FLEXIBLE BUDGETING EXAMPLE
To illustrate the shortcoming of fixed budgeting in a dynamic environment, consider the following paradox facing a recreational vehicle company’s manufacturing manager. His fixed budget states that direct and indirect labor is budgeted as follows for the month of June:
Direct labor budget $500,000
Indirect labor budget $100,000
This budget was made based on an assumed manufacturing volume of 100 motor homes. When June finally ends, he manufacturing manager notes the following statistics:
Motor Homes Built 95
Actual Direct Labor Expense $487,500
Actual Indirect Labor Expense $97,500
Even though the manager has kept his labor costs under the original fixed budget, his assumption of production volume was inaccurate. This inaccuracy taints any comparison of actual and budget amounts. At first it may seem that he should be lauded for keeping these expenses under the fixed budget amounts. But examination of a broader picture—an income statement showing budget versus actual performance—would reveal that sales and profit goals were off for the month of June. This can be directly attributed to both the shortfall in volume (100 budgeted versus 95 actual) and the higher cost per unit than was actually expected. This higher per unit cost is a result of the manufacturing manager's unfavorable performance—a fact not made evident by his performance against the fixed budget!
To circumvent this problem, management must use a flexible budget that is based on units of production.
Direct labor budget $5,000 x Number of Units Produced
Indirect labor budget $5,000 x Number of Units Produced
Using the actual manufacturing volume of 95 mobile homes produces a flexible budget that has more meaning when compared with actual performance:
|
|
Fixed Budget |
Flexible Budget |
Actual
|
Variance
(Flexible vs. Actual) |
|
Production Volume |
100 |
|
95 |
(5) |
|
Direct Labor Budget |
500,000 |
475,000 |
487,500 |
(12,500) |
|
Indirect Labor Budget |
100,000 |
95,000 |
97,500 |
(2,500) |
As this example indicates, flexible budgeting enables a true measure of performance to be achieved: the variance indicates that the manufacturing manager controlled labor expenses unfavorably for the month and that perhaps marketing did not get enough orders to require the budgeted production volume.
Note that most flexible budgeting reports will also show the fixed budget alongside to indicate how performance fared against the overall target. The variance is always shown as the difference between the flexible budget and actual performance.
Political Considerations. The primary benefit to flexible budgeting is that it allows the separation of costs into areas of responsibility that are accountable to individual budget managers. Flexible budgeting can identify areas of inefficiency that had otherwise been masked by a fixed budget. Because of this, some people in the organization may resist the implementation of a flexible budget. Often these are the same people that are operating the inefficient departments and are hiding their inefficiencies in the fixed budget.
TIMING ISSUES
Often the business volume indicator that is driving the flexible budget is not available until after the end of the month. In the earlier example, production volumes for each month would not be known until the end of the month. This may present a problem if it is desirable to prepare budget reports ahead of time to show department managers what their flexible budget is for the coming months.
To circumvent this, it is possible to forecast the business volume indicator's performance for the coming period(s) and use this forecast to prepare a forecasted flexible budget. This may be done on a monthly basis by rolling the forecast forward each month to predict the coming month's volume. A large health maintenance organization uses this technique to prepare monthly a flexible budget based on their four-month forecast of membership, which is revised each month. The membership forecast feeds the budgeting system, which produces flexible budgets for each budget manager. This way the budget managers can see what is expected of them at the onset of each new period.
This approach gives rise to a related problem: should the budget managers be evaluated based on their adherence to the forecasted flexible budget or on the actual flexible budget available at the end of the period? The answer depends on the budge manager's ability to detect and react to the forecast error. Often he has no ability to control costs in time to react to any forecast error. Quite likely he may even have no ability to measure the forecast error. In these cases he should be evaluated based on his adherence to the forecast-based flexible budget.
NEXT MONTH'S TOPIC: ZERO-BASE BUDGETING
Material in this chapter has been adapted and reprinted with the permission of Warren, Gorham & Lamont, Inc., from Chapter 43, “Automated Budget Systems,” in Budgeting and Profit Planning Manual, 2nd edition, by James D. Willson. Copyright 1983, 1989 by Warren, Gorham & Lamont, Inc. 210 South Street, Boston, MA 02111. All rights reserved.