Flexible Budgets and Performance Analysis Chapter 10 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Improve performance evaluation. May be prepared for any activity level in the relevant range. Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons. Help managers control costs. Let’s look at Larry’s Lawn Service. Characteristics of Flexible Budgets 10-2

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. Larry’s Budget Deficiencies of the Static Planning Budget 10-3

 Larry identified 7 major expenses for his business. In addition, Larry estimated a cost formula for revenue and for each expense in terms of the number of lawns mowed. Revenue, along with each of the 7 major expense categories, and their relationship to the number of lawns (Q) is as follows:  Revenue, $75 per lawn (Q)  Wages and salaries, $5,000 + $30 per lawn (Q)  Gasoline and supplies, $9Q  Equipment maintenance, $3Q  Some expenses are not directly related to the number of lawns mowed. They are the fixed costs: office and shop utilities, $1,000; office and shop rent, $2,000; equipment depreciation, $2,500; and insurance, $1,000. Larry’s static planning budget is based on an activity level of 500 lawns.

Deficiencies of the Static Planning Budget Larry’s Planning Budget 10-5

Deficiencies of the Static Planning Budget Larry’s Actual Results 10-6

Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget 10-7

Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget Since these variances are favorable, has Larry done a good job controlling costs? Since these variances are unfavorable, has Larry done a poor job controlling costs? 10-8

 The relevant question is... “How much of the cost variances is due to higher activity, and how much is due to cost control?”  To answer the question, we must the budget to the actual level of activity.  The relevant question is... “How much of the cost variances is due to higher activity, and how much is due to cost control?”  To answer the question, we must the budget to the actual level of activity. Has Larry done a poor job controlling those costs with unfavorable variances? Has he done a good job controlling the costs with favorable variances 10-9

How a Flexible Budget Works To a budget we need to know that:  Total variable costs change in direct proportion to changes in activity.  Total fixed costs remain unchanged within the relevant range. Fixed Variable 10-10

Preparing a Flexible Budget Larry’s Flexible Budget 10-11

 Larry’s flexible budget for an activity level of 550 lawns mowed is as shown on this slide.  The key to preparing a flexible budget is to state each variable cost as a function of activity. For example, gasoline and supplies are equal to $9 per lawn, and the variable portion of wages and salaries is $30 per lawn. While variable costs are expressed per unit of activity, fixed costs are not. The fixed costs are not sensitive to changes in the activity level.  Notice, the “Q” in all revenue and cost formulas is 550 lawns mowed. So, for example: Revenue of $41,250 is computed by multiplying $75 × 550. Wages and salaries of $21,500 is computed by multiplying $30 × 550 plus $5,000 in fixed salaries

Activity Variances Planning budget revenues and expenses Flexible budget revenues and expenses The differences between the budget amounts are called activity variances

Activity Variances Larry’s Flexible Budget Compared with the Planning Budget 10-14

 The activity variances for Larry’s Lawn Service would be computed as shown on this slide. Notice:  The level of activity in the flexible budget (550 lawns) is 10% higher than the level of activity in the planning budget (500 lawns). The planning budget shows revenue and cost amounts at the original planned level of activity while the flexible budget shows revenue and cost amounts at the actual level of activity. The differences (variances) between the planning budget for 500 lawns and the flexible budget for 550 lawns are due solely to the activity increase.  Revenue in the flexible budget is 10% higher than the planning budget because revenue varies proportionally to changes in the activity level. The higher activity level results in a favorable activity variance for revenue.  The variable costs in the flexible budget (gasoline and supplies and equipment maintenance) are 10% higher than the planning budget because variable costs vary proportionally to changes the activity level. The mixed cost (wages and salaries) in the flexible budget is less than 10% higher than the planning budget because the fixed cost component of the mixed cost does not change when the activity level changes. The higher activity level results in unfavorable activity variances for these costs.  The fixed costs in the flexible budget are the same as the planning budget because they do not change in response to changes in the activity level within the relevant range.

Revenue and Spending Variances Flexible budget revenueActual revenue The difference is a revenue variance. Flexible budget costActual cost The difference is a spending variance

Revenue and Spending Variances Larry’s Flexible Budget Compared with the Actual Results $1,750 favorable revenue variance 10-17

 The revenue and spending variances for Larry’s Lawn Service would be computed as shown on this slide. Notice:  The apple icons on the slide indicate that the flexible budget and actual results columns are both based on 550 lawns mowed.  The $1,750 favorable revenue variance indicates that actual revenue exceeded the budgeted amount that would be expected for an activity level of 550 lawns mowed. This could happen for a number of reasons including an increase in the amount charged for each lawn or a change in lawn services. In Larry’s case, several homeowners requested some additional edging and trimming, beyond the customary monthly services, that resulted in increased revenue.

Larry’s Flexible Budget Compared with the Actual Results Revenue and Spending Variances Spending variances 10-19

 The $1,950 unfavorable spending variance indicates that total expenses were $1,950 greater than would be expected for an activity level of 550 lawns mowed. Larry explained the individual spending variances that make up the total $1,950 unfavorable spending variance as follows:  The $1,500 unfavorable wages and salaries spending variance occurred because of extra hours required for the additional trimming. The $150 unfavorable gasoline and supplies spending variance was primarily the result of rising gasoline prices. The $350 favorable equipment maintenance spending variance occurred because maintenance was postponed in order to get the extra edging and trimming work completed.  Fixed cost variances are not the result of increased activity. The utility bill was less because the weather was milder than normal for June, while insurance was higher because of an unexpected premium increase.  Overall, net operating income was $200 less than would be expected for an activity level of 550 lawns mowed.

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 10-21

Because of the large unfavorable wages and salaries spending variance, Larry decided to add an additional cost driver for wages 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 both his revenue and expense budget formulas. Larry’s New Budget Flexible Budgets with Multiple Cost Drivers 10-22

Flexible Budgets with Multiple Cost Drivers Larry’s Budget Based on More than One Cost Driver 10-23

Some Common Errors The most common errors in preparing performance reports are to implicitly assume that: 1. All costs are fixed or that 2. All costs are variable. The most common errors in preparing performance reports are to implicitly assume that: 1. All costs are fixed or that 2. All costs are variable. Assume all costs are fixed

Common Error 1: Assuming All Costs Are Fixed Faulty Analysis Comparing Budgeted Amounts to Actual Amounts 10-25

Common Error 2: Assuming All Costs Are Variable Faulty Analysis that Assumes All budget Items Are Variable 10-26

End of Chapter