Flexible Budgets and Performance Analysis

Basic Variance Analysis Cycle

• Prepare a performance report (budget vs. actual report).
• Analyze variances (differences from the budget) and raise questions.
• Find the root cause of variances and develop solutions or adjust the budget for the next period.

Static Budget (Planning Budget)

• Based on a certain planned level of sales or activity.
• Performance evaluation is difficult if actual activity differs from the planned level.

Flexible Budget

• Prepared for any activity level within the relevant range.
• Shows costs that should have been incurred at the actual level of activity.
• Enables an "apples to apples" cost comparison, unlike comparing a static budget to actual results (which is like comparing "apples to oranges").
• Helps managers better control costs and understand variances.
• If our sales exceeded the budget, we would expect that certain expenses are gonna be over budget.

Example: Larry's Lawn Service

• Larry prepared his June budget based on mowing 500 lawns.
• The number of lawns mowed measures overall activity.
• Revenue: 75q (where q = quantity of lawns).
• Wages: 5,000 + 30q (mixed cost: fixed component + variable component).
• Gas and Supplies: 9q (purely variable expense).
• Equipment Maintenance: 3q.
• Fixed Costs: Office/shop utilities, rent, depreciation, insurance.
• Planned Budget: 500 lawns, $32,500 total expenses, $5,000 operating income.
• Actual Results: 550 lawns, $6,004.50 net operating income.

Initial Comparison: Actual vs. Static Budget

• Reveals variances (favorable or unfavorable).
• Favorable variance: Actual revenue > planned revenue (good for revenue accounts).
• Unfavorable variance: Actual expense > planned expense (bad for expense accounts).
• Deficiencies of the static budget: It doesn't explain why variances occurred.
• It is necessary to discern how much of the cost variances are due to higher activity and how much are due to cost control.

Flexible Budget Explained

• Total variable costs change in direct proportion to changes in activity.
• Total fixed costs remain unchanged within the relevant range.

Larry's Lawn Service Flexible Budget

• Uses the same revenue and cost formulas as the static budget.
• Inputs the actual level of activity (550 lawns).
• Revenue: 75
  eq 550 = $41,250.
• Wages: 5,000 + (30
  eq 550).
• Variable expenses increase due to higher activity (higher q).
• Fixed costs remain the same.

Example Question

• What would the total wages and salaries cost be if the flexible budget was for 600 lawns?
• 5,000 + (30
  eq 600) = $23,000

Activity Variance

• Arises solely due to the difference between the actual level of activity and the level of activity from the planning budget.
• Compares the flexible budget to the planning budget.
• For Larry's Lawn Service: Compares the flexible budget based on 550 lawns to the planning budget based on 500 lawns.
• Example: An increase in activity causes an unfavorable expense variance given the variable expenses will go up as a consequence of the increase.
• Key point – we’re hopping the increase activity causes total revenue to exceed expenses i.e. 50 more lawns will lead to more money!
• If activity and revenue increased by 10%, net operating income increases by more than that due to fixed costs.

Revenue and Spending Variances

• Revenue Variance: Difference between actual revenue and flexible budget revenue.
• Spending Variance: Difference between actual cost and flexible budget cost.
• Compare actual results with the flexible budget.
• Isolates revenue and spending variances separately from activity variances.
• Reveals whether extra revenues make up for cost overruns.
• Revenue spending variance = + favorable numbers – unfavorable ones. With a higher level of activity, firms may not do a great job controlling the consequences, leading to an unfavorable variance.
• This process helps firms isolate whether the success came from good, strategic control of costs.

Performance Report

• Combines activity variances with revenue and spending variances.
• Typical Format:
  • Actual results compared to the flexible budget --> Revenue and spending variance.
  • Flexible budget compared to the planning budget --> Activity variance.
• Overall variance broken down into activity and revenue/spending components.

Performance Reports in Non-Profit Organizations

• More complex due to unpredictable and inconsistent funding inflows.
• Funding sources include state funding (mixed), tuition/fees (variable), donations/endowments (tricky to predict).
• Budgeting and performance reports are still important.

Performance Reports for Cost Centers

• Focus on managing costs within a department.
• Compares activity and spending variances.
• Isolates the impact of changes in activity levels versus cost control efforts.

Flexible Budget with Multiple Cost Drivers

• More than one cost driver may be needed to explain costs.
• Cost formulas in the flexible budget can be adjusted.
• Example: Larry adds hours for edging and trimming as a second cost driver (h).
  • Revenue: 75q + 25h.
  • Wage & Salary, Gas and Supplies, and other expense formulas would also be updated to factor in these different costs.

Common Errors in Performance Reports

• Assuming all costs are fixed or all costs are variable.

Assuming All Costs are Fixed

• Comparing the planning budget to actual results.
• Faulty analysis because it doesn't account for changes in activity level.
• Results in an "apples to oranges" comparison.

Assuming All Costs are Variable

• Multiplying the planning budget by the percentage change in activity.
• Doesn't factor in fixed costs.
• Also faulty analysis.

Key Takeaways

• Focus on the format of comparing actual vs. flexible (revenue/spending variances) and flexible vs. planning (activity variances).
• Breaks down the total variance into activity and cost control components.