BUDGETING – PART 1

Budgeting is an essential part of planning, financial control, and performance

management. It is a competency that must be acquired for anyone who is working in
finance and accounting and is also a topic which is guaranteed to come up on your
Performance Management (PM) exam. Expect to see it in Sections A or B, and there is
a fair chance of it appearing in Section C, so you need to be ready to handle 20-mark
questions from both a numerical and a discussion-based perspective. This series of
articles will cover the budgeting approaches flexible budgeting, activity-based
budgeting, rolling budgeting, zero-based budgeting, and beyond budgeting.

Flexible budgeting

A flexible budget is a summary of revenues and costs across a range of different activity
levels. So instead of looking at only one activity level (which is called a ‘fixed’ budget—
you should remember this from F2 [FMA]), various activity levels are considered. A
critical aspect of this approach is to determine fixed and variable costs, which can then
be expressed as a linear equation:

y = a + bx

Total cost (y) = Fixed cost (a) + (Variable cost per unit (b) * Activity level (x))

TC = FC + (VC * activity level)

With an understanding of revenue per unit and cost behaviours (ie fixed, variable, and
stepped), financial results can then be budgeted within a range of activity levels.

You should be ready for complications on your PM exam, such as:

• dealing with a stepped cost

• incorporating the impact of a learning curve
• using the high/low method to separate fixed and variable costs from a total cost

Flexible vs flexed budget

Ensure you know the difference between these terms. Flexible budgeting happens at
the beginning of a budgeting period—revenue, costs, and profit are forecast across a
range of activity levels. With this information, a flexed budget can then be created at
the end of the budget period based on the actual activity level. This flexed budget
becomes a core part of financial control when using standard costing—the flexed
budget answers the question, “What should our financial results be at the actual activity
level?”

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For more on this topic, see the Standard Costing section of your study materials.

Pros and cons

With flexible budgeting, managers will be able to plan and forecast more accurately.
Performance management can be more meaningful as actual results can be easily
compared to flexed results – total variances can then be calculated for each revenue
and cost.

However, some businesses may have a high level of indirect costs, making it difficult to
separate fixed and variable costs from total indirect costs.

Flexed budget example (Q Corfe, Q 20 & 21, September 2016, F5 exam)

Corfe Co is a business which manufactures computer laptop batteries and it has

developed a new battery which has a longer usage time than batteries currently
available in laptops. The selling price of the battery is forecast to be $45. The maximum
production capacity of Corfe Co is 262,500 units. The company’s management
accountant is currently preparing an annual flexible budget and has collected the
following information so far:

Production (units) 185,000 200,000 225,000

$ $ $

Material costs 740,000 800,000 900,000

Labour costs 1,017,500 1,100,000 1,237,500

Fixed costs 750,000 750,000 750,000

In addition to the above costs, the management accountant estimates that for each
increment of 50,000 units produced, one supervisor will need to be employed. A
supervisor’s annual salary is $35,000.

Assuming the budgeted figures are correct, what would the flexed total
production cost be if production is 80% of maximum capacity?

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Solution

An 80% activity level is 210,000 units.

Material and labour are both variable costs. Material is $4 per unit and labour is $5.50
per unit, so total variable cost per unit is $9.50

Total variable costs = $9.50 x 210,000 units = $1,995,000

Fixed costs = $750,000

Supervision = $175,000 as five supervisors are required for a production level of

210,000 units.

Total annual budgeted cost allowance = $1,995,000 + $ 750,000 + $ 175,000 =

$2,920,000

Part 2 Question

The management accountant has said that a machine maintenance cost was not
included in the flexible budget but needs to be taken into account.

The new battery will be manufactured on a machine currently owned by Corfe Co which
was previously used for a product which has now been discontinued. The management
accountant estimates that every 1,000 units will take 14 hours to produce. The annual
machine hours and maintenance costs for the machine for the last four years have been
as follows:

Machine time (hours)

Maintenance costs

$'000

Year 1 5000 850

Year 2 4400 735

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Machine time (hours)

Maintenance costs

Year 3 4850 815

Year 4 1800 450

What is the estimated maintenance cost if production of the battery is 80% of the
maximum capacity?

Solution

Variable cost per hour ($850,000 -$450,000)/(5,000 hours – 1,800 hours) = $125 per
hour

Fixed cost ($850,000 – (5,000 x $125)) = $225,000

Number of machine hours required for production = 210 x 14 hours = 2,940 hours

Total cost ($225,000 + (2,940 x $125)) = $592,500, or $ 593,000 to the nearest $’000.

Written by Steve Willis, finance and accountancy trainer