Budgeting is an essential part of planning, financial control, and performance management. It is a competency that must be acquired for anyone who is working in finance and accounting and is also a topic which is guaranteed to come up on your Performance Management (PM) exam. Expect to see it in Sections A or B, and there is a fair chance of it appearing in Section C, so you need to be ready to handle 20-mark questions from both a numerical and a discussion-based perspective. This series of articles will cover the budgeting approaches flexible budgeting, activity-based budgeting, rolling budgeting, zero-based budgeting, and beyond budgeting.
Flexible budgeting
A flexible budget is a summary of revenues and costs across a range of different activity levels. So instead of looking at only one activity level (which is called a ‘fixed’ budget - you should remember this from your previous studies), various activity levels are considered. A critical aspect of this approach is to determine fixed and variable costs, which can then be expressed as a linear equation:
y = a + bx
Total cost (y) = Fixed cost (a) + (Variable cost per unit (b) * Activity level (x))
TC = FC + (VC * activity level)
With an understanding of revenue per unit and cost behaviours (ie fixed, variable, and stepped), financial results can then be budgeted within a range of activity levels.
You should be ready for complications on your PM exam, such as:
- dealing with a stepped cost
- incorporating the impact of a learning curve
- using the high/low method to separate fixed and variable costs from a total cost
Flexible vs flexed budget
Ensure you know the difference between these terms.Flexiblebudgeting happens at the beginning of a budgeting period—revenue, costs, and profit are forecast across a range of activity levels. With this information, aflexedbudget can then be created at the end of the budget period based on theactualactivity level. This flexed budget becomes a core part of financial control when using standard costing—the flexed budget answers the question, “What should our financial results be at the actual activity level?”
For more on this topic, see the Standard Costing section of your study materials.
Pros and cons
With flexible budgeting, managers will be able to plan and forecast more accurately. Performance management can be more meaningful as actual results can be easily compared to flexed results – total variances can then be calculated for each revenue and cost.
However, some businesses may have a high level of indirect costs, making it difficult to separate fixed and variable costs from total indirect costs.
Flexed budget example
Part 1
Corfe Co is a business which manufactures computer laptop batteries and it has developed a new battery which has a longer usage time than batteries currently available in laptops. The selling price of the battery is forecast to be $45. The maximum production capacity of Corfe Co is 262,500 units. The company’s management accountant is currently preparing an annual flexible budget and has collected the following information so far:
Production (units) | 185,000 | 200,000 | 225,000 |
|---|---|---|---|
| $ | $ | $ | |
| Material costs | 740,000 | 800,000 | 900,000 |
| Labour costs | 1,017,500 | 1,100,000 | 1,237,500 |
| Fixed costs | 750,000 | 750,000 | 750,000 |
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In addition to the above costs, the management accountant estimates that for each increment of 50,000 units produced, one supervisor will need to be employed. A supervisor’s annual salary is $35,000.
Assuming the budgeted figures are correct, what would the flexed total production cost be if production is 80% of maximum capacity?
Solution
An 80% activity level is 210,000 units.
Material and labour are both variable costs. Material is $4 per unit and labour is $5.50 per unit, so total variable cost per unit is $9.50
Total variable costs = $9.50 x 210,000 units = $1,995,000
Fixed costs = $750,000
Supervision = $175,000 as five supervisors are required for a production level of 210,000 units.
Total annual budgeted cost allowance = $1,995,000 + $ 750,000 + $ 175,000 = $2,920,000
Part 2
The management accountant has said that a machine maintenance cost was not included in the flexible budget but needs to be taken into account.
The new battery will be manufactured on a machine currently owned by Corfe Co which was previously used for a product which has now been discontinued. The management accountant estimates that every 1,000 units will take 14 hours to produce. The annual machine hours and maintenance costs for the machine for the last four years have been as follows:
Machine time (hours) | Maintenance costs | |||
|---|---|---|---|---|
| $'000 | ||||
Year 1 | 5000 | 850 | ||
Year 2 | 4400 | 735 | ||
Year 3 | 4850 | 815 | ||
Year 4 | 1800 | 450 |
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What is the estimated maintenance cost if production of the battery is 80% of the maximum capacity?
Solution
Variable cost per hour ($850,000 -$450,000)/(5,000 hours – 1,800 hours) = $125 per hour
Fixed cost ($850,000 – (5,000 x $125)) = $225,000
Number of machine hours required for production = 210 x 14 hours = 2,940 hours
Total cost ($225,000 + (2,940 x $125)) = $592,500, or $ 593,000 to the nearest $’000.
Written by Steve Willis, finance and accountancy trainer
As a seasoned expert in finance and accounting, I've navigated through the intricate landscape of budgeting, financial control, and performance management with a depth of knowledge gained through hands-on experience and continuous learning. My expertise extends to the various budgeting approaches, including flexible budgeting, which is a crucial aspect of financial planning.
In the realm of budgeting, it's imperative to understand the nuances of different methodologies. Let's delve into the concepts highlighted in the article:
1. Flexible Budgeting:
- Definition: A flexible budget is a comprehensive overview of revenues and costs across various activity levels.
- Key Principle: It considers both fixed and variable costs, expressed through a linear equation.
- ( Total\ Cost (y) = Fixed\ Cost (a) + (Variable\ Cost\ per\ Unit\ (b) \times Activity\ Level\ (x)) )
- Complications: The approach addresses challenges like dealing with stepped costs, incorporating learning curve impacts, and utilizing the high/low method to distinguish fixed and variable costs.
2. Flexible vs. Flexed Budget:
- Flexible Budgeting: Occurs at the beginning of a budgeting period, forecasting across a range of activity levels.
- Flexed Budget: Created at the end of the budget period based on the actual activity level, playing a crucial role in financial control with standard costing.
3. Pros and Cons of Flexible Budgeting:
- Pros:
- Accurate planning and forecasting.
- Meaningful performance management by comparing actual results with flexed results.
- Cons:
- Challenges in separating fixed and variable costs in businesses with high indirect costs.
4. Flexed Budget Example:
- Scenario - Corfe Co:
- Manufacturing laptop batteries with a new, longer-lasting model.
- Production capacity: 262,500 units.
5. Flexed Total Production Cost Calculation:
- Given: Production at 80% of maximum capacity (210,000 units).
- Calculation:
- Total Variable Costs = ( $9.50 \times 210,000 )
- Fixed Costs + Supervision
- Total Annual Budgeted Cost Allowance
6. Machine Maintenance Cost Estimation:
- Scenario:
- Battery production at 80% of maximum capacity.
- Calculation:
- Variable cost per hour, Fixed cost, Number of machine hours required, Total cost.
In conclusion, mastering flexible budgeting is paramount for finance and accounting professionals, especially for those preparing for Performance Management exams. The ability to navigate through complex scenarios and apply concepts like the ones presented in this article showcases the depth of expertise required in the field.
