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Flexible Budget Problem
Flexible Budget Problem
chapter
contents
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11
learning outcomes
This chapter continues the syllabus sub-section entitled Medium-term planning and decision-
making. The specic syllabus topics are Fixed budgets, exible budgets, rolling budgets and
ABB. After carefully working through the material contained in this chapter, you should be able
to:
Explain the limitations of using xed budgets for control purposes.
Describe the reasons why actual results may vary from budgeted results.
Construct a exible budget operating statement from given information.
Convert multi-product output gures into standard hours.
Explain the benets of using exible budgets for control and planning.
Prepare an activity-based budget from given information.
Explain the benets to organisations of using an ABB system.
Explain the drawbacks of using xed-period budgets.
Describe the mechanics of constructing rolling budgets.
Explain how rolling budgets can overcome xed-period budgets problems.
Describe the potential problems with rolling budgets and how these may be overcome.
Recognise that exible, activity-based and rolling budget systems are compatible.
1 Fixed budgets
2 Flexible budgets
3 Activity-based budgeting
4 Rolling/continuous budgets
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The aims of budgeting include planning, facilitating control and providing motiv-
ation. Some of these aims may conict. Such conicts may be overcome by producing
separate budgets for planning from those prepared for control purposes. For
instance, CIMA Ofcial Terminology suggests that a xed budget could be used for plan-
ning and a exible budget could be used for control purposes.
There are a variety of alternative approaches to budgeting. The best known are
listed below.The denitions are all taken from CIMA Ofcial Terminology.
Fixed budget:A budget which is normally set prior to the start of an accounting
period, and which is not changed in response to subsequent changes in activity or
costs/revenues. Fixed budgets are generally used for planning purposes. Fixed
budgets suffer from a number of disadvantages if used for control.These are elab-
orated in section 1, below.
Flexible budget A budget which, by recognising different cost behaviour
patterns, is designed to change as volume of activity changes. Flexible budgets are
covered in section 2 below.
Activity-based budgeting (ABB): A method of budgeting based on an activity
framework and utilising cost driver data in the budget-setting and variance feed-
back process. See section 3 below for details on ABB.
Rolling/continuous budget: A budget continuously updated by adding a further
accounting period (month or quarter) when the earlier accounting period has
expired. Its use is particularly benecial where future costs and/or activities
cannot be forecast accurately. The mechanics and benets of rolling budgets are
described in Section 4 of this chapter.
Incremental budgeting:A method of budget setting in which the prior period
budget is used as a base for the current budget, which is set by adjusting the prior
budget to take account of any anticipated changes. For example, if activity levels
are expected to be unchanged the budget for the coming year is simply based on
the current years budget, plus an increase or decrease to compensate for expected
price changes. This method is crude and cannot be recommended, as it does not
stimulate managers to continually improve efciency levels.
Zero-based budgeting: A method of budgeting which requires each cost
element to be specically justied, as though the activities to which the budget
relates were being undertaken for the rst time. Without approval, the budget
allowance is zero. Zero-based budgeting (ZBB) attempts to overcome the defects
of incremental budgeting by requiring managers to obtain detailed approval for
all projected expenditure. While the principle is sound the ZBB process can
become over-bureaucratic, costly and time-consuming. For this reason, full ZBB
systems are rare.
This chapter, and the syllabus, is restricted to xed, exible, rolling/continuous and
activity-based budgeting systems. Incremental budgeting canscarcely be described as
a system, while ZBB is not used widely enough to justify its inclusion in the syllabus.
1 Fixed budgets
Before looking at the various other types of budget we should consider why xed
budgets are unsuitable for control purposes.
1.1 Variances
Chapter 3 section 5.3 explains that in budgetary control systems, actual revenues and
expenditures are compared with budgeted gures to identify variances. A variance is
dened as The difference between a planned, budgeted or standard cost and the
actual cost incurred. The same comparison may be made for revenues (CIMA Ofcial
Terminology).
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incremental budgeting
A method of budget setting
in which the prior period
budget is used as a base for
the current budget, which is
set by adjusting the prior
budget to take account of
any anticipated changes.
zero-based budgeting
A method of budgeting
which requires each cost
element to be specically
justied, as though the
activities to which the
budget relates were being
undertaken for the rst time.
Without approval, the
budget allowance is zero.
xed budget
A budget which is normally
set prior to the start of an
accounting period, and
which is not changed in
response to subsequent
changes in activity or
costs/revenues. Fixed
budgets are generally used
for planning purposes.
variance
The difference between a
planned, budgeted or
standard cost and the actual
cost incurred. The same
comparison may be made for
revenues.
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An adverse variance occurs when actual revenue is less than budget or actual cost
is higher than budget, while if actual revenue is higher than budget or actual cost is
below budget the difference is described as a favourable variance.
Please note that in this text adverse variances in operating statements are shown in
brackets. This is normal practice, and should be followed at all times in the examin-
ation.The reason is that gures in brackets are easier to see than if initials or words are
used to distinguish between favourable and adverse variances. For example,
100,000F and 100,000A can look similar on an operating statement, whereas
100,000 and (100,000) are clearly different.
1.2 Reasons for variances
There are three reasons why the actual revenue achieved in a budget period may
differ from the budgeted revenue.
1 The most likely is that the quantity sold may be more or less than that in the
budget.
2 Alternatively, if there is more than one product, the mix of sales may differ.
3 There could be a difference between the budgeted and actual selling prices.
There are four reasons why the actual material costs, direct labour costs and variable
production overheads incurred may be different from those budgeted.
1 The variances could be due to the higher, or lower, volume of sales causing the
quantities of materials, direct labour and variable production overheads
consumed, to exceed, or fall below, the budget.
2 Variances could also occur due to changes in the prices paid for materials, direct
labour and variable production overheads.
3 The mix of materials, or the composition of the direct labour employed, could
also vary from budget.
4 A change in the efciency with which material, direct labour and variable produc-
tion overheads are used could result in the quantities of these resources consumed
being different from that in the budget.
Sales commission is the only other common variable cost. It should only vary from
budget if the sales revenue differs, or if there has been a change in the way in which
the commission is calculated.
Actual xed overhead costs should only differ from the budget if the actual prices
of the xed overheads were different or if some of the xed overhead costs had been
omitted from the budget.
All variable costs will differ from the budget if the sales volume is higher or lower
than the budget. If the production managements performance is assessed against a
xed budget and the actual sales are higher than the budget it is likely that there will
be adverse production cost variances. But these increases in the variable production
costs are simply due to the actual sales volume being different from the budget, so
these volume variances are not really the responsibility of the production managers.
It has already been established (in Chapter 3 section 5.3) that, if we are to use
budgets for control purposes, then we should distinguish between controllable and
non-controllable costs.Therefore, budgetary control should concentrate on control-
lable factors such as price, efciency and mix. However, if we compare actual costs
with a xed budget, it will be difcult to isolate any variances that are due to changes
in the actual prices, efciency or mix (i.e. controllable variances), as they may well be
swamped by the variances due to differing sales volumes (a non-controllable vari-
ance).Therefore, xed budgets are not really effective for control purposes.
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2 Flexible budgets
The ineffectiveness of xed budgets for control purposes can be dealt with by using
a exible budget instead. A exible budget is designed to change as a businesss
activity increases or decreases.
2.1 Using sales volume to ex a budget
When the volume of sales differs from that which was budgeted it makes sense to
revise the original budgets variable costs and revenues. For example if actual sales
volume is 10 per cent higher than the original budget we should increase the variable
costs budget by 10 per cent. Otherwise, those differences between the budget and
actual gures that are solely due to volume differences will mask the variances due to
differences in purchases prices and usage efciency.
worked example 11.1
Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for last year were 10
million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs were
xed, and were budgeted at 250,000 for the year. The actual out-turn for the year was sales of 12 million
bags, while unit selling-prices, unit material prices and total xed costs were exactly as budgeted.
Required
Prepare an operating statement, which compares Blackbags Ltds budgeted and actual results for the last year.
Answer
Blackbags Ltd Operating statement for the year ending XX/XX/XX
Budget Actual Variance Variance as per cent
of budget
Sales quantity 10,000,000 12,000,000 2,000,000 20 per cent
Revenue 500,000 600,000 100,000 20 per cent
Material costs 200,000 240,000 (40,000) (20 per cent)
Contribution 300,000 360,000 60,000 20 per cent
Fixed cost 250,000 250,000 0 0
Prot 50,000 110,000 60,000 120 per cent
It appears from the above statement that the sales manager has contributed an extra 100,000 towards
prots, while the production manager has depressed prots by 40,000. In fact, the adverse materials cost
variance is entirely due to the 20 per cent increase in sales. What matters is the 20 per cent improvement in
total contribution, which has resulted in a 120 per cent improvement in prots.
test your knowledge 11.1
Why is xed budgeting not very effective for control purposes?
exible budget
A budget which, by
recognising different cost
behaviour patterns, is
designed to change as
volume of activity changes.
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2.2 Using exible budgets for control purposes
Flexible budgets are particularly valuable for control purposes in manufacturing
industry because they can be used to remove those variances that are simply caused
by actual sales volumes differing from the budget.
worked example 11.2
(Using the same facts as Worked Example 11.1)
Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for the last year were
10 million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs
are xed, and were budgeted at 250,000 for the year. The actual outturn for the year was sales of 12 million
bags, while unit selling-prices, unit material prices and xed costs were exactly as budgeted.
Required
Prepare a exible budget operating statement, which compares Blackbags Ltds budgeted and actual results
for the last year.
Answer
Operating statement for the year ending XX/XX/XX
Original budget Flexed budget Actual Variance
Sales quantity 10,000,000 12,000,000 12,000,000 0
Revenue 500,000 600,000 600,000 0
Material costs 200,000 240,000 240,000 0
Contribution 300,000 360,000 360,000 0
Fixed cost 250,000 250,000 250,000 0
Prot 50,000 110,000 110,000 0
The sales volume is 20 per cent higher so we ex the original budget so that the budgeted revenue, material
cost and contribution are all 20 per cent higher. By exing the budget, the above operating statement
eliminates the volume effect entirely and shows that there were no variances due to prices or efciency
differing from budget. The only problem is that the sales managers achievement is not apparent. We can
portray the effect of the improvement in sales by adding a 60,000 favourable sales volume variance to the
end of the operating statement. The sales volume variance is the difference between the original budget prot
and the exed budget prot, i.e. 110,000 50,000 60,000 favourable volume variance.
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While most examples in this text will show exible budgets being used for control in
a manufacturing context, the technique is just as useful for extractive industries and
for any service industries that have signicant variable costs.
2.3 Standard hours
Budgeted and actual sales volumes can be measured in units, tonnes or litres if there
is a single product. It is more difcult to nd a single measure for output if there is
more than one product. One solution is to use the standard time required to achieve
the particular level of output. As you would expect, standard time is measured in
standard hours and minutes. CIMA Ofcial Terminology denes a standard hour or minute
as The amount of work achievable, at standard efciency levels, in an hour or
minute. The standard time may relate to machine hours if all output goes through
the same, or similar, machines. Standard time can also relate to process hours, if all
output goes through the same process. However, in most cases standard time relates
to direct labour hours, whether for a manufactured product or for a service.
worked example 11.3
(Figures based on the answer to Worked Example 11.2, but with different actual revenues and costs)
Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for the last year were
10 million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs
are xed, and were budgeted at 250,000 for the year.
The exible budget operating statement is set out below.
Operating statement for the year ending XX/XX/XX
Original budget Flexed budget Actual Variance
Sales quantity 10,000,000 12,000,000 12,000,000 0
Revenue 500,000 600,000 550,000 (50,000)
Material costs 200,000 240,000 230,000 10,000
Contribution 300,000 360,000 320,000 (40,000)
Fixed overheads 250,000 250,000 240,000 10,000
Prot 50,000 110,000 80,000 (30,000)
Sales volume variance (Original budget prot exed budget prot) 60,000
Required
Explain why the revenue variance is adverse and the material variance is favourable, when a comparison
between the original budget and the actual results appears to show the opposite.
Answer
If we had simply compared the actual results with the original budget the sales variance would have appeared
favourable, whereas in fact, the revenue did not rise by as great a proportion as the volume. Therefore, the
selling price must have gone down compared with the budget, and comparison with the exible budget
identies this, correctly, as an adverse variance. Similarly, although the materials costs are higher than the
original budget they are lower than would be expected for the level of sales achieved. This could be because
material prices were lower than budgeted or the quantity of material used for each bag was lower. Comparison
with the exible budget highlights the favourable material cost variance achieved.
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Most costs vary with input-based activity levels, e.g. direct wages vary with direct
hours worked. However, the exible budget allowance should be based on output
measures, such as tonnes delivered or standard hours produced. This will highlight
the efciency with which resources are used. So, we should identify those costs and
revenues that vary with output and amend the budget to reect actual activity, before
comparing it with actual costs and revenues.
2.4 Format for exible budget operating statements
Flexible budgeting can be used in both marginal and absorption costing systems.
In an absorption costing system the xed costs are also exed to match output.
This approach is misleading as it implies that xed costs are variable, and so
requires a volume variance to be calculated if any over- or under-spends are to
be isolated. Many managers nd exed absorption costing budgets confusing. If
you prepare a exible budget in the examination it should always have a marginal
costing format.
worked example 11.4
Crewed Fabrications manufactures breglass canoes. The manufacturing process is very labour-intensive.
Crewed Fabrications make three products, two-seat, four-seat and eight-seat canoes. It takes ve direct labour
hours to build a two-seat canoe. Four-seat canoes require eight direct labour hours and eight-seat canoes
fourteen direct labour hours.
Set out below are the standard direct labour-hours for each type of canoe, plus the budgeted and actual
outputs of each type for the last month.
Type of canoe: 2 seats 4 seats 8 seats Total
Standard direct hours per canoe 5 8 14 n.a.
Budgeted output for the month 100 100 100 300
Actual output in the month 200 50 50 300
Required
Compare the budgeted and actual standard hours produced in the last month.
Answer
Type of canoe: 2 seats 4 seats 8 seats Total
Standard direct hours per canoe 5 8 14 n.a.
Budgeted output for the month (units) 100 100 100 300
Actual output in the month (units) 200 50 50 300
Budgeted output for the month (standard hours) 500 800 1,400 2,700
Actual output in the month (standard hours) 1,000 400 700 2,100
Variance (standard hours) 500 (400) (700) (600)
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worked example 11.5
Salamander Lamps Ltd make a single type of garden oodlight. The budgeted and actual results for the last
month are set out below. As the company operates JIT purchasing and manufacturing systems its opening and
closing stocks are not signicant.
Budget Actual Variances
Units sold 10,000 11,000 1,000
Sales revenue 250,000 255,000 5,000
Costs:
Materials 45,000 48,600 (3,600)
Labour 60,000 71,400 (11,400)
Variable overhead 30,000 40,000 (10,000)
Production overheads 35,000 38,000 (3,000)
Selling overheads 15,000 13,000 2,000
Administration 20,000 21,000 (1,000)
Total costs: 205,000 232,000 (27,000)
Prot (loss) 45,000 23,000 (22,000)
Required
Prepare a revised operating statement in a marginal costing format that includes a exible budget.
Answer
Flex the budgeted sales, variable costs and contribution by multiplying the original budget gures by 11,000
units 10,000 units, i.e. 110 per cent or 1.1.
Salamander Lamps Ltd Budgeted and actual results for the last month.
Original Budget Flexed budget Actual Variances
Units sold 10,000 11,000 11,000
Sales revenue 250,000 275,000 255,000 (20,000)
Variable costs:
Materials 45,000 49,500 48,600 900
Labour 60,000 66,000 71,400 (5,400)
Variable overhead 30,000 33,000 40,000 (7,000)
Total variable cost 135,000 148,500 160,000 (11,500)
Contribution 115,000 126,500 95,000 (31,500)
Fixed costs:
Production overheads 35,000 35,000 38,000 (3,000)
Selling overheads 15,000 15,000 13,000 2,000
Administration 20,000 20,000 21,000 (1,000)
Total xed costs 70,000 70,000 72,000 (2,000)
Prot (loss) 45,000 56,500 23,000 (33,500)
Sales volume variance Flexed budget prot less original budget prot 11,500
2.5 The linear assumption
Budgets contain several activities so variations in their costs may not always be linear.
For example, there may be bulk discounts, which affect material costs, learning
effects can affect labour costs and some xed costs may, in fact, be stepped costs. It
may be possible to construct appropriate cost and revenue formulae to deal with this
problem. For instance, we could use
Material costs per unit which decrease each time the volume exceeds the bulk
discount points.
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Material costs per unit, for scarce materials, which increase if the quantity
required exceeds the quantities available from lower cost suppliers.
Labour costs per unit which decrease as cumulative output increases, due to the
learning effect.
Stepped supervision costs.
However, all calculation questions in the examination will be based on the linear
assumption for revenue, variable costs and activity based costs. Questions will use a
xed cost assumption for space costs and non-activity based overheads, unless
distinct steps in these costs are necessary to t the facts of the question.To recap:
For all revenue, or variable costs or activity-based costs, the budgeted revenues and
costs PER UNIT will be the same, irrespective of the volume change.
For those space costs and overheads that are not activity-based, the budgeted xed
cost gure will remain the same, whatever the volume, unless distinct steps are
more logical.
2.6 Flexible budgets for planning
Flexible budgeting can be used at the budget planning stage to test the effects of
alternative activity levels.
theory into practice 11.1
Set out below is next years budget for Angouleme Ltd. Prepare a budget comparison that shows the effects on
revenues, costs and prot if sales are 10 per cent below budget, 20 per cent below budget and 10 per cent
above budget.
Angouleme Ltd Budget for the coming year
Standard hours sold 100,000