Construct a flexible budget performance report

Required Assignment 2—Manufacturing Budget Analysis

Chapter 9 Flexible Budgets and Performance Analysis

LEARNING OBJECTIVES

After studying Chapter 9 , you should be able to:

· LO1 Prepare a flexible budget.

· LO2 Prepare a report showing activity variances.

· LO3 Prepare a report showing revenue and spending variances.

· LO4 Prepare a performance report that combines activity variances and revenue and spending variances.

· LO5 Prepare a flexible budget with more than one cost driver.

· LO6 Understand common errors made in preparing performance reports based on budgets and actual results.

BUSINESS FOCUS: The Inevitability of Forecasting Errors

While companies derive numerous benefits from planning for the future, they must be able to respond when actual results deviate from the plan. For example, just two months after telling Wall Street analysts that it would break even for the first quarter of 2005, General Motors (GM) acknowledged that its actual sales were far less than its original forecast and the company would lose $850 million in the quarter. For the year, GM acknowledged that projected earnings would be 80% lower than previously indicated. The company's stock price dropped by $4.71.

When a company's plans deviate from its actual results, managers need to understand the reasons for the deviations. How much is caused by the fact that actual sales differ from budgeted sales? How much is caused by the actions of managers? In the case of GM, the actual level of sales is far less than the budget, so some actual costs are likely to be less than originally budgeted. These lower costs do not signal managerial effectiveness. This chapter explains how to analyze the sources of discrepancies between budgeted and actual results.▪

Source: Alex Taylor III, “GM Hits the Skids,” Fortune, April 4, 2005, pp. 71–74.

In the last chapter we explored how budgets are developed before a period begins. Budgeting involves a lot of time and effort and the results of the budgeting process should not be shoved into a filing cabinet and forgotten. To be useful, budgets should provide guidance in conducting actual operations and should be part of the performance evaluation process. However, managers need to be very careful about how budgets are used. In government, budgets often establish how much will be spent, and indeed, spending more than was budgeted may be a criminal offense. That is not true in other organizations. In for-profit organizations, actual spending will rarely be the same as the spending that was budgeted at the beginning of the period. The reason is that the actual level of activity (such as unit sales) will rarely be the same as the budgeted activity; therefore, many actual costs and revenues will naturally differ from what was budgeted. Should a manager be penalized for spending 10% more than budgeted for a variable cost like direct materials if unit sales are 10% higher than budgeted? Of course not. In this chapter we will explore how budgets can be adjusted so that meaningful comparisons to actual costs can be made.

Flexible Budgets

LEARNING OBJECTIVE 1

Prepare a flexible budget.

Characteristics of a Flexible Budget

The budgets that we explored in the last chapter were planning budgets. A planning budget is prepared before the period begins and is valid for only the planned level of activity. A static planning budget is suitable for planning but is inappropriate for evaluating how well costs are controlled. If the actual level of activity differs from what was planned, it would be misleading to compare actual costs to the static, unchanged planning budget. If activity is higher than expected, variable costs should be higher than expected; and if activity is lower than expected, variable costs should be lower than expected.

Flexible budgets take into account how changes in activity affect costs. A flexible budget is an estimate of what revenues and costs should have been, given the actual level of activity for the period. When a flexible budget is used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period rather than to the static planning budget. This is a very important distinction. If adjustments for the level of activity are not made, it is very difficult to interpret discrepancies between budgeted and actual costs.

IN BUSINESS: WHY DO COMPANIES NEED FLEXIBLE BUDGETS?

The difficulty of accurately predicting future financial performance can be readily understood by reading the annual report of any publicly traded company. For example Nucor Corporation, a steel manufacturer headquartered in Charlotte, North Carolina, cites numerous reasons why its actual results may differ from expectations, including the following: (1) the supply and cost of raw materials, electricity, and natural gas may change unexpectedly; (2) the market demand for steel products may change; (3) competitive pressures from imports and substitute materials may intensify; (4) uncertainties regarding the global economy may affect customer demand; (5) changes to U.S. and foreign trade policy may alter current importing and exporting practices; and (6) new government regulations could significantly increase environmental compliance costs. Each of these factors could cause static budget revenues and/or costs to differ from actual results.

Source: Nucor Corporation 2004 annual report, p. 3.

Deficiencies of the Static Planning Budget

To illustrate the difference between a static planning budget and a flexible budget, consider Rick's Hairstyling, an upscale hairstyling salon located in Beverly Hills that is owned and managed by Rick Manzi. The salon has very loyal customers—many of whom are associated with the film industry. Recently Rick has been attempting to get better control of his revenues and costs, and at the urging of his accounting and business adviser, Victoria Kho, he has begun to prepare monthly budgets. Victoria Kho is an accountant in independent practice who specializes in small service-oriented businesses like Rick's Hairstyling.

At the end of February, Rick prepared the March budget that appears in Exhibit 9–1 . Rick believes that the number of customers served in a month is the best way to measure the overall level of activity in his salon. He refers to these visits as client-visits. A customer who comes into the salon and has his or her hair styled is counted as one client-visit.

EXHIBIT 9–1 Planning Budget

Note that the term revenue is used in the planning budget rather than sales. We use the term revenue throughout the chapter because some organizations have sources of revenue other than sales. For example, donations, as well as sales, are counted as revenue in nonprofit organizations.

Rick has identified eight major categories of costs—wages and salaries, hairstyling supplies, client gratuities, electricity, rent, liability insurance, employee health insurance, and miscellaneous. Client gratuities consist of flowers, candies, and glasses of champagne that Rick gives to his customers while they are in the salon.

Working with Victoria, Rick had already estimated a cost formula for each cost. For example, they determined that the cost formula for electricity should be $1,500 + $0.10 q, where q equals the number of client-visits. In other words, electricity is a mixed cost with a $1,500 fixed element and a $0.10 per client-visit variable element. Once the budgeted level of activity was set at 1,000 client-visits, it was easy to compute the budgeted amount for each line item in the budget. For example, using the cost formula, the budgeted cost for electricity was set at $1,600 (= $1,500 + $0.10 × 1,000).

At the end of March, Rick found that his actual profit was $21,230 as shown in the income statement in Exhibit 9–2 . It is important to realize that the actual results are not determined by plugging the actual number of client-visits into the revenue and cost formulas. The formulas are simply estimates of what the revenues and costs should be for a given level of activity. What actually happens usually differs from what is supposed to happen.

EXHIBIT 9–2 Actual Results—Income Statement

Referring back to Exhibit 9–1 , the budgeted net operating income was $16,800, so the actual profit was substantially higher than planned at the beginning of the month. This was, of course, good news, but Rick wanted to know more. Business was up by 10%—the salon had 1,100 client-visits instead of the budgeted 1,000 client-visits. Could this alone explain the higher net income? The answer is no. An increase in net operating income of 10% would have resulted in net operating income of only $18,480 (= 1.1 × $16,800), not the $21,230 actually earned during the month. What is responsible for this better outcome? Higher prices? Lower costs? Something else? Whatever the cause, Rick would like to know the answer and then hopefully repeat the same performance next month.

In an attempt to analyze what happened in March, Rick prepared the report comparing actual to budgeted costs that appears in Exhibit 9–3 . Note that most of the variances in this report are labeled unfavorable (U) rather than favorable (F) even though net operating income was actually higher than expected. For example, wages and salaries show an unfavorable variance of $4,900because the budget called for wages and salaries of $102,000, whereas the actual wages and salaries expense was $106,900. The problem with the report, as Rick immediately realized, is that it compares revenues and costs at one level of activity (1,000 client-visits) to revenues and costs at a different level of activity (1,100 client-visits). This is like comparing apples to oranges. Because Rick had 100 more client-visits than expected, some of his costs should be higher than budgeted. From Rick's standpoint, the increase in activity was good and should be counted as a favorable variance, but the increase in activity has an apparently negative impact on most of the costs in the report. Rick knew that something would have to be done to make the report more meaningful, but he was unsure of what to do. So he made an appointment to meet with Victoria Kho to discuss the next step.

EXHIBIT 9–3 Comparison of Static Planning Budget to Actual Results

MANAGERIAL ACCOUNTING IN ACTION

The Issue

· Victoria: How is the budgeting going?

· Rick: Pretty well. I didn't have any trouble putting together the budget for March. I also prepared a report comparing the actual results for March to the budget, but that report isn't giving me what I really want to know.

· Victoria: Because your actual level of activity didn't match your budgeted activity?

· Rick: Right. I know the level of activity shouldn't affect my fixed costs, but we had more client-visits than I had expected and that had to affect my other costs.

· Victoria: So you want to know whether the higher actual costs are justified by the higher level of activity?

· Rick: Precisely.

· Victoria: If you leave your reports and data with me, I can work on it later today, and by tomorrow I'll have a report to show you.

How a Flexible Budget Works

A flexible budget approach recognizes that a budget can be adjusted to show what costs should befor the actual level of activity. To illustrate how flexible budgets work, Victoria prepared the report in Exhibit 9–4 that shows what the revenues and costs should have been given the actual level of activity in March. Preparing the report is straightforward. The cost formula for each cost is used to estimate what the cost should have been for 1,100 client-visits—the actual level of activity for March. For example, using the cost formula $1,500 + $0.10 q, the cost of electricity in March should have been $1,610 (= $1,500 + $0.10 × 1,100).

EXHIBIT 9–4 Flexible Budget Based on Actual Activity

We can see from the flexible budget that the net operating income in March should have been $30,510, but recall from Exhibit 9–2 that the net operating income was actually only $21,230. The results are not as good as we thought. Why? We will answer that question shortly.

To summarize to this point, Rick had budgeted for a profit of $16,800. The actual profit was quite a bit higher—$21,230. However, given the amount of business in March, the profit should have been even higher—$30,510. What are the causes of these discrepancies? Rick would certainly like to build on the positive factors, while working to reduce the negative factors. But what are they?

Flexible Budget Variances

To answer Rick's questions concerning the discrepancies between budgeted and actual costs, we will need to break down the variances shown in Exhibit 9–3 into two types of variances—activity variances and revenue and spending variances. We do that in the next two sections.

Activity Variances

LEARNING OBJECTIVE 2

Prepare a report showing activity variances.

Part of the discrepancy between the budgeted profit and the actual profit is due to the fact that the actual level of activity in March was higher than expected. How much of this discrepancy was due to this single factor? The report in Exhibit 9–5 is designed to answer this question. In that report, the planning budget from the beginning of the period is compared to the flexible budget based on the actual level of activity for the period. The planning budget shows what should have happened at the budgeted level of activity whereas the flexible budget shows what should have happened at the actual level of activity. Therefore, the differences between the planning budget and the flexible budget show what should have happened solely because the actual level of activity differed from what had been expected.

EXHIBIT 9–5 Activity Variances from Comparing the Planning Budget to the Flexible Budget Based on Actual Activity

For example, the budget based on 1,000 client-visits shows revenue of $180,000 (= $180 per client-visit × 1,000 client-visits). The flexible budget based on 1,100 client-visits shows revenue of $198,000(= $180 per client-visit × 1,100 client-visits). Because the salon had 100 more client-visits than anticipated in the budget, actual revenue should have been higher than budgeted revenue by $18,000 (= $198,000 − $180,000). This activity variance is shown on the report as $18,000 F(favorable). Similarly, the budget based on 1,000 client-visits shows electricity costs of $1,600 (= $1,500 + $0.10 per client-visit × 1,000 client-visits). The flexible budget based on 1,100 client-visits shows electricity costs of $1,610 (= $1,500 + $0.10 per client-visit × 1,100 client-visits). Because the salon had 100 more client-visits than anticipated in the budget, actual electricity costs should have been higher than budgeted costs by $10 (= $1,610 − $1,600). The activity variance for electricity is shown on the report as $10 U (unfavorable). Note that in this case, the label “unfavorable” may be a little misleading. Costs should be $10 higher for electricity simply because business was up by 100 client-visits; therefore, is this variance really unfavorable if it was a necessary cost of serving more customers? For reasons such as this, we would like to caution you against assuming that unfavorable variances always indicate bad performance and favorable variances always indicate good performance.

Because all of the variances on this report are solely due to the difference in the level of activity between the planning budget from the beginning of the period and the actual level of activity, they are called activity variances. For example, the activity variance for revenue is $18,000 F, the activity variance for electricity is $10 U, and so on. The most important activity variance appears at the very bottom of the report; namely, the $13,710 F (favorable) variance for net operating income. This variance says that because activity was higher than expected in the planning budget, the net operating income should have been $13,710 higher. We caution against placing too much emphasis on any other single variance in this report. As we have said above, one would expect some costs to be higher as a consequence of more business. It is misleading to think of these unfavorable variances as indicative of poor performance.

On the other hand, the favorable activity variance for net operating income is important. Let's explore this variance a bit more thoroughly. First, as we have already noted, activity was up by 10%, but the flexible budget indicates that net operating income should have increased much more than 10%. A 10% increase in net operating income from the $16,800 in the planning budget would result in net operating income of $18,480 (= 1.1 × $16,800); however, the flexible budget shows much higher net operating income of $30,510. Why? The short answer is: Because of the presence of fixed costs. When we apply the 10% increase to the budgeted net operating income to estimate the profit at the higher level of activity, we implicitly assume that the revenues and all of the costs increase by 10%. But they do not. Note that when the activity level increases by 10%, three of the costs—rent, liability insurance, and employee health insurance—do not increase at all. These are all purely fixed costs. So while sales do increase by 10%, these costs do not increase. This results in net operating income increasing by more than 10%. A similar effect occurs with the mixed costs which contain fixed cost elements—wages and salaries, electricity, and miscellaneous. While sales increase by 10%, these mixed costs increase by less than 10%, resulting in an overall increase in net operating income of more than 10%. Because of the existence of fixed costs, net operating income does not change in proportion to changes in the level of activity. There is a leverage effect. The percentage changes in net operating income are ordinarily larger than the percentage increases in activity.

Revenue and Spending Variances

LEARNING OBJECTIVE 3

Prepare a report showing revenue and spending variances.

In the last section we answered the question “What impact did the change in activity have on our revenues, costs, and profit?” In this section we will answer the question “How well did we control our revenues, our costs, and our profit?”

Recall that the flexible budget based on the actual level of activity in Exhibit 9–4 shows what should have happened given the actual level of activity. If we compare this flexible budget to actual results, we compare what should have happened to what actually happened. This is done in Exhibit 9–6 .

EXHIBIT 9–6 Revenue and Spending Variances from Comparing the Flexible Budget to the Actual Results

IN BUSINESS: STATE OF THE UNION SPEECH HURTS CORPORATE JET INDUSTRY

In December 2008, Detroit auto executives flew private corporate jets to Washington D.C. to plead for billions of taxpayer dollars to save their companies. The public outcry was loud and clear: How could companies on the verge of bankruptcy afford to transport their executives in private corporate jets? One month later President Obama's State of the Union speech included criticism of CEOs who “disappear on a private jet.”

The impact of these events on the corporate jet manufacturing industry was swift and severe.Dassault Aviation had 27 more order cancellations than new orders in the first quarter of 2009.Cessna Aircraft had 92 first-quarter order cancellations and laid off 42% of its workforce. Approximately 3,100 jets flooded the resale market compared to 1,800 jets for resale in the first quarter of the prior year. The CEO of Cessna and the president of Gulfstream Aerospace went to the White House in May 2009 to seek an end to the rhetoric that was destroying their sales.

These facts illustrate how an activity variance can be affected by uncontrollable events. The actual first-quarter sales at these companies were substantially lower than their budgeted sales due to reasons that they could not foresee or control.

Source: Carol Matlack, “Public Flak Grounds Private Jets,” BusinessWeek, June 8, 2009, p. 13.

Focusing first on revenue, the flexible budget indicates that, given the actual level of activity, revenue should have been $198,000. However, actual revenue totaled $194,200. Consequently, revenue was $3,800 less than it should have been, given the actual number of client-visits for the month. This discrepancy is labeled as a $3,800 U (unfavorable) variance and is called a revenue variance. A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue. If actual revenue exceeds what the revenue should have been, the variance is labeled favorable. If actual revenue is less than what the revenue should have been, the variance is labeled unfavorable. Why would actual revenue be less than or more than it should have been, given the actual level of activity? Basically, the revenue variance is favorable if the average selling price is greater than expected; it is unfavorable if the average selling price is less than expected. This could happen for a variety of reasons including a change in selling price, a different mix of products sold, a change in the amount of discounts given, poor accounting controls, and so on.

Focusing next on costs, the flexible budget indicates that electricity costs should have been $1,610for the 1,100 client-visits in March. However, the actual electricity cost was $1,550. Because the cost was $60 less than we would have expected for the actual level of activity during the period, it is labeled as a favorable variance, $60 F. This is an example of a spending variance. By definition, a spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost. If the actual cost is greater than what the cost should have been, the variance is labeled as unfavorable. If the actual cost is less than what the cost should have been, the variance is labeled as favorable. Why would a cost have a favorable or unfavorable variance? There are many possible explanations including paying a higher price for inputs than should have been paid, using too many inputs for the actual level of activity, a change in technology, and so on. In the next chapter we will delve into this topic in greater detail.

Note from Exhibit 9–6 that the overall net operating income variance is $9,280 U (unfavorable). This means that given the actual level of activity for the period, the net operating income was $9,280 lower than it should have been. There are a number of reasons for this. The most prominent is the unfavorable revenue variance of $3,800. Next in line is the $2,360 unfavorable variance for client gratuities. Looking at this in another way, client gratuities were more than 50% larger than they should have been according to the flexible budget. This is a variance that Rick would almost certainly want to investigate further. Rick may directly control the client gratuities himself. If not, he may want to know who authorized the additional expenditures. Why were they so large? Was more given away than usual? If so, why? Were more expensive gratuities given to clients? If so, why? Note that this unfavorable variance is not necessarily a bad thing. It is possible, for example, that more lavish use of gratuities led to the 10% increase in client-visits.

A Performance Report Combining Activity and Revenue and Spending Variances

LEARNING OBJECTIVE 4

Prepare a performance report that combines activity variances and revenue and spending variances.

Exhibit 9–7 displays a performance report that combines the activity variances (from Exhibit 9–5 ) with the revenue and spending variances (from Exhibit 9–6 ). The report brings together information from those two earlier exhibits in a way that makes it easier to interpret what happened during the period. The format of this report is a bit different from the format of the previous reports in that the variances appear between the amounts being compared rather than after them. For example, the activity variances appear between the planning budget amounts and the flexible budget amounts. In Exhibit 9–5 , the activity variances appeared after the planning budget and the flexible budget.

EXHIBIT 9–7 Performance Report Combining Activity Variances with Revenue and Spending Variances

Note two numbers in particular in the performance report—the activity variance for net operating income of $13,710 F (favorable) and the overall revenue and spending variance for net operating income of $9,280 U (unfavorable). It is worth repeating what those two numbers mean. The $13,710 favorable activity variance occurred because actual activity (1,100 client-visits) was greater than the budgeted level of activity (1,000 client-visits). The $9,280 unfavorable overall revenue and spending variance occurred because the profit was not as large as it should have been for the actual level of activity for the period. These two different variances mean very different things and call for different types of actions. To generate a favorable activity variance for net operating income, managers must take actions to increase client-visits. To generate a favorable overall revenue and spending variance, managers must take actions to protect selling prices, increase operating efficiency, and reduce the prices of inputs.

The performance report in Exhibit 9–7 provides much more useful information to managers than the simple comparison of budgeted to actual results in Exhibit 9–3 . In Exhibit 9–3 , the effects of changes in activity were jumbled together with the effects of how well prices were controlled and operations were managed. The performance report in Exhibit 9–7 clearly separates these effects, allowing managers to take a much more focused approach in evaluating operations.

To get a better idea of how the performance report accomplishes this task, look at hairstyling supplies in the performance report. In the planning budget, this cost was $1,500, whereas the actual cost for the period was $1,620. In the comparison of the planning budget to actual results in Exhibit 9–3 , this difference is shown as an unfavorable variance of $120. Exhibit 9–3 uses a static planning budget approach that compares actual costs at one level of activity to budgeted costs at a different level of activity. As we said before, this is like comparing apples to oranges. This variance is actually a mixture of two very different effects. This becomes clear in the performance report in Exhibit 9–7 . The difference between the budgeted amount and the actual results is composed of two different variances—an unfavorable activity variance of $150 and a favorable spending variance of$30. The activity variance occurs because activity was greater than anticipated in the planning budget, which naturally resulted in a higher total cost for this variable cost. The favorable spending variance occurred because less was spent on hairstyling supplies than one would have expected, given the actual level of activity for the month.

The flexible budget performance report in Exhibit 9–7 provides a more valid assessment of performance than simply comparing static planning budget costs to actual costs because actual costs are compared to what costs should have been at the actual level of activity. In other words, apples are compared to apples. When this is done, we see that the spending variance for hairstyling supplies is $30 F (favorable) rather than $120 U (unfavorable) as it was in the original static planning budget performance report (see Exhibit 9–3 ). In some cases, as with hairstyling supplies in Rick's report, an unfavorable static planning budget variance may be transformed into a favorable revenue or spending variance when an increase in activity is properly taken into account. The following discussion took place the next day at Rick's salon.

MANAGERIAL ACCOUNTING IN ACTION

The Wrap-up

· Victoria: Let me show you what I've got. [Victoria shows Rick the flexible budget performance report in Exhibit 9–7 .] I simply used the cost formulas to update the budget to reflect the increase in client-visits you experienced in March. That allowed me to come up with a better benchmark for what the costs should have been.

· Rick: That's what you labeled the “flexible budget based on 1,100 client-visits”?

· Victoria: That's right. Your original budget was based on 1,000 client-visits, so it understated what some of the costs should have been when you actually served 1,100 customers.

· Rick: That's clear enough. These spending variances aren't quite as shocking as the variances on my first report.

· Victoria: Yes, but you still have an unfavorable variance of $2,360 for client gratuities.

· Rick: I know how that happened. In March there was a big Democratic Party fundraising dinner that I forgot about when I prepared the March budget. To fit all of our regular clients in, we had to push them through here pretty fast. Everyone still got top-rate service, but I felt bad about not being able to spend as much time with each customer. I wanted to give my customers a little extra something to compensate them for the less personal service, so I ordered a lot of flowers, which I gave away by the bunch.

· Victoria: With the prices you charge, Rick, I am sure the gesture was appreciated.

· Rick: One thing bothers me about the report. When we discussed my costs before, you called rent, liability insurance, and employee health insurance fixed costs. How can I have a variance for a fixed cost? Doesn't fixed mean that it doesn't change?

· Victoria: We call these costs fixed because they shouldn't be affected by changes in the level of activity. However, that doesn't mean that they can't change for other reasons. Also, the use of the term fixed also suggests to people that the cost can't be controlled, but that isn't true. It is often easier to control fixed costs than variable costs. For example, it would be fairly easy for you to change your insurance bill by adjusting the amount of insurance you carry. It would be much more difficult for you to significantly reduce your spending on hairstyling supplies—a variable cost that is a necessary part of serving customers.

· Rick: I think I understand, but it is confusing.

· Victoria: Just remember that a cost is called variable if it is proportional to activity; it is called fixed if it does not depend on the level of activity. However, fixed costs can change for reasons unrelated to changes in the level of activity. And controllability has little to do with whether a cost is variable or fixed. Fixed costs are often more controllable than variable costs.

IN BUSINESS: HOTELS MANAGE REVENUE AND COST LEVERS AMID RECESSION

When the economy spiraled downward in 2009, it forced hotel chains to make tough decisions in an effort to achieve their profit goals. For example, Wyndham Hotels and Resorts decided to take sewing kits, mouthwash, and showercaps out of its rooms—instead, requiring customers to ask for these amenities at the front desk. Intercontinental Hotels Group stopped delivering newspapers to loyalty-program members' rooms; Marriott International cut back its breakfast offerings; and theRitz-Carlton reduced operating hours at its restaurants, spas, and retail shops. In addition, many hotel chains reduced their rental rates.

A flexible budget performance report can help hotel managers analyze how the changes described above impact net operating income. It isolates activity, revenue, and spending variances that help identify the underlying reasons for differences between budgeted and actual net operating income.

Source: Sarah Nassauer, “No Showercaps at the Inn,” The Wall Street Journal, January 22, 2009, pp. D1–D2.

Performance Reports in Nonprofit Organizations

The performance reports in nonprofit organizations are basically the same as the performance reports we have considered so far—with one prominent difference. Nonprofit organizations usually receive a significant amount of funding from sources other than sales. For example, universities receive their funding from sales (i.e., tuition charged to students), from endowment income and donations, and—in the case of public universities—from state appropriations. This means that, like costs, the revenue in governmental and nonprofit organizations may consist of both fixed and variable elements. For example, the Seattle Opera Company's revenue in a recent year consisted of grants and donations of $12,719,000 and ticket sales of $8,125,000 (or about $75.35 per ticket sold). Consequently, the revenue formula for the opera can be written as:

where q is the number of tickets sold. In other respects, the performance report for the Seattle Opera and other nonprofit organizations would be similar to the performance report in Exhibit 9–7 .

Performance Reports in Cost Centers

Performance reports are often prepared for organizations that do not have any source of outside revenue. In particular, in a large organization a performance report may be prepared for each department—including departments that do not sell anything to outsiders. For example, a performance report is very commonly prepared for production departments in manufacturing companies. Such reports should be prepared using the same principles we have discussed and should look very much like the performance report in Exhibit 9–7 —with the exception that revenue, and consequently net operating income, will not appear on the report. Because the managers in these departments are responsible for costs, but not revenues, they are often calledcost centers.

Flexible Budgets with Multiple Cost Drivers

LEARNING OBJECTIVE 5

Prepare a flexible budget with more than one cost driver.

At Rick's Hairstyling, we have thus far assumed that there is only one cost driver—the number of client-visits. However, in the activity-based costing chapter, we found that more than one cost driver might be needed to adequately explain all of the costs in an organization. For example, some of the costs at Rick's Hairstyling probably depend more on the number of hours that the salon is open for business than the number of client-visits. Specifically, most of Rick's employees are paid salaries, but some are paid on an hourly basis. None of the employees is paid on the basis of the number of customers actually served. Consequently, the cost formula for wages and salaries would be more accurate if it were stated in terms of the hours of operation rather than the number of client-visits. The cost of electricity is even more complex. Some of the cost is fixed—the heat must be kept at some minimum level even at night when the salon is closed. Some of the cost depends on the number of client-visits—the power consumed by hair dryers depends on the number of customers served. Some of the cost depends on the number of hours the salon is open—the costs of lighting the salon and heating it to a comfortable temperature. Consequently, the cost formula for electricity would be more accurate if it were stated in terms of both the number of client-visits and the hours of operation rather than just on the number of client-visits.

Exhibit 9–8 shows a flexible budget in which these changes have been made. In that flexible budget, two cost drivers are listed—client-visits and hours of operation—where q1 refers to client-visits andq2 refers to hours of operation. For example, wages and salaries depend on the hours of operation and its cost formula is Because the salon actually operated 185 hours, the flexible budget amount for wages and salaries is $105,700 (= $65,000 + $220 × 185). The electricity cost depends on both client-visits and the hours of operation and its cost formula is Because the actual number of client-visits was 1,100 and the salon actually operated for 185 hours, the flexible budget amount for electricity is $1,610 (= $390 + $0.10 × 1,100 + $6.00 × 185).

EXHIBIT 9–8 Flexible Budget Based on More than One Cost Driver

This revised flexible budget based on both client-visits and hours of operation can be used exactly like we used the earlier flexible budget based on just client-visits to compute activity variances as in Exhibit 9–5 , revenue and spending variances as in Exhibit 9–6 , and a performance report as in Exhibit 9–7 . The difference is that because the cost formulas based on more than one cost driver are more accurate than the cost formulas based on just one cost driver, the variances will also be more accurate.

IN BUSINESS: HOSPITALS TURN TO FLEXIBLE BUDGETS

Mary Wilkes, a senior managing director with Phase 2 Consulting, says that hospitals may have to pay as much as $300,000 to install a flexible budgeting system, but the investment should readily pay for itself by enabling “more efficient use of hospital resources, particularly when it comes to labor.” One of the keys to creating an effective flexible budgeting system is to recognize the existence of multiple cost drivers. Many hospitals frequently use patient volume as a cost driver when preparing flexible budgets; however, other variables can influence revenues and costs. For example, the percentage of patients covered by private insurance, Medicaid, or Medicare, as well as the proportion of uninsured patients all influence revenues and costs. A flexible budgeting system that incorporates patient volume and these other variables will be more accurate than one based solely on patient volume.

Source: Paul Barr, “Flexing Your Budget,” Modern Healthcare, September 12, 2005, pp. 24–26.

Some Common Errors

LEARNING OBJECTIVE 6

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

We started this chapter by discussing the need for managers to understand the difference between what was expected to happen—formalized by the planning budget—and what actually happened. To meet this need, we developed a flexible budget that allowed us to isolate activity variances and revenue and spending variances. Unfortunately, this approach is not always followed in practice—resulting in misleading and difficult-to-interpret reports. The most common errors in preparing performance reports are to implicitly assume that all costs are fixed or to implicitly assume that all costs are variable. These erroneous assumptions lead to inaccurate benchmarks and incorrect variances.

We have already discussed one of these errors—assuming that all costs are fixed. This is the error that is made when static planning budget costs are compared to actual costs without any adjustment for the actual level of activity. Such a comparison appeared in Exhibit 9–3 . For convenience, the comparison of budgeted to actual revenues and costs is repeated in Exhibit 9–9 . Looking at that exhibit, note that the budgeted cost of hairstyling supplies of $1,500 is directly compared to the actual cost of $1,620, resulting in an unfavorable variance of $120. But this comparison only makes sense if the cost of hairstyling supplies is fixed. If the cost of hairstyling supplies isn't fixed (and indeed it is not), one would expect the cost to go up because of the increase in activity over the budget. Comparing static planning budget costs to actual costs only makes sense if the cost is fixed. If the cost isn't fixed, it needs to be adjusted for any change in activity that occurs during the period.

EXHIBIT 9–9 Faulty Analysis Comparing Budgeted Amounts to Actual Amounts (Implicitly Assumes All Income Statement Items Are Fixed)

The other common error when comparing budgets to actual results is to assume that all costs are variable. A report that makes this error appears in Exhibit 9–10 . The variances in this report are computed by comparing actual results to the amounts in the second numerical column where all of the budget items have been inflated by 10%—the percentage by which activity increased. This is a perfectly valid adjustment to make if an item is strictly variable—like sales and hairstyling supplies. It is not a valid adjustment if the item contains any fixed element. Take, for example, rent. If the salon serves 10% more customers in a given month, would you expect the rent to increase by 10%? The answer is no. Ordinarily, the rent is fixed in advance and does not depend on the volume of business. Therefore, the amount shown in the second numerical column of $31,350 is incorrect, which leads to the erroneous favorable variance of $2,850. In fact, the actual rent paid was exactly equal to the budgeted rent, so there should be no variance at all on a valid report.

EXHIBIT 9–10 Faulty Analysis That Assumes All Budget Items Are Variable

IN BUSINESS: KNOW YOUR COSTS

Understanding the difference between fixed and variable costs can be critical. Kennard T. Wing, ofOMG Center for Collaborative Learning, reports that a large health care system made the mistake of classifying all of its costs as variable. As a consequence, when volume dropped, managers felt that costs should be cut proportionately and more than 1,000 people were laid off—even though “the workload of most of them had no direct relation to patient volume. The result was that morale of the survivors plummeted and within a year the system was scrambling to replace not only those it had let go, but many others who had quit. The point is, the accounting systems we design and implement really do affect management decisions in significant ways. A system built on a bad model of the business will either not be used or, if used, will lead to bad decisions.”

Source: Kennard T. Wing, “Using Enhanced Cost Models in Variance Analysis for Better Control and Decision Making,” Management Accounting Quarterly, Winter 2000, pp. 27–35.

Summary

Directly comparing static planning budget revenues and costs to actual revenues and costs can easily lead to erroneous conclusions. Actual revenues and costs differ from budgeted revenues and costs for a variety of reasons, but one of the biggest is a change in the level of activity. One would expect actual revenues and costs to increase or decrease as the activity level increases or decreases. Flexible budgets enable managers to isolate the various causes of the differences between budgeted and actual costs.

A flexible budget is a budget that is adjusted to the actual level of activity. It is the best estimate of what revenues and costs should have been, given the actual level of activity during the period. The flexible budget can be compared to the budget from the beginning of the period or to the actual results.

When the flexible budget is compared to the budget from the beginning of the period, activity variances are the result. An activity variance shows how a revenue or cost should have changed in response to the difference between budgeted and actual activity.

When the flexible budget is compared to actual results, revenue and spending variances are the result. A favorable revenue variance indicates that revenue was larger than should have been expected, given the actual level of activity. An unfavorable revenue variance indicates that revenue was less than it should have been, given the actual level of activity. A favorable spending variance indicates that the cost was less than expected, given the actual level of activity. An unfavorable spending variance indicates that the cost was greater than it should have been, given the actual level of activity.

A flexible budget performance report combines the activity variances and the revenue and spending variances on one report.

Common errors in comparing budgeted costs to actual costs are to assume all costs are fixed or to assume all costs are variable. If all costs are assumed to be fixed, the variances for variable and mixed costs will be incorrect. If all costs are assumed to be variable, the variances for fixed and mixed costs will be incorrect. The variance for a cost will only be correct if the actual behavior of the cost is used to develop the flexible budget benchmark.

Review Problem: Variance Analysis Using a Flexible Budget

Harrald's Fish House is a family-owned restaurant that specializes in Scandinavian-style seafood. Data concerning the restaurant's monthly revenues and costs appear below (q refers to the number of meals served):

Required:

· 1. Prepare the restaurant's planning budget for April assuming that 1,800 meals are served.

· 2. Assume that 1,700 meals were actually served in April. Prepare a flexible budget for this level of activity.

· 3. The actual results for April appear below. Prepare a flexible budget performance report for the restaurant for April.

Solution to Review Problem

· 1. The planning budget for April appears below:

· 2. The flexible budget for April appears below:

· 3. The flexible budget performance report for April appears below:

Glossary

Activity variance

The difference between a revenue or cost item in the static planning budget and the same item in the flexible budget. An activity variance is due solely to the difference between the level of activity assumed in the planning budget and the actual level of activity used in the flexible budget. (p. 389)

Flexible budget

A report showing estimates of what revenues and costs should have been, given the actual level of activity for the period. (p. 384)

Planning budget

A budget created at the beginning of the budgeting period that is valid only for the planned level of activity. (p. 384)

Revenue variance

The difference between how much the revenue should have been, given the actual level of activity, and the actual revenue for the period. A favorable (unfavorable) revenue variance occurs because the revenue is higher (lower) than expected, given the actual level of activity for the period. (p. 390)

Spending variance

The difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost. A favorable (unfavorable) spending variance occurs because the cost is lower (higher) than expected, given the actual level of activity for the period. (p. 391)

Questions

· 9–1 What is a static planning budget?

· 9–2 What is a flexible budget and how does it differ from a static planning budget?

· 9–3 What are some of the possible reasons that actual results may differ from what had been budgeted at the beginning of a period?

· 9–4 Why is it difficult to interpret a difference between how much expense was budgeted and how much was actually spent?

· 9–5 What is an activity variance and what does it mean?