The flexible budget
The need for a flexible budget can be simply illustrated as follows. The owner of a car knows that the more he uses it per year, the more it costs him to operate it; you also know that the more you use your vehicle, the lower the cost per kilometer or mile traveled.
The reason for this lies in the nature of the expenses, some of which are fixed while others are variable or semi-variable.
Tax, official registration and garage insurance are fixed costs, which remain the same whether operating 1,000 or 20,000 miles. The costs of tires, gasoline, oil and repairs are variable depending in large part on the miles traveled.
Obsolescence and depreciation result in a semi-variable type of cost, which fluctuates to some degree, but not directly with the use of the vehicle.
The cost per mile of car operation depends on the number of miles driven.
This mileage is the basis for judging the activity of the car. If the owner prepares an estimate of the total costs and compares his actual expenses, at the end of the year, with what he has budgeted, he still cannot say how successful he has been in keeping his expenses within the allowed limits without keeping an accounting for the mileage factor traveled. (1)
The fundamental principle of a flexible budget is the need for some standard of expenditures for a given volume of business, which must be known in advance to provide a guide to actual expenditures. To recognize this principle is to accept the fact that every business is a dynamic, ever-changing and never aesthetic entity.
It is wrong, if not futile, to expect a business to conform to a fixed, preconceived pattern. (1)
Flexible budgeting results in the construction of a series of formulas, one for each department. Each series in turn has a formula for each account in the department or cost center. (1)
The predetermination of the total fixed expenditure and the variable rate, as well as the subsequent application of the rate to the level of activity actually experienced, makes it possible to calculate the allowable expenditures for the volume of activity achieved. These budget figures are compared with the true costs, which allows a closer control of performance by the departmental head than in the case of allocations based on a fixed budget.
The end-of-period comparison is used to measure the performance of each department head. It is this easily accomplished comparison that makes flexible budgeting a valuable tool for cost control.
Flexible budgeting aids in evaluating the effects of varying volumes of activity on earnings and cash position. (1)
Flexible budget, definition
According to Fullana and Paredes (p.443):
The preparation of the cost budget is based on the premise that the variable costs depend on the planned activity, while the fixed costs will remain unchanged, whatever the level of activity, since they are the costs of the structure required to develop the exercise.
The flexible budget is the budget adjusted to different levels of activity, taking into account the variable unit costs of the initial budget and keeping the fixed costs.
Comparing the actual data with respect to the flexible budget is the best criterion to carry out budget control, since now the magnitudes to be compared are homogeneous and the effects of excess or shortage of activity are isolated. The deviations obtained represent effective indicators of the organization's efficiency level.
In practice, a flexible budget is prepared each month that, based on the initial budget, is adjusted with the actual activity data for the corresponding month.
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Professor Marc Pérez Bonaventura, in the following short video lesson, explains what flexible budgeting is and the reasons why it is used:
goals
Both, the fixed budget and the flexible budget, provide management with the information necessary to achieve the main objectives of budget control, through: (1)
- An organized planning procedure A means of coordinating the activities of the various divisions of a business A basis for cost control
Capacity and volume
Discussion of true flexible budgeting must be preceded by some basic understanding of the term capacity. The terms capacity and volume are related to the build and use method for both flexible budgets.
Capacity is the fixed quantity of plant and machinery. the volume is the variable factor of the business. It is related to capacity due to the fact that volume tries to make the best use of existing capacity.
Any business budget is a forecast of sales, costs, and expenses. Expenses for materials, labor, factory cargo, marketing, and administration must be brought into harmony with sales volume.
When discussing the sales budget, it was specifically noted that the volume of sales is not only measured by the sales that the market could absorb but also by the capacity of the plant and machinery available to produce the goods. (1)
Capability levels
Theoretical capacity
The theoretical capacity of a department is its ability to produce at full speed and without interruptions. It is achieved if the plant or department produces at 100 percent of its established capacity. (1)
Practical ability
It is highly unlikely that any company will be able to operate at its theoretical capacity. Allowances must be made for unavoidable interruptions, such as wasted time on repairs, inefficiencies, breakages, unsatisfactory materials, and many more.
The number of shifts or work days must also be considered. (one)
Real expectation capacity
The use of actual expectation capacity for each period is often advocated, a concept that focuses on a short-term perspective. (1)
Normal capacity
Firms can modify the capacity levels listed above by considering plant or multi-department utilization from the point of view of the need to meet average sales or commercial demands over a period long enough to match expectations. highs and lows that come from seasonal and cyclical variations.
Finding a satisfactory and logical balance between plant capacity and sales volume is one of the most important problems in business management. (1)
Once the normal capacity level has been agreed upon, the overhead costs can be estimated and the factory load rates computed.
The use of these will cause the absorption of all general expenses of the period, provided that normal capacity and normal expenses prevail during the period. Any deviation from normal capacity and normal expenses will result in variations, as discussed in the chapters on factory cargo.
It is the ease and speed with which actual results can be compared to budgeted figures that makes flexible budgeting invaluable when analyzing end-of-period deviations.
Current internal revenue administration regulations allow the use of either practical capacity, actual expectation, or normal when assigning factory cargo costs to inventories. (1)
The effect of various capacity levels on predetermined factory load rates is illustrated in the table below; If the 75 percent capacity level is considered the normal operating level, the overhead rate is $ 2.40 per direct labor hour. At higher levels of capacity, the rate is lower due to fixed overhead. (1)
Effect of Various Capacity Levels on Pre-determined Factory Loading Rates - The Flexible Budget
Budgeted and standard amounts
Two terms that are used frequently here are budgeted and standard.
All quantities in a budget are budget quantities, but not all quantities in a budget are budget quantities, but not all budgeted quantities are standard quantities.
A standard quantity is a specific type of budgeted quantity. A standard represents a good level, or the best level, of performance. A standard is usually developed through careful study of specific operations, and is expressed on a per-unit basis. (2)
Budgeted amounts - Standard amounts. The flexible budget
Bibliography
- Cost accounting, a general approach. Eighth edition. Charles T. Horngren, George Foster, and Srikant M. Datar. Editorial Prentice Hall Cost accounting, planning and control. Sixth edition. Adolph Matz, Milton F. Usry and Ivonne Huertas de Irizarry. Editorial South Western Publishing Co. Cost Accounting Manual. Fullana Belda, Carmen and Paredes Ortega, José Luis. Delta Publications.
