Flexible budgets and control - Flexing to actual activity le...

Learning Outcomes

After reading this article, you will be able to explain why flexible budgets provide superior control over fixed budgets, particularly when actual activity levels differ from original estimates. You will understand how to adjust (or "flex") a budget to the actual output, distinguish between variable, fixed, and semi-variable costs, and use flexed budgets to interpret cost variances. This knowledge is key for producing insightful budgetary control statements in the ACCA exam.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how businesses apply flexible budgeting for effective performance control, especially when operating at different activity levels than originally planned.

• Explain why flexible budgets offer better control compared to fixed budgets.
• Identify situations where flexible or fixed budgets would be appropriate.
• Adjust (“flex”) a budget to match actual activity volume.
• Analyse cost behavior (fixed, variable, semi-variable) for flexible budgeting.
• Prepare and interpret control reports including flexed budgets.
• Calculate and interpret cost variances using flexed (not fixed) budgets.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary reason a fixed budget is unsuitable for control if actual activity levels vary?
2. When actual output is below budget, how should the budgeted variable costs be adjusted for variance analysis?
3. Classify the following costs as fixed, variable, or semi-variable:
   • Machine maintenance charges (base monthly fee plus charge per machine hour)
   • Rent of production facility
   • Raw material usage
4. True or false? A flexed budget adjusts both fixed and variable costs for the actual output achieved.
5. If actual labour costs are $25,000 and flexed budget labour costs at actual production are $23,000, what is the direct labour variance?

Introduction

Budgets are essential planning and control tools for any organisation. Typically, a budget is set for a specific planned level of output. However, actual activity seldom matches the budget precisely. To enable proper control, it is necessary to compare like with like: expected costs and revenues for the actual activity achieved, not the original planned level.

This is where flexible budgets are extremely valuable. A flexible budget is designed to change (or "flex") in line with actual activity, distinguishing between fixed, variable, and semi-variable costs. Comparing actual results to a flexed budget allows meaningful performance evaluation.

Key Term: Flexible budget
A budget that adjusts costs and revenues to the actual level of activity achieved, allowing for meaningful performance comparison and variance analysis.

The Limitations of Fixed Budgets

A fixed budget is prepared for only one level of activity, usually the expected or most likely output. However, if actual output differs, any variance analysis will include differences due purely to operating at a different scale, not to fundamental efficiency or inefficiency.

Fixed budgets:

• Are suitable only when actual output matches budget exactly.
• Can mislead management by attributing all cost differences to performance, ignoring the effect of changed activity levels.
• Cannot distinguish volume variances from genuine cost overruns.

Worked Example 1.1

A company budgets to produce 1,000 units. The fixed budget for direct materials is $7,000. Actual production is 800 units and material costs are $5,800.

Question: Is comparing actual costs to the fixed budget appropriate? If not, what should be compared?

Answer:
No, because the actual costs relate to only 800 units, not 1,000. The flexed budget for 800 units should be used for comparison, not the original fixed budget.

Cost Behaviour in Flexible Budgeting

To flex a budget accurately, you must split costs according to their behavior:

• Variable costs: Change in direct proportion to activity (e.g., materials, piecework labour).
• Fixed costs: Remain unchanged within a relevant range, regardless of output (e.g., rent, salaried supervisors).
• Semi-variable costs: Contain both elements. Requires separation into fixed and variable components, often using the high-low method.

Key Term: Cost behaviour
The way in which a cost reacts to changes in the level of activity or volume.

Flexing a Budget — The Process

To prepare a flexed budget for actual activity:

1. Identify all costs as variable, fixed, or semi-variable.
2. Calculate the total variable cost based on actual output (Budgeted variable cost per unit × actual units).
3. Keep total fixed costs unchanged.
4. For semi-variable costs, separate into fixed and variable parts and recalculate as above.

Worked Example 1.2

Budgeted costs at 2,000 units:

• Direct materials: $5 per unit
• Wages: $8 per unit
• Factory rent: $6,000 (fixed)
• Machine maintenance: $1,000 fixed + $0.50 per unit

Actual output: 1,800 units

Question: Flex the budget for actual output.

Answer:

• Direct materials: 1,800 × $5 = $9,000
• Wages: 1,800 × $8 = $14,400
• Factory rent: $6,000
• Machine maintenance: $1,000 + (1,800 × $0.50) = $1,900 Total flexed budget = $9,000 + $14,400 + $6,000 + $1,900 = $31,300

Comparing Actual to Flexed Budget

Only after flexing the budget can you compare each actual cost to what it should have been for the level of activity achieved. This isolates operational variances and helps management take corrective action.

Variance = Actual cost − Flexed budget cost

Worked Example 1.3

Using the previous example, if the actual costs were:

• Direct materials: $9,500
• Wages: $14,800
• Factory rent: $6,000
• Machine maintenance: $1,950

Question: Calculate the variance for each cost.

Answer:

• Direct materials: $9,500 − $9,000 = $500 (Adverse)
• Wages: $14,800 − $14,400 = $400 (Adverse)
• Factory rent: $6,000 − $6,000 = $0 (No variance)
• Machine maintenance: $1,950 − $1,900 = $50 (Adverse)

Reporting Variances: The Budgetary Control Statement

The variances found allow you to focus attention on areas needing management action. A sample control statement is shown below:

Key Term: Variance analysis
The process of evaluating differences between actual and budgeted results to assess performance and identify the causes.

When to Use Fixed vs Flexible Budgets

• Use fixed budgets for planning, or where cost behaviour is mostly fixed and activity does not vary significantly.
• Use flexible budgets for control in operational environments where output fluctuates, making it critical to compare like with like.

Exam Warning

Comparing actual costs to a fixed budget (when output differs) can lead to incorrect conclusions about efficiency. Always flex the budget for meaningful variance analysis.

Revision Tip

As you prepare for your exam, practice flexing budgets using both variable and semi-variable costs. Ensure you can quickly distinguish cost types.

Summary

Flexible budgets allow true performance measurement by comparing actual results to what costs and revenues should have been, given actual activity levels. Understanding cost behaviour is essential. This approach improves control and supports corrective management action.

Key Point Checklist

This article has covered the following key knowledge points:

• Describe the limitations of fixed budgets for control purposes.
• Identify and classify variable, fixed, and semi-variable costs.
• Flex a budget to the actual output level.
• Prepare a budgetary control statement using flexed budgets.
• Calculate and interpret variances using flexed budgets.
• Distinguish between appropriate use of fixed and flexible budgets.

Key Terms and Concepts

• Flexible budget
• Cost behaviour
• Variance analysis