7.4 Prepare Flexible Budgets

Flexible budgets adjust for actual activity levels, providing a more accurate basis for performance evaluation. They help managers distinguish between volume-related variances and other factors affecting performance, making them crucial for effective cost control and decision-making.

Understanding cost behavior is key to creating flexible budgets. By identifying fixed and variable costs, managers can adjust budgets for different production levels, enabling more precise comparisons between actual results and expectations.

Flexible Budgets

Flexible budgets for sales volumes

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• Flexible budgets adjust budgeted amounts based on actual activity levels enables more accurate performance evaluation by considering changes in volume (sales or production)
• Steps to create a flexible budget:
  1. Determine the budgeted variable cost per unit and total fixed costs
  2. Multiply the actual sales or production volume by the budgeted variable cost per unit to calculate total variable costs
  3. Add the total budgeted fixed costs to the total variable costs calculated in step 2
• Comparing actual results to the flexible budget helps identify variances due to factors other than changes in volume provides insight into the efficiency and effectiveness of operations (cost control, pricing strategies)
• Budget performance reports compare actual results to flexible budget figures, highlighting variances for management review

Static vs flexible budgets

• Static budgets prepared for a single level of activity do not adjust for changes in actual sales or production volume useful for planning and setting initial expectations (revenue targets, cost limits) limited usefulness in performance evaluation when actual volume differs from budgeted volume
• Flexible budgets adjust budgeted amounts based on actual activity levels provide a more relevant comparison to actual results help distinguish between volume variances and other factors affecting performance (material prices, labor rates) more useful for performance evaluation when actual volume differs from budgeted volume
• Flexible budgets are an essential tool in responsibility accounting, allowing managers to be evaluated based on factors within their control

Budget adjustments for production levels

• Identifying fixed and variable costs:
  • Fixed costs remain constant within a relevant range, regardless of changes in activity level (rent, depreciation, salaries)
  • Variable costs change in direct proportion to changes in activity level (direct materials, direct labor, variable overhead)
• Adjusting budgets for different production levels involves multiplying the budgeted variable cost per unit by the actual production volume while fixed costs remain the same
• Calculating the total flexible budget:
  • Sum of the adjusted variable costs and the fixed costs
  • $Total\,flexible\,budget = (Budgeted\,variable\,cost\,per\,unit \times Actual\,production\,volume) + Total\,fixed\,costs$
  • Example: If budgeted variable cost per unit is $10, actual production volume is 1,000 units, and total fixed costs are$5,000, then: $Total\,flexible\,budget = ($10 \times 1,000,units) + $5,000 =$15,000$

Understanding Cost Behavior and Budgeting

• Cost behavior refers to how costs change in response to changes in activity levels
• The relevant range is the range of activity within which cost behavior patterns are expected to hold true
• Master budget is a comprehensive financial plan that includes various sub-budgets (e.g., sales budget, production budget, operating budget)
• Budget variance is the difference between actual results and budgeted amounts, which can be analyzed to improve future performance