Chapter 9: Flexible Budgets and Performance Analysis

Flexible Budgets andPerformance AnalysisChapter 9Characteristics of Flexible Budgets Planning budgetsare prepared fora single, plannedlevel of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity.Hmm! Comparingstatic planning budgets with actual costsis like comparingapples and oranges.Improve performance evaluation.May be prepared for any activity level in the relevant range.Show costs that should have beenincurred at the actual level ofactivity, enabling “apples to apples”cost comparisons.Help managers control costs.Let’s look at Larry’s Lawn Service.Characteristics of Flexible BudgetsLarry’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 onmowing 500 lawns. Since all of the lawns are similar in size,Larry felt that the number of lawns mowed in a month wouldbe the best way to measure overall activity for his business. Larry’s Budget Deficiencies of the Static Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Actual Results Compared with the Planning BudgetDeficiencies of the Static Planning BudgetLarry’s Actual Results Compared with the Planning BudgetSince these variances are unfavorable, has Larry done a poor job controlling costs? Since these variances are favorable, has Larry done a good job controlling costs?The relevant question is . . . “How much of the cost variances are due to higher activity and how much are due to cost control?”To answer the question,we mustthe budget to theactual level of activity. Deficiencies of the Static Planning BudgetHow a Flexible Budget Works To a budget, we need to know that:Total variable costs changein direct proportion to changes in activity.Total fixed costs remainunchanged within therelevant range. FixedVariablePreparing a Flexible BudgetLarry’s Flexible BudgetActivity VariancesFlexible budget revenues and expensesPlanning budget revenuesand expensesThe differences between the budget amounts are called activity variances.Activity VariancesLarry’s Flexible Budget Compared with the Planning BudgetRevenue and Spending VariancesActual revenueFlexible budget revenueThe difference is a revenue variance.Actual costFlexible budget costThe difference is a spending variance.Revenue and Spending VariancesLarry’s Flexible Budget Compared with the Actual Results$1,750 favorablerevenue varianceLarry’s Flexible Budget Compared with the Actual ResultsRevenue and Spending VariancesSpending variancesMore than one cost driver may be needed toadequately explain all ofthe costs in an organization. The cost formulas usedto prepare a flexiblebudget can be adjustedto recognize multiplecost drivers.Flexible Budgets with Multiple Cost DriversBecause the time required for edging and trimming is different for different lawns, Larry decided to add an additional cost driver (hours) for the time required for edging and trimming. So Larry estimated the additional hours and developed a new flexible budget that includes the second cost driver in both his revenue and expense budget formulas. Larry’s New Budget Flexible Budgets with Multiple Cost DriversFlexible Budgets with Multiple Cost DriversLarry’s Budget Based on More than One Cost DriverSome Common ErrorsThe most common errors when preparing performancereports are to implicitly assume that:1. All costs are fixed, or that; All costs are variable. Assume all costs are fixed.Common Error 1: Assuming All Costs Are FixedFaulty Analysis Comparing Budgeted Amounts to Actual AmountsCommon Error 2: Assuming All Costs Are VariableFaulty Analysis that Assumes All Budget Items Are VariableEnd of Chapter 9