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 (1)

In matrix form, we would write this as

Total cost C = F + vQ (2)

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.

3. 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.

Common uses of flexible budgets include:

1. to estimate total indirect factory costs at different levels of activity to

compute budgeted activity cost rates,

2. to budget total indirect factory costs at different levels of activity to

compute standard activity cost rates,
 3. to estimate total activity costs at different levels of activity to compute
budgeted or standard activity cost rates.

4. to estimate total activity cost for the level of activity achieved for
control and performance evaluation purposes,

5. to forecast total activity costs for cash budgeting purposes,

6. to forecast activity costs for expense budgeting purposes, and

7. 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).

2. Determine the budgeted level of fixed costs.

3. Determine the actual volume of output achieved (e.g., units produced for
a factory, units sold for a retailer, patient days for a hospital).

4. Build the flexible budget based on the budgeted cost information from
steps 1 and 2, and the actual volume of output from step 3.

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

Fixed Factory Overhead

Supervisory Salaries $19,000 $19,000 $19,000
Depreciation 15,000 15,000 15,000
Utilities 4,500 4,500 4,500
Other 10,900 10,900 10,900
Total Fixed Costs $49,400 $49,400 $49,400
Total Costs $178,400 $199,900 $221,400