavorable activity variances for these costs. The fixed costs in the flexible budget are the same as the planning budget because they do not change in response to changes in the activity level within the relevant range.

18. Activity Variances Activity and revenue increase by 10 percent, but net operating income increases by more than 10 percent (33 percent) due to the presence of fixed costs.Activity and revenue increase by 10 percent, but net operating income increases by more than 10 percent (33 percent) due to the presence of fixed costs.

19. Learning Objective 3 Learning objective number 3 is to prepare a report showing revenue and spending variances.Learning objective number 3 is to prepare a report showing revenue and spending variances.

20. Revenue and Spending Variances Part I. A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.   Part II. A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.Part I. A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.   Part II. A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.

21. Revenue and Spending Variances The revenue and spending variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The apple icons on the slide indicate that the flexible budget and actual results columns are both based on 550 lawns mowed. The $1,750 favorable revenue variance indicates that actual revenue exceeded the budgeted amount that would be expected for an activity level of 550 lawns mowed. This could happen for a number of reasons including an increase in the amount charged for each lawn or a change in lawn services. In Larry’s case, several homeowners requested some additional edging and trimming, beyond the customary monthly services, that resulted in increased revenue. The revenue and spending variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The apple icons on the slide indicate that the flexible budget and actual results columns are both based on 550 lawns mowed. The $1,750 favorable revenue variance indicates that actual revenue exceeded the budgeted amount that would be expected for an activity level of 550 lawns mowed. This could happen for a number of reasons including an increase in the amount charged for each lawn or a change in lawn services. In Larry’s case, several homeowners requested some additional edging and trimming, beyond the customary monthly services, that resulted in increased revenue.

22. Revenue and Spending Variances The $1,950 unfavorable spending variance indicates that total expenses were $1,950 greater than would be expected for an activity level of 550 lawns mowed. Larry explained the individual spending variances that make up the total $1,950 unfavorable spending variance as follows: The $1,500 unfavorable wages and salaries spending variance occurred because of extra hours required for the additional trimming. The $150 unfavorable gasoline and supplies spending variance was primarily the result of rising gasoline prices. The $350 favorable equipment maintenance spending variance occurred because maintenance was postponed in order to get the extra edging and trimming work completed. Fixed cost variances are not the result of increased activity. The utility bill was less because the weather was milder than normal for June, while insurance was higher because of an unexpected premium increase. Overall, net operating income was $200 less than would be expected for an activity level of 550 lawns mowed. The $1,950 unfavorable spending variance indicates that total expenses were $1,950 greater than would be expected for an activity level of 550 lawns mowed. Larry explained the individual spending variances that make up the total $1,950 unfavorable spending variance as follows: The $1,500 unfavorable wages and salaries spending variance occurred because of extra hours required for the additional trimming. The $150 unfavorable gasoline and supplies spending variance was primarily the result of rising gasoline prices. The $350 favorable equipment maintenance spending variance occurred because maintenance was postponed in order to get the extra edging and trimming work completed. Fixed cost variances are not the result of increased activity. The utility bill was less because the weather was milder than normal for June, while insurance was higher because of an unexpected premium increase. Overall, net operating income was $200 less than would be expected for an activity level of 550 lawns mowed.

23. Learning Objective 4 Learning objective number 4 is to prepare a performance report that combines activity variances and revenue and spending variances.Learning objective number 4 is to prepare a performance report that combines activity variances and revenue and spending variances.

24. A Performance Report Combining Activity and Revenue and Spending Variances Here we see a flexible budget performance report that shows both activity variances and revenue and spending variances. Note that the activity variances appear between the planning budget and the flexible budget and that the revenue and spending variances appear between the flexible budget and the actual results.Here we see a flexible budget performance report that shows both activity variances and revenue and spending variances. Note that the activity variances appear between the planning budget and the flexible budget and that the revenue and spending variances appear between the flexible budget and the actual results.

25. A Performance Report Combining Activity and Revenue and Spending Variances The activity variances are based on the 50 lawns mowed in excess of the static planned level of 500. You can see that the activity revenue variance is $3,750 favorable (50 lawns times $75 per lawn), and the wages and salaries expense is $1,500 unfavorable (50 lawns times $30 per lawn). Make sure you can calculate the other activity variances for Larry.The activity variances are based on the 50 lawns mowed in excess of the static planned level of 500. You can see that the activity revenue variance is $3,750 favorable (50 lawns times $75 per lawn), and the wages and salaries expense is $1,500 unfavorable (50 lawns times $30 per lawn). Make sure you can calculate the other activity variances for Larry.

26. A Performance Report Combining Activity and Revenue and Spending Variances The revenue and spending variances are computed by comparing the flexible budget amounts and the actual amounts. For example: The revenue variance of $1,750 favorable is computed by taking the difference between the actual amount ($43,000) and the flexible budget amount ($41,250). When interpreting a flexible budget performance report it is important to remember two things: First, to generate a favorable activity variance for net operating income, managers must take actions to increase the level of activity. Second, to generate a favorable overall revenue and spending variance, managers must take actions to protect selling prices, increase operating efficiency, and reduce the prices of inputs.   The revenue and spending variances are computed by comparing the flexible budget amounts and the actual amounts. For example: The revenue variance of $1,750 favorable is computed by taking the difference between the actual amount ($43,000) and the flexible budget amount ($41,250). When interpreting a flexible budget performance report it is important to remember two things: First, to generate a favorable activity variance for net operating income, managers must take actions to increase the level of activity. Second, to generate a favorable overall revenue and spending variance, managers must take actions to protect selling prices, increase operating efficiency, and reduce the prices of inputs.  

27. Performance Reports in Non-Profit Organizations The performance reports in non-profit organizations are essentially the same as the performance reports for a business like Larry’s Lawn Service except for one major difference. Non-profit organizations may receive a significant amount funding from sources other than revenue from the sale of goods and services. For example, universities may receive funding from donations and endowment income as well as from student tuition and state appropriations. Tuition and state appropriations are a function of the number of students, while donations and endowment income are not. This means that, like costs, the revenue in governmental and non-profit organizations may consist of both fixed and variable elements. The performance reports in non-profit organizations are essentially the same as the performance reports for a business like Larry’s Lawn Service except for one major difference. Non-profit organizations may receive a significant amount funding from sources other than revenue from the sale of goods and services. For example, universities may receive funding from donations and endowment income as well as from student tuition and state appropriations. Tuition and state appropriations are a function of the number of students, while donations and endowment income are not. This means that, like costs, the revenue in governmental and non-profit organizations may consist of both fixed and variable elements.

28. Performance Reports in Cost Centers Performance reports are often prepared for cost centers. These reports should be prepared using the same principles discussed so far, except for the fact that these reports will not contain revenue or net operating income variances.Performance reports are often prepared for cost centers. These reports should be prepared using the same principles discussed so far, except for the fact that these reports will not contain revenue or net operating income variances.

29. Learning Objective 5 Learning objective number 5 is to prepare a flexible budget with more than one cost driver.Learning objective number 5 is to prepare a flexible budget with more than one cost driver.

30. Flexible Budgets with Multiple Cost Drivers It is unlikely that all variable costs within a company are driven by a single factor such as the number of units produced, labor hours, or machine hours (or lawns mowed in Larry’s Lawn Service). More than one cost driver may be needed to adequately explain all of the costs in an organization. The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.  It is unlikely that all variable costs within a company are driven by a single factor such as the number of units produced, labor hours, or machine hours (or lawns mowed in Larry’s Lawn Service). More than one cost driver may be needed to adequately explain all of the costs in an organization. The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.  

31. Flexible Budgets with Multiple Cost Drivers Because of the large unfavorable wages and salaries spending variance, Larry decided to add an additional cost driver for wages and salaries. The variance is due primarily to the number of hours required for the additional edging and trimming. So Larry estimates the additional hours and builds those hours into both his revenue and expense budget formulas. Because of the large unfavorable wages and salaries spending variance, Larry decided to add an additional cost driver for wages and salaries. The variance is due primarily to the number of hours required for the additional edging and trimming. So Larry estimates the additional hours and builds those hours into both his revenue and expense budget formulas.

32. Flexible Budgets with Multiple Cost Drivers The new revenue formula is $75 times the number of lawns (Q) plus $30 per hour spent on edging and trimming (H). The new cost formula for wages and salaries is $5,000 plus $30 per lawn (Q) plus $25 per hour spent edging and trimming (H). As you can see, the flexible budget is based on mowing 550 lawns with 100 hours spent edging and trimming. The new flexible budget, based on both the number of lawns and the additional hours for edging and trimming, is used exactly like the original flexible budget that was based on number of lawns. The new flexible budget should result in more accurate budgets and variances.The new revenue formula is $75 times the number of lawns (Q) plus $30 per hour spent on edging and trimming (H). The new cost formula for wages and salaries is $5,000 plus $30 per lawn (Q) plus $25 per hour spent edging and trimming (H). As you can see, the flexible budget is based on mowing 550 lawns with 100 hours spent edging and trimming. The new flexible budget, based on both the number of lawns and the additional hours for edging and trimming, is used exactly like the original flexible budget that was based on number of lawns. The new flexible budget should result in more accurate budgets and variances.

33. Learning Objective 6 Learning objective number 6 is to understand common errors made in preparing performance reports based on budgets and actual results. Learning objective number 6 is to understand common errors made in preparing performance reports based on budgets and actual results.

34. Some Common Errors The most common errors in preparing performance reports are to implicitly assume that all costs are fixed or that all costs are variable. The most common errors in preparing performance reports are to implicitly assume that all costs are fixed or that all costs are variable.

35. Common Error 1: Assuming All Costs Are Fixed The first common error is to assume that all costs are fixed. When we compare actual results at one level of activity with a static planning budget at another level of activity, without any adjustment for activity change, we are implicitly assuming that the costs are fixed. Comparing static planning budget costs to actual costs only makes sense if the cost is fixed. If the cost isn’t fixed, it needs to be adjusted for any change in activity that occurs during the period. Note that the results on the slide are identical to the “apples to oranges” comparison on Slide 8. The first common error is to assume that all costs are fixed. When we compare actual results at one level of activity with a static planning budget at another level of activity, without any adjustment for activity change, we are implicitly assuming that the costs are fixed. Comparing static planning budget costs to actual costs only makes sense if the cost is fixed. If the cost isn’t fixed, it needs to be adjusted for any change in activity that occurs during the period. Note that the results on the slide are identical to the “apples to oranges” comparison on Slide 8.

36. Common Error 2: Assuming All Costs Are Variable The second common error is to compare actual results to the dollar amounts in the planning budget multiplied by the percentage increase in activity level. This approach is equivalent to assuming that all costs are variable with respect to changes in the activity level.   Although incrementing the planning budget by the percentage increase in activity is a valid adjustment to make if an item is strictly variable (gasoline and supplies and equipment maintenance), this mode of analysis is flawed if fixed costs exist. When fixed costs exist, the amount of the fixed cost in the planning budget should not be flexed to accommodate the actual level of activity.The second common error is to compare actual results to the dollar amounts in the planning budget multiplied by the percentage increase in activity level. This approach is equivalent to assuming that all costs are variable with respect to changes in the activity level.   Although incrementing the planning budget by the percentage increase in activity is a valid adjustment to make if an item is strictly variable (gasoline and supplies and equipment maintenance), this mode of analysis is flawed if fixed costs exist. When fixed costs exist, the amount of the fixed cost in the planning budget should not be flexed to accommodate the actual level of activity.

37. End of Chapter 10 End of chapter 10.End of chapter 10.

38. How a Flexible Budget Works Let’s continue the Larry’s Lawn Service example by preparing a flexible budget at the actual level of activity.Let’s continue the Larry’s Lawn Service example by preparing a flexible budget at the actual level of activity.

39. Quick Check ? Here’s the question. What should be the total wages and salaries cost in a flexible budget for 600 lawns? Here’s the question. What should be the total wages and salaries cost in a flexible budget for 600 lawns?

40. Quick Check ? 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.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.

41. Activity Variances Part of the discrepancy between the budgeted net operating income and the actual net operating income is because the actual level of activity is higher than the planned activity. Now that we can prepare flexible budgets, let’s see how we can use them to develop performance reports. We will again use the Larry’s Lawn Service data and begin with activity variances.Part of the discrepancy between the budgeted net operating income and the actual net operating income is because the actual level of activity is higher than the planned activity. Now that we can prepare flexible budgets, let’s see how we can use them to develop performance reports. We will again use the Larry’s Lawn Service data and begin with activity variances.

42. Revenue and Spending Variances We have seen the impact that a change in activity has on revenues, costs, and profits, but we haven’t yet answered the question “How well did Larry control his revenues, costs, and profits.” We will answer that question by computing revenue and spending variances.We have seen the impact that a change in activity has on revenues, costs, and profits, but we haven’t yet answered the question “How well did Larry control his revenues, costs, and profits.” We will answer that question by computing revenue and spending variances.

43. A Performance Report Combining Activity and Revenue and Spending Variances This report will bring together the information from the two earlier reports in a way that makes it easier to interpret what has happened during the period. This report will bring together the information from the two earlier reports in a way that makes it easier to interpret what has happened during the period.