Flexible Budgets andFlexible Budgets and Performance Analysisdocenti.luiss.it/protected-uploads/229/2011/11/20111123185544-cha… · Characteristics of Flexible BudgetsCharacteristics

Flexible Budgets andFlexible Budgets andPerformance Analysis

Chapter 10

© 2010 The McGraw-Hill Companies, Inc.

Learning Objective 1Learning Objective 1

P fl ibl b dP fl ibl b dPrepare a flexible budget.Prepare a flexible budget.

McGraw‐Hill/Irwin Slide 2

Characteristics of Flexible BudgetsCharacteristics of Flexible Budgets

C

Planning budgetsHmm! Comparing

static planning budgetswith actual costs

are prepared fora single, plannedl l f ti it

with actual costsis like comparing

apples and oranges.level of activity.

Performance evaluation is difficult when actual activity

diff f thdiffers from the planned level of

activity


activity.

Characteristics of Flexible BudgetsCharacteristics of Flexible Budgets

May be prepared for any activity level in the relevant range.

Show costs that should have beenincurred at the actual level ofincurred at the actual level ofactivity, enabling “apples to apples”cost comparisons.

Help managers control costs.

Improve performance evaluation.

Let’s look at Larry’s Lawn ServiceMcGraw‐Hill/Irwin Slide 4

Let’s look at Larry’s Lawn Service.

Deficiencies of the Static Planning BudgetDeficiencies of the Static Planning Budget

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 onAt the end of May, Larry prepared his June budget based onmowing 500 lawns. Since all of the lawns are similar in size,Larry felt that the number of lawns mowed in a month wouldybe the best way to measure overall activity for his business.

Larry’s BudgetMcGraw‐Hill/Irwin Slide 5

Larry’s Budget

Deficiencies of the Static Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Planning Budget


Deficiencies of the Static Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Actual Results


Deficiencies of the Static Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Actual Results Compared with the Planning Budget



F = Favorable variance that occurs when actual revenue is greater than budgeted revenue.

U = Unfavorable variance that occurs when

F = Favorable variance that occurs when

actual costs are greater than budgeted costs.

F = Favorable variance that occurs when actual costs are less than budgeted costs.



Since these variances are unfavorable, has

Since these variances are favorable has

Larry done a poor job controlling costs?

Since these variances are favorable, has Larry done a good job controlling costs?



I don’t think Ican answer thequestions using

Actual activity is above planned activity. questions using

a static budget. So, shouldn’t the variablecosts be higher if actual

activity is higher?activity is higher?



The relevant question is . . .“How much of the cost variances is due to higherHow much of the cost variances is due to higher activity, and how much is due to cost control?”

To answer the question,we mustwe mustthe budget to theactual level of activity actual level of activity.


How a Flexible Budget WorksHow a Flexible Budget Works

To a budget we need to know that:Total variable costs changein direct proportion to h i ti itchanges in activity.

Total fixed costs remainh d i hi hunchanged within the

relevant range. Fixed


How a Flexible Budget WorksHow a Flexible Budget Works

Let’s prepare aLet s prepare abudget

for Larry’s Lawnfor Larry’s Lawn Service.


Preparing a Flexible BudgetPreparing a Flexible BudgetLarry’s Flexible Budget


Quick CheckQuick Check

What should the total wages and salaries costWhat should the total wages and salaries cost be in a flexible budget for 600 lawns?a $18 000a. $18,000b. $20,000.

$23 000c. $23,000.d. $25,000.


Quick CheckQuick Check

What should be the total wages and salariesWhat should the total wages and salaries costWhat should be the total wages and salaries cost in a flexible budget for 600 lawns?a $18 000

What should the total wages and salaries cost be in a flexible budget for 600 lawns?a $18 000a. $18,000b. $20,000.

$23 000

a. $18,000b. $20,000.

$23 000c. $23,000.d. $25,000.c. $23,000.d. $25,000.

Total wages and salaries cost

= $5,000 + ($30 per lawn × 600 lawns)

= $5 000 + $18 000 = $23 000


$5,000 + $18,000 $23,000


P h i P h i Prepare a report showing Prepare a report showing activity variances.activity variances.yy


Activity VariancesActivity Variances

Planning Flexible gbudget revenues

and expensesbudget revenues

and expensesand expenses and expenses

The differences between The differences between the budget amounts are the budget amounts are called activity variancescalled activity variances


called activity variances.called activity variances.

Activity VariancesActivity Variances

Let’s use budgeting

concepts to comp te acti it

concepts to compute activity variances for Larry’s Lawn Service.


Activity VariancesActivity VariancesLarry’s Flexible Budget Compared with the Planning Budget


Activity VariancesActivity VariancesLarry’s Flexible Budget Compared with the Planning BudgetActivity and revenue increase by 10 percent, but net operating income increases by more than 10 percent due to the presence of fixed costs.



P h i P h i Prepare a report showing Prepare a report showing revenue and spending revenue and spending p gp g

variances.variances.


Revenue and Spending VariancesRevenue and Spending Variances

Flexible budget revenue Actual revenueFlexible budget revenue Actual revenue

The difference is a revenue variance.The difference is a revenue variance.

Flexible budget cost Actual cost

The difference is a spending varianceThe difference is a spending variance


The difference is a spending variance.The difference is a spending variance.

Revenue and Spending VariancesRevenue and Spending Variances

Now let’s use budgetingNow, let s use budgeting

concepts to compute revenue andconcepts to compute revenue and spending variances for Larry’s Lawn

ServiceService.


Revenue and Spending VariancesRevenue and Spending VariancesLarry’s Flexible Budget Compared with the Actual Results

$ f$ f$1,750 favorable$1,750 favorablerevenue variancerevenue variance


Revenue and Spending VariancesLarry’s Flexible Budget Compared with the Actual ResultsRevenue and Spending Variances

SpendingSpending variances



P f P f Prepare a performance Prepare a performance report that combines activity report that combines activity p yp y

variances and revenue and variances and revenue and spending variancesspending variancesspending variances.spending variances.


A Performance Report Combining Activity and Revenue and Spending Variancesand Revenue and Spending Variances

Now let’s use budgetingNow, let s use budgeting

concepts to combine the revenue andconcepts to combine the revenue and spending variances reports for Larry’s

Lawn ServiceLawn Service.





50 lawns × $75 per lawn 50 lawns × $30 per lawn



$43,000 actual - $41,250 budget


Performance Reports in Non-Profit OrganizationsOrganizations

N fit i ti i f di fNon-profit organizations may receive funding from sources other than the sale of goods and services,

i t f b th fi d dso revenues may consist of both fixed and variable elements.

DonationsState funding

Tuition and fees Endowments


Universities

Performance Reports in Cost CentersPerformance Reports in Cost Centers

Performance reports are often preparedPerformance reports are often prepared for cost centers. These reports should be

prepared using the same principles discussed so far, except for the fact that pthese reports will not contain revenue or

net operating income variancesnet operating income variances.



P fl ibl b d P fl ibl b d Prepare a flexible budget Prepare a flexible budget with more than one cost with more than one cost

driver.driver.


Flexible Budgets with Multiple Cost DriversFlexible Budgets with Multiple Cost Drivers

More than one cost driver may be needed toadequately explain all of

the costs in an organization.

The cost formulas usedThe cost formulas usedto prepare a flexible

budget can be adjustedbudget can be adjustedto recognize multiple

cost drivers


cost drivers.

Flexible Budgets with Multiple Cost DriversFlexible Budgets with Multiple Cost Drivers

Because of the large unfavorable wages and salaries spendingvariance, Larry decided to add an additional cost driver for

wages and salaries The variance is due primarily to the numberwages and salaries. The variance is due primarily to the number of hours required for the additional edging and trimming. So

Larry estimates the additional hours and builds those hours into yboth his revenue and expense budget formulas.

Larry’s New BudgetMcGraw‐Hill/Irwin Slide 37

Larry’s New Budget

Flexible Budgets with Multiple Cost DriversFlexible Budgets with Multiple Cost DriversLarry’s Budget Based on More than One Cost Driver



U d d U d d Understand common errors Understand common errors made in preparing made in preparing p p gp p g

performance reports based performance reports based on budgets and actual on budgets and actual on budgets and actual on budgets and actual

results.results.


Some Common ErrorsSome Common Errors

The most common errors in preparing performancereports are to implicitly assume that:reports are to implicitly assume that:1. All costs are fixed or that 2 All costs are variable2. All costs are variable.

Assume all costs are fixedMcGraw‐Hill/Irwin Slide 40

Assume all costs are fixed.

Common Error 1: Assuming All Costs Are FixedFixed

Faulty Analysis Comparing Budgeted Amounts to Actual Amounts


Common Error 2: Assuming All Costs Are VariableVariableFaulty Analysis that Assumes All budget Items Are Variable


End of Chapter 10End of Chapter 10


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Flexible Budgets andFlexible Budgets and Performance Analysisdocenti.luiss.it/protected-uploads/229/2011/11/20111123185544-cha… · Characteristics of Flexible BudgetsCharacteristics