Budget Devices

Static versus Flexible Budgets

Static budgets do not vary with volume. Each line item is a fixed amount.

Static budgets do not change as the level of services or volume levels increase or decrease.

Unlike a flexible budget, a static budget does not take into account monthly or yearly changes in the volume of service provided.

The static budget is set for only one level of services and spending—the projected level estimated at the beginning of the new budget year.

In contrast to the static budget, a flexible budget is stated as a function of some volume measure.

Flexible budgets are adjusted for changes in volume. A flexible budget shows how costs vary with changes in volume levels, such as volume of service, volume of use, and volume of activity.

Flexible budgets and static budgets provide different incentives.

To prepare a flexible budget, the way costs respond to changes in volume must be known. As an example of flexible budgeting, consider the case of a concert. A popular local band is hired for $20,000 plus 15 percent of the gate receipts.

The auditorium is rented for $5,000 plus 5 percent of the gate receipts. Security guards are hired, one for every 200 people, at a cost of $80 per guard.

Advertising, insurance, and other fixed costs are $28,000. Ticket prices are $18 each.

A flexible budget for the concert is presented in Table X1.

Ticket
(Formula)       3,0004,0005,000
Revenues$18N↑$54,000$72,000$90,000
Band$20,000 + 0.15(18N)(28,100)(30,800)(33,500)
Auditorium$5,000 + 0.05(18N)(7,700)(8,600)(9,500)
Security$80(N/200)(1,200)(1,600)(2,000)
Other costs$28,000(28,000)(28,000)(28,000)
Profit/(Loss)$ (11,000)$ 3,000$17,000
↑ N is the number of tickets sold.

Each line item in the budget is stated in terms of how it varies with volume, ticket sales in this case.

A budget is prepared at different volume levels. At ticket sales of 3,000, an $11,000 loss is projected. At sales of 4,000 and 5,000 tickets, $3,000 and $17,000 of profit are forecasted, respectively.

Reason for Using Flexible Budget

The major reason for using flexible rather than static budgets is to better gauge the actual performance of a person or venture after controlling for volume effects, assuming, of course, that the individual being evaluated is not responsible for the volume changes.

For example, consider the following illustration:

5,000 persons attended the concert and the actual cost of the auditorium was $9,900.

The budget for the auditorium is automatically increased to $9,500 as a result of the 5,000 ticket sales and the manager is not held responsible for volume changes. However, the manager is held responsible for the $400 unfavorably variance between the actual charge of $9,900 and $9,500.

In evaluating the manager’s performance, the cause of the variance should be investigated; for example, if the $400 had been caused by damage to the auditorium, would additional security personnel have prevented this damage?

When should a firm or department use a static budget and when should it use a flexible budget?

Static budgets do not adjust for volume effects. Volume fluctuations in static budgets are passed through, and show up in the difference between actual and budgeted numbers. Thus, static budgets force managers to be responsible for volume fluctuations. If the manager has some control over volume or the consequences of volume, then static budgets should be used as the benchmark to gauge performance.

Flexible budgets adjust for volume effects. Volume fluctuations in flexible budgets are not passed through, and do not show up in the difference between actual and budgeted numbers; flexible budgets do not hold managers responsible for volume fluctuations.

Therefore, if the manager does not have any control over volume, then flexible budgets should be used as the benchmark to gauge performance.

Flexible budgets reduce the risk that volume changes are borne by managers. Numerical Example I further illustrates the use of flexible budgeting.

Numerical Example I

Rugged Terrain Inc. makes crash helmets for extreme mountain bikers. The company establishes a flexible annual budget. The company sells its helmets for $200 each. The fixed manufacturing costs are budgeted to be $2 million.

The variable manufacturing costs are budgeted to be $80 per helmet. Selling and administrative costs are expected to be fixed and are budgeted to be $1 million. There are no beginning and ending inventories.

  1. Prepare a budgeted profit and loss statement for Rugged Terrain Inc. assuming the manufacture and sale of 20,000, 30,000, and 40,000 helmets.
  2. The company produced and sold 34,000 helmets. Actual revenues are $6,500,000, actual variable costs are $2,500,000, actual fixed manufacturing costs are $2.1 million, and actual selling and administration costs are $950,000. What are the variances of each of these accounts and the profit variance?

Solution

  1. Rugged Terrain Inc.
    Budgeted Profit and Loss Statement
    Number of Helmets Manufactured and Sold
    20,000              30,000       40,000
    Revenues (x $200)$4,000,000$6,000,000$8,000,000
    Variable costs (x $80)(1,600,000)(2,400,000)(3,200,000)
    Fixed manufacturing(2,000,000)(2,000,000)(2,000,000)
    Selling and administration(1,000,000)(1,000,000)(1,000,000)
    Profit (loss)$ (600,000)$   600,000$ 1,800,000
  2. If 34,000 helmets are produced and sold, the following are the budgeted revenues and costs, actual revenues and costs, and variances:
    Budgeted      ActualVariance
    Revenues (34,000 x $200)$6,800,000$6,500,000$300,000 U
    Variable costs (34,000 x $80)(2,720,000)(2,500,000)  220,000 F
    Fixed manufacturing(2,000,000)(2,100,000)  100,000 U
    Selling and administration(1,000,000)   (950,000)   50,000 F
    Budgeted profit$1,080,000$    950,000$130,000 U

The unfavorable variance results from lower than expected prices and higher than expected fixed manufacturing costs.

Understand the Concept of Volume and Its Measurement as Part of the Budget Process

As we have seen, a flexible budget is developed and presented as a function of a volume measure. This volume measure is used to adjust the budget.

The previous section has outlined the different incentive effects of a flexible budget and how these incentives relate to the use of the budget for control purposes. However, what is meant by volume merits further attention.

Volume is generally measured in terms of inputs; for example, direct material dollars, direct labor hours or machine hours. The use of inputs simplifies planning as firms produce many products but use common inputs.

The type of volume measure varies across organizations but once selected, it must be quantified in some manner. For instance, if a firm selects machine hours as the measure of volume, the firm must quantify the number of machine hours for the budget period.

This measure, budgeted volume, is used to determine rates for the assignment of indirect costs (overhead) and can be calculated in different ways.

Budgeted volume based on sales and production forecasts results in a volume measure that increases and decreases with increases and decreases in demand.

Normal volume is a longer-term measure based on the average production level in the long run.

These volume measures are also related to capacity, as organizations must take into account its current capacity, excess, or capacity constraints when developing its budget and measures of volume.

Flexible budgets are used primarily in manufacturing settings, especially as manufacturing offers readily available volume measures and many costs vary with volume.

However, flexible budgets are also employed in other settings such as distribution, marketing, R&D, or general and administrative expenses.