Accounting, Behaviour and Organisations

Week 5
Static and Flexible Budgets
Objectives

After completing this topic you should be able to:

• Understand the concept of flexible budgeting
• Critique the need for standard costs and prices
• Explain why flexible budgets are used by managers;
• Recognise favourable and unfavourable variances and
explain what they mean
• Describe the difference between efficiency and
effectiveness variances
• Be able to prepare and calculate a flexible budget

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Preparing Flexible Budgets

Flexible budgets
• A flexible budget is a set of cost relationships that can be
used to estimate costs and cash flows within the relevant
range
• Budgeted sales and variable costs information is ‘flexed’
with actual sales and variable cost information to reflect
values for actual volumes.
–Because fixed costs are not expected to change, these
values are carried over from the static budget.
• Flexible budgets are considered ‘profit plans’ and provide
detailed budget information for product or service output
–Used in planning and control

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Preparing Flexible Budgets

Flexible budgets and Standards

• Flexible budgets are prepared from the development of
standards (benchmarks) required for operations
• Flexible budgets represent expected revenues:
–i.e. Iron ore is a major commodity input for steel
manufacturing. Standard selling prices (set by the
market) fluctuate between $50 to $200 per tonne
• Flexible budgets represent expected costs of the inputs -
direct materials; direct labour, variable overheads and non-
variable or fixed overheads
–i.e. Icecream production requires inputs such as milk
and fruit. Standards used for budgeting might be:
$2.50 per litre of milk or $1 per 1 kg of blackberries
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 Developing Standards

• Flexible budgets are the starting point for the

analysis of variances between budgeted and
actual values
• When developing flexible budgets it is critically
important that accurate standards are developed
–E.g. standard selling price; standard volumes; standard direct
material costs; standard direct material usage; standard
overhead applied
• Inaccurate standards
– Provide misleading data for budgeting
– Provide misleading benchmarks to compare to actual profit
performance

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 Types of Standards for budgeting
• Ideal standards
–Require maximum efficiency
–But might be difficult to attain, de-motivating for managers
–Influenced by purchasing power of company
• Kaizen standards
–Standards representing continuous improvement over time
–Have cost minimisation/reduction as their focus
–Standards are constantly being revised
• Currently attainable standards – most common
–Budgets achievable if operations are efficient & effective
–Should be challenging but achievable for motivation
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 Budgets for standards and benchmarking
• Actual results reveal performance for the past period

• Budgeted performance (Static (Master) Budget)

represents the anticipated activity of a future period:
• But budgeted activity based on projected circumstances at
the time - rarely equals actual
• Accountants can prepare ‘flexible budgets” so budgeted
results can be measured at the actual activity level
– i.e. comparing “apples with apples”
• Flexible Budget are calculated as follows:
–Budgeted revenues and costs for actual level of activity
–Use original budgeted rates * Actual driver

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Benny’s Ice cream Profit Plan (‘000)       Actual (‘)000)  

Volume $ Variance Flexible Variance Volume $ Total

Litres Budget Litres Variance

Sales Data                
French Vanilla 2,020 28,076       2,104 29,283  

Macadamia Twirl 336 8,570       350 8,910  

Total Sales 2,356 36,646       2,454 38,193  

                 
Less Variable cost                
Cost ice-cream (French Vanilla)                

Dairy ingredients (litres) 1,919 16,106       1,934 16,684  

Other ingredients (100gr.) 1,313 6,213       1,335 6,367  

Labour (hours) 34.01 988       37.10 1,081  
Cost ice cream (Macadamia                
Twirl)
Dairy ingredients (litres) 320 2,726       318 2,675  
Other ingredients (100gr.) 241 1,680       244 1,699  
Labour (hours) 30 869       28.79 839  
Total variable cost   28,582         29,345  

 Contribution margin    8,064          8,848  

Fixed costs   3,000         3,500  
Profit   5,064         5,348  
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Typical cost standards for production

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Variance analysis

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 Budget Variances

• Variance analysis involves comparing actual against

budgeted results
– The differences (variances) might be ‘favourable or
‘unfavourable’
• A favourable variance is when the difference
between actual results and the flexible budget
increases profits
• An unfavourable variance is when the difference
between actual results and the flexible budget
reduces profits

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 Different variances calculated

The different types of variances calculated are:

1. Static budget compared to actual results
= budget variance
2. Static budget compared to flexible budget
= volume variance
3. Flexible budget compared to actual results
= price/efficiency variance

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 Budgets as benchmarks

• Consider the following monthly profit results for

Benny’s Purple Madness Icecream
– Is this budget variance favourable or unfavourable
variance? Page 309

Static Budget Actual Results

77,700 31,775

• It is an unfavourable variance as actual profits

are $41,425 lower than the budgeted profit
• What has made up that difference? A flexible
budget will help provide this information.
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Flexible Budgets

• The variance between actual and budgeted profit can

be explained in two ways:
–Competitive effectiveness variances
–Operating efficiency variances
• Flexible budgets can help to explain whether it was
competitive effectiveness, operating efficiency or both
factors that contributed to the variance in profit.
• When Benny’s accountants “flex” the budget, they
use budgeted prices (selling price and cost prices)
but actual volumes. In that way, they can find out what
Benny’s should have achieved, given actual volume of
Purple Madness ice cream sold.

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Competitive Effectiveness
• Competitive effectiveness variances refer to changes in
market performance and are reflected in the following:
1. Selling Price Variance – a selling price higher than
budget will impact volumes sold
2. Volume Variance - can be drilled further to calculate:
– Market size variance – has the market grown or shrunk?
– Is this a result of manager skills or is it an external factor
– Market share variance – the company is selling more/less icecream
compared with competitors
– Is this a result of managers skills or poor performance by competitors?
– Product Mix Variance – Benny’s icecream products have different
contribution margins
– Is selling more higher contribution margin products, a good management
strategy?

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Operating efficiency

• Operating efficiency variances – relates to the price and

usage (efficiency) of input resources (direct materials;
direct labour and overheads).
• Price/Efficiency Variances:
– For example, the cost of raw materials, labour and overheads
might be different to budget. The usage of the inputs into
production might be different to budget.
– The difference might contribute to changes in quality and are
related to management decisions (such as the purchase of
poor/superior quality raw materials; change in supplier; more
efficient workers)
– The difference could be contributable to a lack of management
oversight and lack of good planning

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Flexible Budgets to help understand changes in profits

Changes in profits
(prepare a flexible budget)

Competitive Effectiveness Operating Efficiency

Variance due to Variance due to Variance due to

Market Product Mix Selling Price

Market Share Market Size

Variance Variance

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What actions should be taken when identifying variances

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