7.1: The Performance Report

Flexible Budget A flexible budget is a budget prepared using the ACTUAL level of production instead of the budgeted activity. The difference between actual costs incurred and the flexible budget amount for that same level of operations is called a budget variance. Budget variances can indicate a department’s or company’s degree of efficiency, since they emerge from a comparison of what was with what should have been. The performance report shows the budget variance for each line item.

A flexible budget allows volume differences to be removed from the analysis since we are using the same actual level of activity for both budget and actual. How can we do this? We will need to determine the budgeted variable cost per unit for each variable cost. Budgeted fixed costs would remain the same because they do not change based on volume.

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To illustrate the computation of budget variances, assume that Leed’s management prepared an overhead budget based on an expected volume of 100% capacity, or 25,000 units. At this level of production, the budgeted amount for supplies is a variable cost at $0.08 per unit for a total of $2,000 (25,000 units x $0.08). By the end of the period, Leed has used $1,900 of supplies. Our first impression is that a favorable variance of $100 exists ($1,900 actual amount is less than the $2,000 budget amount).

However, if Leed’s actual production for the period was only 22,500 units (90% of capacity), the company would have an unfavorable variance of $100. Why? Because at 90% capacity of 22,500 units, the flexible operating budget for supplies would be $1,800 (22,500 units x $0.08). The $1900 actual supplies used is $100 more than the flexible budget amount of $1,800. Consequently, it appears that Leed used supplies inefficiently.

To give another example using the data in Exhibit 6, Leed’s management may have budgeted maintenance at USD 5,600 for a given period assuming the company planned to produce 20,000 units (80 per cent of operating capacity). However, Leed’s actual maintenance costs may have been USD 6,200 for the period. This result does not necessarily mean that Leed had an unfavorable variance of USD 600. The variance depends on actual production volume.

Assume once again that Leed actually produced 22,500 units during the period. The company had budgeted maintenance costs at USD 6,300 for that level of production. Therefore, there would actually be a favorable variance of USD 100 (USD 6,300 – USD 6,200).

Flexible budgets often show budgeted amounts for every 10 per cent change in the level of operations, such as at the 70 per cent, 80 per cent, 90 per cent, and 100 per cent levels of capacity. However, actual production may fall between the levels shown in the flexible budget. If so, the company can find the budgeted amounts at that level of operations using the following formula:

Budgeted amount = Budgeted fixed portion of costs + [Budgeted variable portion of cost per unit X Actual units of output]

Flexible operating budget and budget variances illustrated As stated earlier, a flexible operating budget provides detailed information about budgeted expenses at various levels of activity. The main advantage of using a flexible operating budget along with a planned operating budget is that management can appraise performance on two levels. First, management can compare the actual results with the planned operating budget, which enables management to analyze the deviation of actual output from expected output. Second, given the actual level of operations, management can compare actual costs at actual volume with budgeted costs at actual volume. The use of flexible operating budgets gives a valid basis for comparison when actual production or sales volume differs from expectations.

Using the data from Exhibit 3, Exhibit 7 and Exhibit 8, present Leed’s detailed planned operating budget and flexible operating budget for the quarter ended 2010 March 31. The planned operating budget was based on a sales forecast of 20,000 units and a production forecast of 25,000 units. Exhibit 7 and Exhibit 8 show actual sales of 19,000 units and actual production of 25,000 units. (As is typically the case, the budgeted and actual amounts are not equal.) The actual selling price was USD 20 per unit, the same price that management had forecasted.

Leed Company
Comparison of planned operating budget and actual results
For quarter ended 2010 March 31
	Planned budget	Actual
Sales (budgeted 20,000 units, actual 19,000 units)	$400,000	$380,000
Cost of goods sold:
Beginning finished goods inventory	$130,000	$130,000
Cost of goods manufactured (25,000 units):
Direct materials	$ 50,000	$ 62,500
Direct labor	150,000	143,750
Variable manufacturing overhead	25,000	31,250
Fixed manufacturing overhead	75,000	75,000
Cost of goods manufactured	$300,000	$312,500
Cost of goods available for sale	$430,000	$442,500
Ending finished goods inventory	180,000	200,000
Cost of goods sold	$250,000	$242,500
Gross margin	$150,000	$137,500
Selling and administrative expenses:
Variable	$ 40,000	$ 28,500
Fixed	100,000	95,000
Total selling and administrative expenses	$ 140,000	$123,500
Income before income taxes	$ 10,000	$ 14,000
Deduct: Estimated income taxes (40%)	4,000	5,600
Net income	$ 6,000	$ 8,400

Exhibit 7: Leed Company: Comparison of planned operating budget and actual results

In Exhibit 7 we compare the actual results with the planned operating budget. Comparison of actual results with the planned operating budget yields some useful information because it shows where actual performance deviated from planned performance. For example, sales were 1,000 units lower than expected, sales revenue was USD 20,000 less than expected, gross margin was USD 12,500 less than expected, and net income was USD 2,400 more than expected.

The comparison of actual results with the planned operating budget does not provide a basis for evaluating whether or not management performed efficiently at the actual level of operations. For example, in Exhibit 7, the cost of goods sold was USD 7,500 less than expected. The meaning of this difference is not clear, however, because the actual cost of goods sold relates to the 19,000 units actually sold, while the planned cost of goods sold relates to the 20,000 units expected.

A company makes a valid analysis of expense controls by comparing actual results with a flexible operating budget based on the levels of sales and production that actually occurred. Exhibit 8 shows the comparison of Leed’s flexible operating budget with the actual results. Note that the flexible budget in Exhibit 8 is made up of several pieces. The flexible budget amounts for sales revenue and selling and administrative expenses come from a flexible sales budget (not shown) for 19,000 units of sales.

LeedCompany
Comparison of flexible operating budget and actual results
For quarter ended 2010 March 31
	Flexible budget	Actual	Budget variance over (under)
Sales (19,000 units)	$ 380,000	$ 380,000	$ -0-
Cost of goods sold:
Beginning finished goods inventory	$ 130,000	$ 130,000	$ -0-
Cost of goods manufactured (25,000 units):
Direct materials	$ 50,000	$ 62,500	$ (12,500)
Direct labor	150,000	143,750	(6,250)
Variable manufacturing overhead	25,000	31,250	6,250
Fixed manufacturing overhead	75,000	75,000	-0-
Cost of goods manufactured)	$300,000	$312,500	$ 12,500
Cost of goods available for sale	$430,000	$442,500	$ 12,500
Ending finished goods inventory	192,000	200,000	8,000
Cost of goods sold (19,000 units)	$238,000	$242,500	$ 4,500
Gross margin	$ 142,000	$ 137,500	$ (4,500)
Selling and administrative expenses:
Variable	$ 38,000	$ 28,500	$ (9,500)
Fixed	100,000	95,000	(5,000)
Total selling and administrative expenses	$138,000	$123,500	$ (14,500)
Income before income taxes	$ 4,000	$ 14,000	$ 10,000
Deduct: estimated taxes (40%)	1,600	5,600	4,000
Net income	$ 2,400	$ 8,400	$ 6,000

Exhibit 8: Leed Company: Comparison of flexible operating budget and actual results

In comparisons such as these, if the number of units produced is equal to the number sold, many companies do not show their beginning and ending inventories in their flexible operating budgets. Instead, the flexible operating budget may show the number of units actually sold multiplied by the budgeted unit cost of direct materials, direct labor, and manufacturing overhead. This budget also shows actual costs for direct materials, direct labor, and manufacturing overhead for the number of units sold.

The comparison of the actual results with the flexible operating budget (Exhibit 8) reveals some inefficiencies for items in the cost of goods manufactured section. For instance, direct materials and variable overhead costs were considerably higher than expected. Direct labor costs, on the other hand, were somewhat lower than expected. Both variable and fixed selling and administrative expenses were lower than expected. Net income was USD 6,000 more than expected at a sales level of 19,000 units.

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