Cost and Management Accounting

<<< Previous FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity Next >>>

Cost & Management Accounting (MGT-402)
VU
LESSON­ 36 & 37
FLEXIBLE BUDGET
When a company's activities can be estimated within close limits, the fixed budget is satisfactory.
However, completely predictable situations exist in only a few cases. If business conditions change
radically, causing actual operations to differ widely from fixed budget plans, this management tool
is not reliable or effective. The fact that costs and expenses are affected by fluctuations in volume
limits the use of the fixed budget and leads to the use of the flexible budget. To illustrate, the cost
of operating an automobile per mile depends on the number of miles driven. The more a car is
used per year, the more it costs to operate it but the less it costs per mile. If the owner prepares an
estimate of the total cost and compares actual expenses with the budget at year-end, success in
keeping expenses within the allowed limits cannot be determined without accounting for the
mileage factor. The reason for this lies in the nature of the expenses, some of which arc fixed while
others are variable or semi variable. Insurance, taxes, registration, and garaging are fixed costs,
which remain the same whether the car is operated 1,000 or 20.000 miles. The costs of tires, gas,
and repairs are variable costs, which depend largely upon the miles driven. Obsolescence and
depreciation result in a semi-variable cost. Which fluctuates to some degree but does not vary
directly with the usage of the car?
The underlying principle of a flexible budget is the need for some norm of expenditures for any
given volume of business. This norm should be known beforehand in order to provide a guide to
actual expenditures. To recognize this principle is to accept the fact that every business is dynamic,
ever changing, and never static. It is erroneous, if not futile, to expect a business lo conform to a
fixed, preconceived pattern.
The preparation of a flexible budget results from the development of formulas for each department
and for each account within a department or cost center. The formula for each account indicates
the fixed amount and/or a variable rate. The fixed amount and variable rate remain constant within
prescribed ranges of activity. The variable portion of the formula is a rate expressed in relation to a
base such as direct labor hours, direct labor cost or machine hours.
The application of the formulas to the level of activity actually experienced produces the allowable
expenditures for the volume of activity attained. These budget figures are compared with actual
costs in order to measure the performance of each department. This ready-made comparison
makes the flexible budget a valuable instrument for cost control, because it assists in evaluating the
effects of varying volumes of activity on profits and on the cash position,
Originally, the flexible budget idea was applied principally 10 the control of departmental factory
overhead. Now however, the idea is applied lo the entire budget. So that production as well as
marketing and administrative bud-gels is prepared on a flexible budget basis.
Capacity and volume
The discussion of the actual preparation of a flexible budget must be preceded by a basic
understanding of the term "capacity." The terms "capacity" and "volume" (or activity) are used in
connection with the construction and use of both fixed and flexible budgets. Capacity is that fixed
amount of '
"plant and machinery and number of personnel for which management has
committed itself and with which it expects to conduct the business. Volume is the variable factor
in business. It is related to capacity by the fact that volume (activity) attempts to make the best use
of existing capacity.
209
Cost & Management Accounting (MGT-402)
VU
Any budget is a forecast of sales, costs, and expenses. Material, labor, factory overhead, marketing
expenses, and administrative expenses must be brought into harmony with the sales volume. Sales
volume is measured not only by sales the market could absorb, but also by plant capacity and
machinery available to produce the goods. A plant or a department may produce the goods. A
plant or department may produce 1,000 units or work 10.000 hours, but this volume (or activity)
may not be ' compatible with the capacity of the plant or department. The production of
1.000'units or the working of 10.000 hours may be greater or smaller than the amount of sales the
company can safely expect to achieve in a given market during a given period.
The following terms are used in referring to capacity levels' theoretical practical, expected actual,
and normal. Current Internal Revenue Service regulations permit the use of practical, expected
actual or normal capacity in assigning factory overhead costs to inventories.
Theoretical Capacity. The theoretical capacity of a department is its capacity to produce at full
speed without interruptions. It is achieved if the plant-or department produces at 100 percent of its
rated capacity,
Practical Capacity. It is highly improbable that any company can operate at theoretical capacity.
Allowances must be made for unavoidable interruptions, such as time lost for repairs,
inefficiencies, breakdowns, setups. failures, unsatisfactory materials, delays in delivery of materials
or supplies, labor shortages and absences, Sundays, holidays, vacations, inventory taking, and pat-
tern and model changes. The number of work shifts must also be considered. These allowances
reduce theoretical capacity to the practical capacity level. This reduction is caused by internal
influences and does not consider the chief external cause, lack of customers' orders. Reduction
from theoretical to practical capacity typically ranges from 15 percent to 25 percent, which results
in a practical capacity level or 75 percent lo 85 percent of theoretical capacity.
Expected Actual Capacity. Expected actual capacity is based on a short-range outlook. The use
of expected actual capacity is feasible with firms whose products are of a seasonal natureČ and
market and style changes allow price adjustments according to competitive conditions and
customer demands.
Normal Capacity. Firms may modify the above capacity levels by considering the Utilization of
the plant or various departments in the light of meeting average sales demands over a period long
enough to level out the peaks and valleys which come with seasonal and cyclical variations. Finding
a satisfactory and logical balance between plant capacity and sales volume is one of the important
Once the normal (or average) capacity level has been established, overhead costs can be estimated
and factory overhead rates computed. The use of these rates will cause all overhead of the period
to be absorbed, provided normal capacity and normal expenses prevail during the period.
Purposes of Establishing Normal Capacity. Although there may be some differences between a
normal long-run volume and the sales volume expected in the next period, normal capacity is
useful in establishing sales prices and controlling costs. It is the basis for the entire budget system,
and it can be used for the following purposes and aims:
1. Preparation of departmental flexible budgets and computation of predetermined factory
2. Compilation of the standard cost of each product.
3. Scheduling production.
210
Cost & Management Accounting (MGT-402)
VU
4. Assigning cost to inventories.
5. Measurement of the effects of changing volumes of production.
6. Determination of the break-even point.
Although other capacity assumptions are sometimes used due to existing circumstances, normal
capacity fulfills both long- and short-term purposes. The long-term utilization of the normal
capacity level relates the marketing phase and therewith the pricing policy of the business 10 the
production phase over a long period of time, leveling out fluctuations that are of short duration
and of comparatively minor significance. The short-term utilization relates to management's
analysis of changes or fluctuations that occur during an operating year. This short-term utilization
measures temporary idleness and aids in an analysis of its causes.
Factors Involved in Determining Normal Capacity. In determining the normal capacity of a plant,
both its physical capacity and average sales expectancy must be considered; neither plant capacity
nor sales potential alone is sufficient. As previously mentioned, sales expectancy should be
determined for a period long enough to level out cyclical variations rather than on the sales
expectancy for a short period of time. It should also be noted that outmoded machinery and
machinery bought for future use must be excluded from the considerations which lead to the
determination of the normal capacity level-Calculation of the normal capacity of a plant requires
many different judgment factors. Normal capacity should be determined first for the business as a
whole and then broken down by plants and departments. Determination of a departmental
capacity figure might indicate that for a certain department the planned program is an overload
while in another ii will result in excess capacity. The capacities of several departments will seldom
be in such perfect balance as to produce an unhampered flow of production. For the department
with the overload, often termed the "bottleneck" department, actions such as the following might
have to be taken;
1.
Working overtime.
2.
3.
Temporarily transferring operations to another department where spare capacity is available.
4.