Budgeting is an essential part of planning, financial control, and performance management. It is a competency that must be acquired for anyone who is working in finance and accounting and is also a topic which is guaranteed to come up on your Performance Management (PM) exam. Expect to see it in Sections A or B, and there is a fair chance of it appearing in Section C, so you need to be ready to handle 20-mark questions from both a numerical and a discussion-based perspective. This series of articles will cover the budgeting approaches flexible budgeting, activity-based budgeting, rolling budgeting, zero-based budgeting, and beyond budgeting.
A flexible budget is a summary of revenues and costs across a range of different activity levels. So instead of looking at only one activity level (which is called a ‘fixed’ budget - you should remember this from your previous studies), various activity levels are considered. A critical aspect of this approach is to determine fixed and variable costs, which can then be expressed as a linear equation:
y = a + bx
Total cost (y) = Fixed cost (a) + (Variable cost per unit (b) * Activity level (x))
TC = FC + (VC * activity level)
With an understanding of revenue per unit and cost behaviours (ie fixed, variable, and stepped), financial results can then be budgeted within a range of activity levels.
You should be ready for complications on your PM exam, such as:
Ensure you know the difference between these terms. Flexible budgeting happens at the beginning of a budgeting period—revenue, costs, and profit are forecast across a range of activity levels. With this information, a flexed budget can then be created at the end of the budget period based on the actual activity level. This flexed budget becomes a core part of financial control when using standard costing—the flexed budget answers the question, “What should our financial results be at the actual activity level?”
For more on this topic, see the Standard Costing section of your study materials.
With flexible budgeting, managers will be able to plan and forecast more accurately. Performance management can be more meaningful as actual results can be easily compared to flexed results – total variances can then be calculated for each revenue and cost.
However, some businesses may have a high level of indirect costs, making it difficult to separate fixed and variable costs from total indirect costs.
Part 1
Corfe Co is a business which manufactures computer laptop batteries and it has developed a new battery which has a longer usage time than batteries currently available in laptops. The selling price of the battery is forecast to be $45. The maximum production capacity of Corfe Co is 262,500 units. The company’s management accountant is currently preparing an annual flexible budget and has collected the following information so far:
Production (units) | 185,000 | 200,000 | 225,000 |
|---|---|---|---|
| $ | $ | $ | |
| Material costs | 740,000 | 800,000 | 900,000 |
| Labour costs | 1,017,500 | 1,100,000 | 1,237,500 |
| Fixed costs | 750,000 | 750,000 | 750,000 |
In addition to the above costs, the management accountant estimates that for each increment of 50,000 units produced, one supervisor will need to be employed. A supervisor’s annual salary is $35,000.
Assuming the budgeted figures are correct, what would the flexed total production cost be if production is 80% of maximum capacity?
An 80% activity level is 210,000 units.
Material and labour are both variable costs. Material is $4 per unit and labour is $5.50 per unit, so total variable cost per unit is $9.50
Total variable costs = $9.50 x 210,000 units = $1,995,000
Fixed costs = $750,000
Supervision = $175,000 as five supervisors are required for a production level of 210,000 units.
Total annual budgeted cost allowance = $1,995,000 + $ 750,000 + $ 175,000 = $2,920,000
Part 2
The management accountant has said that a machine maintenance cost was not included in the flexible budget but needs to be taken into account.
The new battery will be manufactured on a machine currently owned by Corfe Co which was previously used for a product which has now been discontinued. The management accountant estimates that every 1,000 units will take 14 hours to produce. The annual machine hours and maintenance costs for the machine for the last four years have been as follows:
Machine time (hours) | Maintenance costs | |||
|---|---|---|---|---|
| $'000 | ||||
Year 1 | 5000 | 850 | ||
Year 2 | 4400 | 735 | ||
Year 3 | 4850 | 815 | ||
Year 4 | 1800 | 450 |
What is the estimated maintenance cost if production of the battery is 80% of the maximum capacity?
Variable cost per hour ($850,000 -$450,000)/(5,000 hours – 1,800 hours) = $125 per hour
Fixed cost ($850,000 – (5,000 x $125)) = $225,000
Number of machine hours required for production = 210 x 14 hours = 2,940 hours
Total cost ($225,000 + (2,940 x $125)) = $592,500, or $ 593,000 to the nearest $’000.
Written by Steve Willis, finance and accountancy trainer