Flexiable budgets and performance analysis
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81554_1416976_Ch9FlexBudg.pptxFlexible Budgets and Performance Analysis
Chapter 9
Activity variance = Volume variance
Chapter 8 was a Static Budget or the Base Budget from which you Flex Ch.9
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Static Budget: The pre-established business Plan or Budget is the “Static” budget
Qty.=Activity variance = Volume variance
McGraw-Hill/Irwin
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I don’t think I can answer the questions using a static budget.
Actual activity is above planned activity.
So, shouldn’t the variable costs be higher if actual activity is higher?
Deficiencies of the Static Planning Budget-1
How much variance is due to volume [ a driver]?
b of Y=a + bX
McGraw-Hill/Irwin
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The answer is unclear because the actual activity level (550 lawns) does not equal the planned activity level (500 lawns).
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The relevant management performance question is . . .
“How much of the cost variances is due to change in activity [volume/driver], and how much is due to cost control [price or performance] ?”
Performance = Controllable
Non-controllable = Volume [from comparison to Budget perspective]
Deficiencies of the Static Planning Budget-2
McGraw-Hill/Irwin
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This raises an additional question, namely – How much of the cost variances is due to higher activity, and how much is due to cost control? To answer this question, we must “flex” the budget.
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Characteristics of Flexible Budgets
Planning budgets are prepared for a single, planned level of activity.
You do a business plan at a specific level of activity
Most Expenses are both fixed and variable and mixed
Y = a + bx
a = fixed portion
b = Activity [Qty.] driver [sales units or $s, production units, hours …]
X = variable cost/expense per driver unit
So, how do you compare actual performance with a pre-established business plan ?
You “Flex” the Budget for volume
McGraw-Hill/Irwin
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A planning budget is prepared before the period begins and is valid for only the planned level of activity. If the actual level of activity differs from what was planned, it would be misleading to evaluate performance by comparing actual costs to the static, unchanged planning budget.
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Improve performance evaluation.
May be prepared for any activity level in the ***relevant range***.
Show costs that should have been incurred [the Budget adjusted for volume] at the actual level of activity, enabling like volume cost comparisons.
Help managers control costs.
Characteristics of Flexible Budgets
Performance evaluation can be difficult when actual activity differs from the planned level of activity.
Focus management effort on controllable variance
McGraw-Hill/Irwin
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A flexible budget provides estimates of what revenues and costs should be for any level of activity, within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons.
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Relevant Range
In establishing the variable cost per unit “b”, the relevant range is determined.
E.g., Variable manufacturing per unit is set at $20 with sales/production varying “+/-” 15%.
So flexible budget is OK within 15% of static budget volumes.
Outside 15% what was “Fixed” may be Variable
McGraw-Hill/Irwin
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A flexible budget provides estimates of what revenues and costs should be for any level of activity, within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons.
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Characteristics of Flexible Budgets FLEX the Budget, i.e. adjust Budget for Volume
Recognizing the variable characteristics of revenue and expense [ including CoGS] in addition to Static Budget’ prepare a Flexible Budget which changes with actual change in cost drivers [sales $s, sales units, units of production, machine hours, labor hours, others…]
Cost /Expense analysis Actual to the Flex’d Budget
McGraw-Hill/Irwin
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A flexible budget provides estimates of what revenues and costs should be for any level of activity, within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons.
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Flexible Budget
You FLEX the Budget within the relevant range
Y = a + bx , so
As b [Activity level or Volume or Driver] changes you change the budget
The difference between Static and this Flex’d budget is Volume variance OR Activity variance
The difference between the Flex’d Budget and Actual is the Performance OR Price OR Spending variance
Name depends on user
McGraw-Hill/Irwin
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Activity Variances [aka VOLUME VARIANCE]
Planning [Static/Base]
budget revenues and expenses
Flexible
budget revenues and expenses
The differences between the two budget amounts are called Activity or Volume Variances.
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An activity variance arises solely due to the difference in the level of activity included in the planning budget and the actual level of activity .
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1. An Activity [aka Volume] variance arises solely due to the difference in the volume OR level of activity between the planning budget and the actual level of activity.
2. A Revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue. Changes in Prices, terms etc. not considered. Flex’d Revenue Vs. Actual Revenue
3. A Spending [controllable] variance is the difference between how much a cost should have been, at the actual level of activity, and the actual amount of the cost [aka Performance]. Flex’d vs. Actual Cost/Expense
Terminology:
McGraw-Hill/Irwin
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Larry’s Lawn Service provides lawn care in a planned community where all lawns are approximately the same size. At the end of May, Larry prepared his June budget based on mowing 500 lawns. Since all of the lawns are similar in size, Larry felt that the number of lawns mowed in a month would be the best way to measure overall activity for his business.
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ClassCo provides services for a set price
ClassCo set a Budget at 500 units/month.
In setting the budget, ClassCo recognized some of its budgeted expenses were fixed, variable & mixed.
Excel 1
Example:
McGraw-Hill/Irwin
Slide ‹#›
Larry’s Lawn Service provides lawn care in a planned community where all lawns are approximately the same size. At the end of May, Larry prepared his June budget based on mowing 500 lawns. Since all of the lawns are similar in size, Larry felt that the number of lawns mowed in a month would be the best way to measure overall activity for his business.
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If we define an item as variable or Mixed then it should vary
So, to measure performance we should vary that item a its cost drivers vary up or down before we measure performance
To measure performance, we must the FLEX the budget to the actual level of activity.
Variable “FLEX”
McGraw-Hill/Irwin
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This raises an additional question, namely – How much of the cost variances is due to higher activity, and how much is due to cost control? To answer this question, we must “flex” the budget.
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How a Flexible Budget Works
To FLEX a budget we need to know that:
Total budgeted variable costs change in direct proportion to changes in activity [driver for that cost] .
Total budgeted fixed costs remain unchanged within the relevant range.
McGraw-Hill/Irwin
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Flexing a budget involves two key assumptions about cost behavior. First, total variable costs change in direct proportion to changes in activity; and second, total fixed costs remain unchanged within a specified activity range.
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Prepare a budget
for ClassCo.
EXCEL 2
Prepare Flexible Budget
Quantity of units sold is the driver is this example
McGraw-Hill/Irwin
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Let’s continue the Larry’s Lawn Service example by preparing a flexible budget at the actual level of activity.
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Activity [or Volume] Variances
Planning [Static]
budget revenues and expenses
Flexible
budget revenues and expenses
The differences between the budget amounts are called activity or Volume variances.
McGraw-Hill/Irwin
Slide ‹#›
An activity variance arises solely due to the difference in the level of activity included in the planning budget and the actual level of activity .
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Revenue and Spending Variances
Flexible budget revenue
Actual revenue
The difference is a Revenue [sometimes Price] variance.
Flexible budget cost/expenses
Actual cost/expenses
The difference is a spending* variance.
There are many subdivisions: performance, productivity, efficiency, price, required, ECN, scrap, rework…
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A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.
A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.
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Activity Variance
Prepare a report showing activity [volume] variances.
Cost v. Activity [volume] variances
EXCEL 3
McGraw-Hill/Irwin
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Learning objective number 2 is to prepare a report showing activity variances.
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Spending Variance [Management control?]
Prepare a report showing both
Activity [due to revenue or volume…Non-controllable]
and
Spending variances [cost control issues---Controllable].
McGraw-Hill/Irwin
Slide ‹#›
Learning objective number 3 is to prepare a report showing revenue and spending variances.
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Revenue and Spending Variances
Flexible budget revenue
Actual revenue
The difference is a Revenue [sometimes Price] variance.
.
Flexible budget cost/Expenses
Actual cost/expenses
The difference is a spending variance.
Changed
McGraw-Hill/Irwin
Slide ‹#›
Part I.
A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.
Part II.
A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.
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Prepare a performance report that combines activity variances and revenue and spending variances.
McGraw-Hill/Irwin
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Learning objective number 4 is to prepare a performance report that combines activity variances and revenue and spending variances.
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Now, let’s use budgeting
concepts to compute revenue and spending variances for ClassCo
EXCEL 4
Revenue [Activity or volume] and Spending Variances
McGraw-Hill/Irwin
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We have seen the impact that a change in activity has on revenues, costs, and profits, but we haven’t yet answered the question “How well did Larry control his revenues, costs, and profits.” We will answer that question by computing revenue and spending variances.
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Performance Reports in Non-Profit Organizations
Non-profit organizations may receive funding [Revenue] from sources other than the sale of goods and services, so revenues may consist of both fixed and variable [unlike most commercial enterprises] elements.
Universities
Tuition and fees
Donations
State funding
Endowments
McGraw-Hill/Irwin
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The performance reports in non-profit organizations are essentially the same as the performance reports for a business like Larry’s Lawn Service except for one major difference. Non-profit organizations may receive a significant amount funding from sources other than revenue from the sale of goods and services. For example, universities may receive funding from donations and endowment income as well as from student tuition and state appropriations. Tuition and state appropriations are a function of the number of students, while donations and endowment income are not. This means that, like costs, the revenue in governmental and non-profit organizations may consist of both fixed and variable elements.
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Performance Reports in Cost Centers
Performance reports are often prepared for Cost Centers. These reports should be prepared using the same principles discussed so far, except for the fact that these reports will not contain Revenue or net operating income variances.
Driver for production cost centers may be production units or DL hours or Machine Hrs. or others
Performance Reports maybe at same levels as management structure
McGraw-Hill/Irwin
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Performance reports are often prepared for cost centers. These reports should be prepared using the same principles discussed so far, except for the fact that these reports will not contain revenue or net operating income variances.
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More than one cost driver may be needed to adequately explain all of the costs in an organization.
The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.
Flexible Budgets with Multiple Cost Drivers
McGraw-Hill/Irwin
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It is unlikely that all variable costs within a company are driven by a single factor such as the number of units produced, labor hours, or machine hours (or lawns mowed in Larry’s Lawn Service). More than one cost driver may be needed to adequately explain all of the costs in an organization. The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.
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Prepare a flexible budget with more than one cost driver.
EXCEL 5 series
McGraw-Hill/Irwin
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Learning objective number 5 is to prepare a flexible budget with more than one cost driver.
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Understand common errors made in preparing performance reports based on budgets and actual results.
McGraw-Hill/Irwin
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Learning objective number 6 is to understand common errors made in preparing performance reports based on budgets and actual results.
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Purpose of Flex Budget: Variance Analysis
Performance/Spending variances are isolated from volume variances to better focus management corrective/improvement action
Isolates change in profits due to change in volume [Sales management from Operating management]
Performance variances are actionable to improve performance: all functional areas
Why occurred, cause, corrective action
McGraw-Hill/Irwin
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Common Errors
In analyzing variances from Plan or Budget [Static] use the SAME ASSUMPTIONS used in Plan preparation; do not assume: 1. All costs are fixed or that
All costs are variable.
Do not use differing assumptions to justify variances
McGraw-Hill/Irwin
Slide ‹#›
The most common errors in preparing performance reports are to implicitly assume that all costs are fixed or that all costs are variable.
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Common Error 1: Assuming All Costs Are Fixed
Faulty Analysis Comparing Budgeted Amounts to Actual Amounts
No consideration of change due to volume or activity
McGraw-Hill/Irwin
Slide ‹#›
The first common error is to assume that all costs are fixed. When we compare actual results at one level of activity with a static planning budget at another level of activity, without any adjustment for activity change, we are implicitly assuming that the costs are fixed. Comparing static planning budget costs to actual costs only makes sense if the cost is fixed. If the cost isn’t fixed, it needs to be adjusted for any change in activity that occurs during the period.
Note that the results on the slide are identical to the “apples to oranges” comparison on Slide 8.
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Common Error 2: Assuming All Costs Are Variable
Faulty Analysis that Assumes All budget Items Are Variable
McGraw-Hill/Irwin
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The second common error is to compare actual results to the dollar amounts in the planning budget multiplied by the percentage increase in activity level. This approach is equivalent to assuming that all costs are variable with respect to changes in the activity level.
Although incrementing the planning budget by the percentage increase in activity is a valid adjustment to make if an item is strictly variable (gasoline and supplies and equipment maintenance), this mode of analysis is flawed if fixed costs exist. When fixed costs exist, the amount of the fixed cost in the planning budget should not be flexed to accommodate the actual level of activity.
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End of Chapter 9
S*T*O*P
McGraw-Hill/Irwin
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End of chapter 10.
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PlanningActual
BudgetResultsVariances
Number of lawns 500 550
Revenue37,500$ 43,000$ 5,500$ F
Expenses:
Wages and salaries20,000$ 23,500$ 3,500$ U
Gasoline and supplies4,500 5,100 600 U
Equipment maintenance1,500 1,300 200 F
Office and shop utilities1,000 950 50 F
Office and shop rent2,000 2,000 -
Equipment Depreciation2,500 2,500 -
Insurance1,000 1,200 200 U
Total expenses32,500 36,550 4,050 U
Net operating income5,000$ 6,450$ 1,450$ F
Class Co
For the Month Ended June 30
Sheet1
| Class Co | |||||||||
| For the Month Ended June 30 | |||||||||
| Planning | Actual | ||||||||
| Budget | Results | Variances | |||||||
| Number of lawns | 500 | 550 | |||||||
| Revenue | $ 37,500 | $ 43,000 | $ 5,500 | F | |||||
| Expenses: | |||||||||
| Wages and salaries | $ 20,000 | $ 23,500 | $ 3,500 | U | |||||
| Gasoline and supplies | 4,500 | 5,100 | 600 | U | |||||
| Equipment maintenance | 1,500 | 1,300 | 200 | F | |||||
| Office and shop utilities | 1,000 | 950 | 50 | F | |||||
| Office and shop rent | 2,000 | 2,000 | - 0 | ||||||
| Equipment Depreciation | 2,500 | 2,500 | - 0 | ||||||
| Insurance | 1,000 | 1,200 | 200 | U | |||||
| Total expenses | 32,500 | 36,550 | 4,050 | U | |||||
| Net operating income | $ 5,000 | $ 6,450 | $ 1,450 | F |
Sheet2
Sheet3
Sheet4
Sheet5
Sheet6
Sheet7
Sheet8
Sheet9
Sheet10
Sheet11
Sheet12
Sheet13
Sheet14
Sheet15
Sheet16
Planning
PlanningBudgetActual
Budget× 110%ResultsVariances
Number of lawns 500 550
Revenue37,500$ 41,250$ 43,000$ 1,750$ F
Expenses:
Wages and salaries20,000$ 22,000$ 23,500$ 1,500$ U
Gasoline and supplies4,500 4,950 5,100 150 U
Equipment maintenance1,500 1,650 1,300 350 F
Office and shop utilities1,000 1,100 950 150 F
Office and shop rent2,000 2,200 2,000 200 F
Equipment Depreciation2,500 2,750 2,500 250 F
Insurance1,000 1,100 1,200 100 U
Total expenses32,500 35,750 36,550 800 U
Net operating income5,000$ 5,500$ 6,450$ 950$ F
Class Co
For the Month Ended June 30
Sheet1
| Class Co | |||||||||||
| For the Month Ended June 30 | |||||||||||
| Planning | |||||||||||
| Planning | Budget | Actual | |||||||||
| Budget | × 110% | Results | Variances | ||||||||
| Number of lawns | 500 | 550 | |||||||||
| Revenue | $ 37,500 | $ 41,250 | $ 43,000 | $ 1,750 | F | ||||||
| Expenses: | |||||||||||
| Wages and salaries | $ 20,000 | $ 22,000 | $ 23,500 | $ 1,500 | U | ||||||
| Gasoline and supplies | 4,500 | 4,950 | 5,100 | 150 | U | ||||||
| Equipment maintenance | 1,500 | 1,650 | 1,300 | 350 | F | ||||||
| Office and shop utilities | 1,000 | 1,100 | 950 | 150 | F | ||||||
| Office and shop rent | 2,000 | 2,200 | 2,000 | 200 | F | ||||||
| Equipment Depreciation | 2,500 | 2,750 | 2,500 | 250 | F | ||||||
| Insurance | 1,000 | 1,100 | 1,200 | 100 | U | ||||||
| Total expenses | 32,500 | 35,750 | 36,550 | 800 | U | ||||||
| Net operating income | $ 5,000 | $ 5,500 | $ 6,450 | $ 950 | F |
