Flexible Budgets and Performance Reports Chapter 8 Flexible Budgets and Performance Reports Business Budgeting Chapter 8

A flexible budget is not based on only one level of activity Flexible Budgeting The accounting measurement tool used by most firms to both plan and control revenues and costs is referred to as a Flexible Budget. As a planning tool, flexible budgets are prepared to enable a firm to quantify expected results at different activity levels. As a control tool, flexible budgets are used to evaluate actual results by restating the original static budget figures to the actual level of activity achieved. A flexible budget is not based on only one level of activity Business Budgeting Chapter 8

Example Data Solution The flexible budget relates to both revenues as well as costs. In fact, it is in the area of costs where flexible budgeting is used extensively as both a planning and control tool. Business Budgeting Chapter 8

Classification of costs (a) Fixed Those costs which remain constant irrespective of the level of activity attained (b) Variable Those costs that vary according to changes in the level of activity The "flex" in a flexible budget concerns the variable costs (that is, those costs that vary with changes in activity levels) whereas the budget for fixed costs is static. Flexible Budget Formula: Flexible Budget Formula = Fixed Cost + (Variable Cost per Unit x Activity) Business Budgeting Chapter 8

Flexible Budgeting for Service Organisations Service organisations are dependent upon the quantity of services that can be provided for their income and are usually labour intensive. In developing budgets it is necessary to: (a) Estimate the level of operations expected to be achieved in the coming period as measured in physical activities which is then related to dollar measures of sales revenue. (b) Quantify the costs and expenses that are expected to be incurred at the expected level of operations. It is important to have a breakdown of costs into variable and fixed categories so as to facilitate budget preparation at varying activity levels. Business Budgeting Chapter 8

Using a Flexible Budget Example The following information relates to the budget of operations for the coming year for Green and Gold Design Co. Required: Based on the information above, prepare an Income Statement Budget using flexible techniques, assuming the company has chargeable hours of: (a) 10,000 hours, and (b) 15,000 hours. Business Budgeting Chapter 8

Solution Business Budgeting Chapter 8

Flexible Budgeting for Trading Operations Trading (retail or wholesale) organisations are in the business of purchasing and selling tangible items or products referred to as Inventory or Stock. When preparing budgets for trading organisations Forecast revenue based on the development of pricing structures to be used for pricing the organisation’s products. Forecast the cost of goods sold (also referred to as Cost of Sales). Forecast other variable costs. Forecast fixed costs associated with running the business. Business Budgeting Chapter 8

Flexible Budgeting Techniques applied to Trading Organisations Example Business Budgeting Chapter 8

Business Budgeting Chapter 8

Flexible Budgeting for Manufacturing Operations Firms which produce or manufacture goods for resale are the most complex form of business organisation. The Manufacturing Firm incurs costs for: Direct Materials classified as a variable cost. Direct Labour classified as a variable cost. Factory Overhead which has both a fixed and variable component. Factory overhead is comprised of all factory costs other than direct materials and direct labour. Variable manufacturing costs vary in proportion to units manufactured Business Budgeting Chapter 8

Flexible Budgeting for Manufacturing Operations Non Manufacturing costs include: Selling Expenses which have both fixed and variable components. Administration Expenses which are mainly fixed in nature. Financial Expenses which relate to financing costs predominantly fixed in nature. Variable Expenses vary in proportion to units sold. Business Budgeting Chapter 8

The Contribution Concept Contribution Margin per unit = Selling Price ‑ Variable Cost The contribution margin can relate to both: • Total sales revenue less total variable cost i.e. total Contribution Margin, and • Sales revenue per unit less variable cost per unit i.e. Contribution Margin per unit. The former is the total contribution margin, whereas the latter is the contribution margin per unit. Business Budgeting Chapter 8

The Contribution Concept Example Calculating profit using contribution margin A company produces a single product. Cost and revenue details are as follows: Required: Determine profit using Contribution Margin. Business Budgeting Chapter 8

The Contribution Concept Solution Business Budgeting Chapter 8

Flexible Budgeting applied to Manufacturing Organisation Example Dwide Manufacturing Company has accumulated the following revenue, cost and expense figures in relation to expected operations for the coming year. You as the accountant have been asked to prepare forecast Statements of Financial Performance using flexible budget techniques and incorporating the following information. All units are sold when manufactured due to the highly perishable nature of the company’s product. As such there are no inventories of raw materials, work in process or finished goods on hand. Business Budgeting Chapter 8

Flexible Budgeting applied to Manufacturing Organisation Example The selling price of the company’s single product is $50.00 and the expected sales quantity for the coming year is in the vicinity of 10,000 and 15,000 units. Required: Prepare a Income Statement budget using flexible budgeting techniques at production and sales levels of: (a) 10,000 units (b) 15,000 units Business Budgeting Chapter 8

Flexible Budgeting applied to Manufacturing Organisation Solution (a) (b) Business Budgeting Chapter 8

Performance Reporting Actual results achieved are compared with the Master (Static) Budget to enable the determination of variances. Revenue Variances Favourable Revenue Variance: If actual sales revenue is greater than budgeted sales revenue, this is a favourable variance. Unfavourable Revenue Variance: If actual sales revenue is less than budgeted sales revenue, this is an unfavourable variance. Business Budgeting Chapter 8

Performance Reporting Cost Variances Favourable Cost Variance: If actual costs and expenses are less than budgeted costs and expenses, this is classified as a favourable variance. Unfavourable Cost Variance: If actual costs and expenses are greater than budgeted costs and expenses, this is classified as an unfavourable variance. Business Budgeting Chapter 8

Effect of variances on budgeted operating profits These terms describe the impact of the variance on the budgeted operating profits- F (favourable) variances increase operating profits U (unfavourable) variances decrease operating profits Business Budgeting Chapter 8

Measurement and Disclosure of Variances Variances may be measured and disclosed in two ways: The absolute size of the variance, namely, the difference between actual results attained and the original master budget, and (b) Percentage analysis, where the absolute size of the variance is divided by the budget amount. The use of percentage analysis enables the comparison of two divisions which are not equal in size or operating characteristics. Business Budgeting Chapter 8

Comparison of Actual Results with the Master Budget At the end of an accounting period actual results should be compared to the budget. Efficiencies or inefficiencies are measured by the resultant variances ( if any ). This is referred to as responsibility accounting. Business Budgeting Chapter 8

Responsibility Centres Revenue Centre. Cost Centre. Profit Centre. Investment Centre. Business Budgeting Chapter 8

Management by Exception Management by exception is where the manager is notified only if there are variances that are significantly larger than expected. Under this principal the manager is not notified if all is well and things are going to plan. Variance analysis is an important investigative tool to help guide the firm to take corrective action in those areas where there are problems as indicated by the size of the variance. Business Budgeting Chapter 8

Horizontal Trend Analysis Analysis involves comparing a base year with future years and measuring the percentage change. Workings: • Between 2012 and 2013 sales increased 20% (i.e. $20,000 / $100,000). • Between 2012 and 2013 expenses increased 33⅓% (i.e. $20,000 / $60,000). Business Budgeting Chapter 8

Vertical Trend Analysis Vertical Trend Analysis involves comparing expenses against sales and measuring the percentage change. The sales are always considered 100 percent. Example Workings: • Between 2012 and 2013 expenses increased 6⅔% as a percentage of sales. • Between 2012 and 2014 expenses increased 20% as a percentage of sales. Business Budgeting Chapter 8

Flexible Budgeting applied to a Manufacturing Organisation Example For the current year’s operations, the following schedule summarising the budgeted and actual results has been prepared: Required: (a) Calculate appropriate variances for revenue and cost items and signify whether each variance is favourable or unfavourable. (b) For each variance calculate the percentage variation, by dividing the variance by the budget amount. Business Budgeting Chapter 8

Flexible Budgeting applied to a Manufacturing Organisation Solution: Business Budgeting Chapter 8

Monitoring and Modifying the Budget The process of setting and reviewing budgets involves ongoing forecasting and performance analysis. Reports compiled are useful not just in forecasting future revenues and expenses, but provide valuable information to other stakeholders Business Budgeting Chapter 8

Monthly and Year-to-Date Performance Analysis When preparing budgets and performance reports most firms prepare annual operating budgets broken down into 12 monthly periods to more accurately predict revenues and costs to take into account monthly and seasonal variations. It is also possible to analyse the operations for the business on a cumulative basis where the year to date budgets are compared to the year to date actual variance. Business Budgeting Chapter 8

Example- Report comparing Actual to Budget COGO Trading has just finalised the preparation of the actual monthly figures for February, 2012 and the accountant has provided the following information in relation to February Budget and Actual and year-to-date Budget and Actual: Business Budgeting Chapter 8

Example continued Business Budgeting Chapter 8 Required: Prepare a report comparing Actual to Budget for both the: (a) February and (b) Year-to-date figures which will disclose relevant variances for revenue and cost items and signify whether the variance is favourable or unfavourable. Business Budgeting Chapter 8

Solution-Report comparing Actual to Budget The above performance report may be shown in various forms. For example: (a) The revenue items are analysed separately from the variable and fixed expenses. (b) The inclusion of a percentage analysis column will show relative differences, to alert management to investigate all variances favourable and unfavourable that exceed 10%. Note that each variance has to have signified whether it is favourable or unfavourable. Remember that: (a) For revenue items, where actual exceed budget the variance is favourable, for cost items, where actual exceed budget the variance is unfavourable; and (b) For revenue items, where actual is less than budget the variance is unfavourable, for cost items, where actual is less than budget the variance is favourable. Business Budgeting Chapter 8

The External Environment The ability of a business to perform in accordance with a predetermined budget can be impacted by factors outside of the business's control. A situation analysis is an investigation of an organisation in order to understand the business’s capabilities, customers and current business environment. Business Budgeting Chapter 8

The External Environment The situation analysis is often conducted using a PESTLE Analysis. PESTLE stands for: Political Economic Sociological Technological Legal and Environmental Business Budgeting Chapter 8

Political Factors Political factors represent government policies and influences on an industry Examples of political factors include: The degree of government intervention in the economy (taxation rates and expenditure). The extent to which the Government believes in subsidising firms. Government priorities in terms of business support. Business Budgeting Chapter 8

Economic Factors Economic Growth Inflation Interest Rates Unemployment The Business Cycle Business Budgeting Chapter 8

Economic Factors The four phases of the business cycle are known as: Recession: Periods of low economic growth and high unemployment. Expansion: Economic growth is rising and unemployment is falling. Boom: Growth is high and unemployment is low, inflation may be high. Contraction: Growth begins to slow and unemployment rises Business Budgeting Chapter 8

Sociological Factors Population demographics, employment patterns and attitudes to work. • Public opinion and social attitudes Business Budgeting Chapter 8

Technological Factors Technological factors that businesses must consider include: • Impact of emerging technologies. • Impact of the internet, such as reduction in communications costs and increased remote working, online distribution, marketing and advertising. • Research & Development activity. Business Budgeting Chapter 8

Legal Factors Legal issues to be considered when budgeting include: • Taxation. • Industrial awards. • Occupational health and safety. • Licencing, permits and approvals. • Trademarks and patents. Business Budgeting Chapter 8

Environmental Factors For example: agriculture, tourism and even the retail industry are impacted by environmental Business Budgeting Chapter 8

Budget Involvement Participation Feedback Setting Budgetary (and Standard) Goals Business Budgeting Chapter 8