7.

1 INTRODUCTION

As we have seen in Unit 6, formal budgeting procedures result in comprehensive operational

and financial plans for future periods. These budgets guide managers and employees as they
make their daily decisions and as they try to anticipate future problems and opportunities.
7.2 MASTER BUDGET VERSUS FLEXIBLE BUDGET

All master budgets discussed in the previous unit are static or inflexible because they assume
fixed level of activity. A master budget or static budget is prepared for only one activity level
(for example one volume of sales activity).

This unit introduces flexible budgets, which are budgets designed to direct management to
areas of actual financial performance that desire attention. Managers can apply this same
basic process to control important areas of performance such as quality or customer service.

Example (1):
(1): Evergreen Company prepares a budget based on detailed expectation for the
forthcoming month. Evergreen Company’s plan tailored to a single sales level, i.e., 9,000
units. However, sales volume units turned out to be only 7, 000 units instead of the original
9, 000 units. Compute the master budget variance for each item given below.

Exhibit 7-1 Evergreen Company Performance Report

Master Budget
Particulars Actual Master Budget
Variances
Units 7,000 units 9,000 units 2,000 units U
Sales Br. 217,000 Br. 279,000 Br. 62,000 U
Variable Expenses
* Manufacturing Br. 151,270 Br. 189,000 Br. 37,730 F
* Selling 5,000 5,400 400 F
* Administrative 2,000 1,800 200 U
Total Variable Expense Br. 158,270 Br. 196,200 Br. 37,930 F
Contribution Margin Br. 58,730 Br. 82,800 Br. 24,070 U
Fixed Expenses
* Manufacturing Br. 37,300 Br. 37,000 300 U
*Selling & Administrative 33,000 33,000 ---
Total Fixed Expenses Br. 70,300 Br. 70,000 300 U
Operating Income (Loss) Br. (11,570) Br. 12,800 Br. 24,370 U

N.B. Master budget variance (static budget variance) is the variance of actual result from the
master budget.
It is customary to label variances favorable (F) or unfavorable (U). The label indicates
whether the target or the actual figure is larger. The way in which labels are applied depends
on the item for which a variance is computed. If the item for which the variance is computed
is a revenue or profit item,
item, favorable variances are those for which actual is greater than the
target; unfavorable variances are those for which actual is less than the target (or the budget).

If the item for which the variance is computed is a cost or expense item,
item, favorable variances
are those for which actual is less than the target. Therefore, if actual cost is greater than target
cost, the variance will be labeled unfavorable.

7.3 FLEXIBLE BUDGET (DYNAMIC BUDGET)

Actual activity may differ significantly from budgeted activity because of an unexpected
labor strike, cancellation of an order, an unexpected large new production contract, and other
factors. When actual results differ considerably from plans, a fixed or static budget may not
be particularly effective in supporting managers. In such cases several budgets prepared for a
variety of activity levels may be more useful.

In contrast to the performance report based only on comparing the master budget to the actual
results, a more useful benchmark for analysis is the flexible budget. A flexible budget
(sometimes called a variable budget) is budget that can easily be adjusted for differences in
the level of activity. It provides managers more useful information for planning and better
basis for comparing performance than, a static or fixed budget.

In performance evaluation, a master budget is kept fixed or static to serve as a benchmark for
evaluating performance. It shows revenues and costs at only the originally planned levels of
activity. However, a flexible budget will be prepared at the actual activity level.

The flexible budget is identical to the master budget in format, but managers may prepare it
for any level of activity.

7.3.1 Distinguishing Features of Flexible Budget

Flexible budgets have several desirable characteristics. They:

 Cover a range of activity
 Are dynamic
 Facilitate performance measurement.
Flexible Budget Cover a Range of Activity. Accurate predictions of activity levels are
sometimes hard to make, and many managers find they make more effective decisions with
the aid of flexible budgets. In developing a flexible budget one activity level at each extreme
of the relevant range is selected, with one or more in between.

Flexible Budget Are Dynamic. Flexible budgets allow managers to adjust plans easily
when activity level differs from the expected level. Such budgets address “what is” rather
than “what was” or “what was expected”. This dynamic nature of flexible budget makes them
a very useful decision making tool for management.

Flexible Budget Facilitate Performance Measurement. Measuring efficiency is an

important role of performance report. Fixed budgets are useful for measuring effectiveness,
i.e., achievement of goal. In some cases, however, fixed budgets do not identify the question,
“what should the result be, given the actual level of activity”. In other words, the flexible-
budget approach says, “Give me any activity level you choose, and I’ll provide a budget
tailored to that particular level.” To summarize, whenever actual and budgeted activity are
significantly different, a flexible budget variance report provides a better measure of
efficiency than a report based on a fixed budget.

7.3.2 Flexible Budgeting Process

The following steps are needed to develop a flexible budget.

i) Determine the range of activity the budget should cover (because cost behavior
patterns may be different in different ranges of activity)
ii) Determine the cost behavior pattern for each cost included in the budget.
iii) Select the activity levels for which budgets will be prepared.
iv) Prepared a flexible budget using the cost behavior data and the selected activity level.
Example (2): Evergreen Company is planning to use a flexible budgeting system to plan and
control its operations. Evergreen made the following cost estimates for budgeting purposes:
Budget Formula Per Unit
Sales Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula Per Month
Fixed Costs
* Manufacturing Br. 37,000
* Selling and administrative 33,000
Total fixed costs Br. 70,000
Required:
a) Prepared a flexible budget for the next month using 7,000, 8,000, and 9,000 units as
activity level. Evergreen Company’s cost functions or flexible budget formulas are
believed to be valid within the range of 7,000 to 9,000 units.
b) At what level of activity dos the company breakeven?
Exhibit 7.2 Evergreen Co. Flexible Budget
Flexible Budgets For Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
* Selling and administrative 33,000 33,000 33,000
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800

BEP (in units) =Total

=Total fixed costs = Br.70,
Br.70, 000
Unit Contribution Margin 31-21.8
=7609
=7609 units(approximation)
units(approximation)

BEP (in birrs) =Total

=Total fixed costs =Br.70,
=Br.70, 000 =Br.235,873(
=Br.235,873(approximation)
approximation)
CM-ratio 9.2/31
Comparing the flexible budget to actual results accomplishes an important performance
evaluation purpose. There are basically two reasons why actual results might not have
conformed to the master budget:
 (i) Sales and other cost-driver activities were not the same as originally forecasted.
(ii) Revenues or variable costs per unit and fixed costs per period were not as
expected.
Flexible Budget Variances: Any variances between the flexible budget and actual results
cannot b due to activity levels. These variances between the flexible budget and actual
results are called flexible budget variances and must be due to departure of actual costs or
revenues from flexible-budget formula amounts.

Activity level variances: Any differences or variances between the master budget and the
flexible budget are due to activity levels. These differences are called activity-level
variances. The sum of the activity level variances and the flexible budget variances equal
the total of the master budget variances.
Example (3): Refer the data given in example (1) and (2). Prepare a condensed table showing
the static (master) budget variance, the sales activity variance, and the flexible-budget
variance.

Exhibit 7.3 Evergreen Co. Summary of Performance

Flexible
Sales Activity
Actual Results Flexible Budget Master Budget Budget
Variances
Variance
Units 7,000 7,000 9,000 - 2,000 U
Sales Br. 217,000 Br. 217,000 Br. 279,000 - Br. 62,000 U
Variable costs 158,270 152,600 196,200 Br. 5,670 U 43,600 F
Contribution margin Br. 58,730 Br. 64,400 Br. 82,800 Br. 5,670 U Br. 18,400 U
Fixed Costs 70,300 70,000 70,000 300 U -
Operating Income (loss) Br. (11,570) Br. (5,600) Br. 12,800 Br. 5,970 U Br. 18,400 U

*U or F indicates whether the variances are unfavorable or favorable, respectively.

Total master budget variance (TMBV) = ALF + FBV
where TMBV = Total Master Budget Variance
ALF = Activity Level Variance
FBV = Flexible Budget Variance

Thus, the total master budget variance for Evergreen Co. amounts to Br. 24,370
unfavorable (Br. 5970 U + Br. 18400 U). The sum of the activity-level variances
here equals sales-activity variances because sales are the only activity used as a
cost driver.
Managers use comparisons between actual results, master budgets, and flexible
budgets to evaluate organizational performance. When evaluating performance, it
is useful to distinguish between effectiveness-the degrees to which a goal,
objective, or target is met- and efficiency-the degree to which inputs are used in
relation to a given level of outputs.

Performance may be effective, efficient, both, or neither. For example, Evergreen

Co. set a master budget objective of manufacturing and selling 9,000 units. Only
7,000 units were actually made and sold, however. Performance, as measured by
sales-activity variances, was ineffective because the sales objective was not met.

Was Evergreen’s performance efficient? Managers judge the degree of efficiency

by comparing actual outputs achieved (7,000 units) with actual inputs (such as the
cost of direct materials and direct labor). The less input used to produce a given
output, the more efficient the operation. Evergreen was in efficient in its use of a
number of inputs. Later in this Chapter, direct material, direct labor and variable
and fixed overhead flexible-budget variances will be discussed in detail.

Flexible-budget variances measure the efficiency of operations at the actual level

of activity. The flexible-budget variances shown in column (4) of Exhibit 7.3 total
Br. 5,970 unfavorable. The total flexible-budget variance arises from sales prices
received and the variable and fixed costs incurred. Evergreen Co. had no
difference between actual sales price and the flexible-budgeted sales price, so the
focus is on the differences between actual costs and flexible-budgeted costs at
actual 7,000-unit level of activity.
Sales-activity variances measure how effective managers have been in meeting the
planned sales objective. In Evergreen Co., sales activity fell 2,000 units short of
the planned level. The sales-activity variances (totaling Br. 18,400 U) are
unaffected by any changes in unit prices or variable costs. Why? Because the
same budgeted unit prices and variable costs are used in constructing both the
flexible and master budgets. Therefore, all unit prices and variable costs are held
constant in columns (2) and (3) of Exhibit 7.3