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. FLEXIBLE BUDGETING Definition:--A flexible budget is a budget that is a function of one or more levels of activity. Thus, the budget depends on one or more measures of activity volume rather than being fixed in amount. Purpose:--The purpose of a flexible budget is to develop an estimate or estimates of cost for one or more levels of activity. Activity levels are typically measured in terms of activity inputs, levels, or outputs. Such a budget is flexible in the sense that it depends upon a specified level of activity volume. Acquisition

budgets focus on the costs to be incurred to acquire actual or planned levels of resources. Labor budgets, purchasing plans, and similar budgets are resource acquisition oriented. Activity budgets focus on the resources that should be required to maintain activities at specified levels based on expected or desired levels of efficiency. Production budgets focus on the resources that would be required to produce a specified set of products and services. Like activity budgets, production budgets are necessarily based on assumed levels of efficiency. The idea of a flexible budget is applicable to all three types of budgets. Temporal issues:--Flexible budgets can be used as ex-ante forecasts of total cost for various levels of activity volume. Or they can be used as ex-post standards of the costs that should have been incurred for various levels of activity volume (measured in terms of input, activity, or output levels). Context:--Flexible budgets are used in a wide variety of circumstances. Such budgets are utilized in not-for-profit organizations as well as business firms, for a variety of activities including administrative and service tasks as well as production activities. Flexible budgets can be used even when there is no functional relationship between activity inputs and outputs. In such cases activity volume is measured in terms of input levels or other proxy measures of activity. Approach:--A flexible budget requires an estimate of the relationship between total cost and activity volume. The form of that relationship depends on the structure of the process for which costs are being estimated. Some criteria for choosing a measure of volume include: 1. Causality -- an individual type of cost should be related whenever possible to that activity which causes the cost to vary. 2. Independence of activity measure -- to the extent possible, the activity measure should be independent of other influences. For example, labor or machine hours are independent of changes in prices. 3. Ease of understanding -- Activity measure units should be easily understandable and obtainable at reasonable expense. Complicated indices of activity volume are best avoided. 4. Functionality - Activity measures should be functional and thus contribute to organizational goals. For example, poor performance should not result in a more generous budget for performance evaluation and control purposes. Practice: the cost behavior assumption that underlies much of current accounting practice is that cost is a simple linear function of volume. Specifically, it is assumed that

Total cost C = F + vQ, where F represents total fixed cost, v represents the variable cost per unit of activity, and Q represents the level of activity for which the budget is to be constructed. When there are multiple cost drivers for an activity, then the linear equation is of the form Total cost C = F + v1Q1 + v2Q2 + + vnQn In matrix form, we would write this as Total cost C = F + vQ (2) (1)

Flexible budgeting can be implemented whenever a reasonably strong relationship exists between total cost and some measure of activity volume. The relationship can be curvilinear or linear. The important concept is that the budget flexes, in a predetermined manner, with changes in volume. Measures of Activity 1. Flexible budgets are sometimes based on measures of activity inputs (e.g., direct labor hours) that indicate the budgeted costs necessary to acquire a given level of resources at specified prices. These are acquisition budgets, such as might be used to budget for the purchase of raw materials for a specified period. 2. Flexible budgets are sometimes based on measures of activity (e.g., hours a production line is in operation) to forecast the cost of operating an activity, usually for a given level of input or output (e.g., standard hours allowed for the output achieved). In constructing such budgets, one must specify the rate at which resources will be consumed to maintain the activity. Flexible budgets are sometimes based on measures of activity output (e.g., number of units produced during a period). In constructing such budgets, one must specify both the rate at which resources will be consumed to maintain the activity and the rate at which the activity will produce units of output. Thus, a flexible budget based on output must be based on specified input/output ratios.

3.

Common uses of flexible budgets include: 1. 2. to estimate total indirect factory costs at different levels of activity to compute budgeted activity cost rates, to budget total indirect factory costs at different levels of activity to compute standard activity cost rates,

3. 4. 5. 6. 7.

to estimate total activity costs at different levels of activity to compute budgeted or standard activity cost rates. to estimate total activity cost for the level of activity achieved for control and performance evaluation purposes, to forecast total activity costs for cash budgeting purposes, to forecast activity costs for expense budgeting purposes, and to forecast total activity costs to forecast earnings under different scenarios.

Steps to Prepare flexible Budget

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). Determine the budgeted level of fixed costs. Determine the actual volume of output achieved (e.g., units produced for a factory, units sold for a retailer, patient days for a hospital). Build the flexible budget based on the budgeted cost information from steps 1 and 2, and the actual volume of output from step 3.

2. 3. 4.

Like all budgets, the flexible budget involves the establishment of line items that address each type of expense incurred for a given financial period. A limit or value is assigned to each line item, with the total amount of the budget coming to something less than the anticipated income for that same period. Ideally, the amount allotted for each budgetary item will be sufficient to cover all related expenses, and the income levels will be sufficient to allow the budget to stand as is. The flexible budget model is a little different because of the built-in contingency approach that makes it possible to quickly amend the line items in the event of some unforeseen complication. For example, if shipments of raw materials are delayed and adversely affect the rates of output related to one or more products, it is possible to adjust the various line items that will be affected by this slowdown in product, and keep the budget balanced. Should sales volume suddenly drop, affecting the amount of generated revenue, the flexible format makes it easy to

quickly change the amounts associated with specific line items to reflect the new set of circumstances.

Flexible Budget
December 14, 2010
Variable Cost Per Unit $2.40 $3.90 $0.60 $0.80 $0.40 $0.50 $8.60 Unit Levels of Activity 15,000 17,500 20,000 $36,000 $42,000 $48,000 58,500 68,250 78,000 9,000 12,000 6,000 7,500 $129,000 10,500 14,000 7,000 8,750 $150,500 12,000 16,000 8,000 10,000 $172,000 Cost Item Direct Materials Direct Labor Variable Factory Overhead Indirect Materials Indirect Labor Utilities Other Total Variable Costs Fixed Factory Overhead Supervisory Salaries Depreciation Utilities Other Total Fixed Costs Total Costs

$19,000 15,000 4,500 10,900 $49,400 $178,400

$19,000 15,000 4,500 10,900 $49,400 $199,900

$19,000 15,000 4,500 10,900 $49,400 $221,400