Flexible Budgets and

Performance Analysis
Chapter 10

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 1

Prepare a flexible budget.

McGraw-Hill/Irwin Slide 2
 Characteristics of Flexible Budgets

Hmm! Comparing
static planning budgets
Planning budgets with actual costs
are prepared for is like comparing
a single, planned apples and oranges.
level of activity.
Performance
evaluation is difficult
when actual activity
differs from the
planned level of
activity.
McGraw-Hill/Irwin Slide 3
 Characteristics of Flexible Budgets

May be prepared for any activity

level in the relevant range.

Show costs that should have been

incurred at the actual level of
activity, enabling “apples to apples”
cost comparisons.

Help managers control costs.

Improve performance evaluation.

Let’s look at Larry’s Lawn Service.
McGraw-Hill/Irwin Slide 4
 Deficiencies of the Static Planning Budget

Larry’s
Larry’s Lawn
Lawn Service
Service provides
provides lawn
lawn care
care inin aa planned
planned
community
community where
where allall lawns
lawns are
are approximately
approximately the the same
same size.
size.
At
At the
the end
end ofof May,
May, Larry
Larry prepared
prepared his his June
June budget
budget based
based onon
mowing
mowing 500500 lawns.
lawns. Since
Since all
all of
of the
the lawns
lawns are
are similar
similar in
in size,
size,
Larry
Larry felt
felt that
that the
the number
number of of lawns
lawns mowed
mowed in in aa month
month would
would
be
be the
the best
best way
way toto measure
measure overall
overall activity
activity for
for his
his business.
business.

Larry’s Budget
McGraw-Hill/Irwin Slide 5
 Deficiencies of the Static Planning Budget
Larry’s Planning Budget

McGraw-Hill/Irwin Slide 6
 Deficiencies of the Static Planning Budget
Larry’s Actual Results

McGraw-Hill/Irwin Slide 7
 Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget

McGraw-Hill/Irwin Slide 8
 Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
F = Favorable variance that occurs when actual
revenue is greater than budgeted revenue.

U = Unfavorable variance that occurs when

actual costs are greater than budgeted costs.

F = Favorable variance that occurs when

actual costs are less than budgeted costs.

McGraw-Hill/Irwin Slide 9
 Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget

Since 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?

McGraw-Hill/Irwin Slide 10
 Deficiencies of the Static Planning Budget

I don’t think I Actual activity is above

can answer the planned activity.
questions using
a static budget. So, shouldn’t the variable
costs be higher if actual
activity is higher?

McGraw-Hill/Irwin Slide 11
 Deficiencies of the Static Planning Budget

 The
The relevant
relevant question
question is
is .. .. ..
“How
“How much
much ofof the
the cost
cost variances
variances is
is due
due to
to higher
higher
activity,
activity, and
and how
how much
much is
is due
due to
to cost
cost control?”
control?”

 To
To answer
answer the
the question,
question,
we
we must
must
the
the budget
budget toto the
the
actual
actual level
level of
of activity
activity..

McGraw-Hill/Irwin Slide 12
 How a Flexible Budget Works

To a budget we need to know that:

 Total variable costs change
in direct proportion to
changes in activity.
 Total fixed costs remain ble
unchanged within the ar ia
V
relevant range. Fixed

McGraw-Hill/Irwin Slide 13
 How a Flexible Budget Works

Let’s prepare a
budget
for Larry’s Lawn
Service.

McGraw-Hill/Irwin Slide 14
 Preparing a Flexible Budget
Larry’s Flexible Budget

McGraw-Hill/Irwin Slide 15
 Quick Check 
What
What should
should thethe total
total wages
wages and
and salaries
salaries cost
cost
be
be in
in aa flexible
flexible budget
budget forfor 600
600 lawns?
lawns?
a.
a. $18,000
$18,000
b.
b. $20,000.
$20,000.
c.
c. $23,000.
$23,000.
d.
d. $25,000.
$25,000.

McGraw-Hill/Irwin Slide 16
 Quick Check 
What
What should
should the be
be the
the total
the total
total wages
total
wageswages
and
andand
wages salaries
and salaries
salaries cost
salaries
cost
cost
be
cost
be in
ininaaaflexible
in flexible
aflexible budget
flexible budget
budget
budgetforfor
for 600
for 600
600 lawns?
600 lawns?
lawns?
lawns?
a.
a. $18,000
$18,000
b.
b. $20,000.
$20,000.
c.
c. $23,000.
$23,000.
d.
d. $25,000.
$25,000.

Total wages and salaries cost

= $5,000 + ($30 per lawn  600 lawns)
= $5,000 + $18,000 = $23,000

McGraw-Hill/Irwin Slide 17
 Learning Objective 2

Prepare a report showing

activity variances.

McGraw-Hill/Irwin Slide 18
 Activity Variances

Planning Flexible
budget revenues budget revenues
and expenses and expenses

The differences between

the budget amounts are
called activity variances.
McGraw-Hill/Irwin Slide 19
 Activity Variances

Let’s use budgeting

concepts to compute activity
variances for Larry’s Lawn Service.

McGraw-Hill/Irwin Slide 20
 Activity Variances
Larry’s Flexible Budget Compared with the Planning Budget

McGraw-Hill/Irwin Slide 21
 Activity Variances
Larry’s Flexible Budget Compared with the Planning Budget
Activity and revenue increase by 10 percent, but net operating income
increases by more than 10 percent due to the presence of fixed costs.

McGraw-Hill/Irwin Slide 22
 Learning Objective 3

Prepare a report showing

revenue and spending
variances.

McGraw-Hill/Irwin Slide 23
 Revenue and Spending Variances

Flexible budget revenue Actual revenue

The difference is a revenue variance.

Flexible budget cost Actual cost

The difference is a spending variance.

McGraw-Hill/Irwin Slide 24
 Revenue and Spending Variances

Now, let’s use budgeting

concepts to compute revenue and
spending variances for Larry’s Lawn
Service.

McGraw-Hill/Irwin Slide 25
 Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
$1,750 favorable
revenue variance

McGraw-Hill/Irwin Slide 26
 Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
Spending
variances

McGraw-Hill/Irwin Slide 27
 Learning Objective 4

Prepare a performance report

that combines activity
variances and revenue and
spending variances.

McGraw-Hill/Irwin Slide 28
 A Performance Report Combining Activity
and Revenue and Spending Variances

Now, let’s use budgeting

concepts to combine the revenue and
spending variances reports for Larry’s
Lawn Service.

McGraw-Hill/Irwin Slide 29
 A Performance Report Combining Activity
and Revenue and Spending Variances

McGraw-Hill/Irwin Slide 30
 A Performance Report Combining Activity
and Revenue and Spending Variances

50
50 lawns
lawns ×× $75
$75 per
per lawn
lawn 50
50 lawns
lawns ×× $30
$30 per
per lawn
lawn

McGraw-Hill/Irwin Slide 31
 A Performance Report Combining Activity
and Revenue and Spending Variances

$43,000
$43,000 actual
actual -- $41,250
$41,250 budget
budget

McGraw-Hill/Irwin Slide 32
 Performance Reports in Non-Profit
Organizations

Non-profit
Non-profit organizations
organizations may
may receive
receive funding
funding from
from
sources other
other than the sale of goods and
and services,
services,
so
so revenues
revenues may
may consist
consist of
of both
both fixed
fixed and
and
variable
variable elements.
elements.

State funding Donations

Tuition and fees Endowments

Universities
McGraw-Hill/Irwin Slide 33
 Performance Reports in Cost Centers

Performance reports are often prepared

for cost centers. These reports should be
prepared using the same principles
discussed so far, except for the fact that
these reports will not contain revenue or
net operating income variances.

McGraw-Hill/Irwin Slide 34
 Learning Objective 5

Prepare a flexible budget

with more than one cost
driver.

McGraw-Hill/Irwin Slide 35
 Flexible Budgets with Multiple Cost Drivers

More than one cost

driver may be needed to
adequately explain all of
the costs in an organization.

The cost formulas used

to prepare a flexible
budget can be adjusted
to recognize multiple
cost drivers.

McGraw-Hill/Irwin Slide 36
 Flexible Budgets with Multiple Cost Drivers

Because
Because ofof the
the large
large unfavorable
unfavorable wages
wages and
and salaries
salaries spending
spending
variance,
variance, Larry
Larry decided
decided toto add
add an
an additional
additional cost
cost driver
driver for
for
wages
wages and
and salaries.
salaries. The
The variance
variance is
is due
due primarily
primarily toto the
the number
number
of
of hours
hours required
required for
for the
the additional
additional edging
edging and
and trimming.
trimming. So So
Larry
Larry estimates
estimates the
the additional
additional hours
hours and
and builds
builds those
those hours
hours into
into
both
both his
his revenue
revenue and
and expense
expense budget
budget formulas.
formulas.

Larry’s New Budget

McGraw-Hill/Irwin Slide 37
 Flexible Budgets with Multiple Cost Drivers
Larry’s Budget Based on More than One Cost Driver

McGraw-Hill/Irwin Slide 38
 Learning Objective 6

Understand common errors

made in preparing
performance reports based on
budgets and actual results.

McGraw-Hill/Irwin Slide 39
 Some Common Errors

The
The most
most common
common errors
errors in
in preparing
preparing performance
performance
reports
reports are
are to
to implicitly
implicitly assume
assume that:
that:
1.
1. All
All costs
costs are
are fixed
fixed or
or that
2.
2. All costs
costs are
are variable.
variable.

Assume all costs are fixed.

McGraw-Hill/Irwin Slide 40
 Common Error 1: Assuming All Costs Are
Fixed
Faulty Analysis Comparing Budgeted Amounts to Actual Amounts

McGraw-Hill/Irwin Slide 41
 Common Error 2: Assuming All Costs Are
Variable
Faulty Analysis that Assumes All budget Items Are Variable

McGraw-Hill/Irwin Slide 42
 End of Chapter 10

McGraw-Hill/Irwin Slide 43