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Accounting Principles II – Flexible Budgets and Standard Costs

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    Study Guide Accounting Principles II – Flexible Budgets and Standard Costs 1. Flexible Budgets A budget report compares what actually happened in a business to what was originally planned in the budget. It helps managers understand how well the company performed during a period, such as a month or a quarter. A typical budget report includes: • Actual amounts • Budgeted amounts • Variances (the differences between actual and budgeted figures) A variance can be favorable or unfavorable .

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    Study Guide 1. Understanding Favorable and Unfavorable Variances To decide whether a variance is favorable or unfavorable, always think about net income . • A favorable variance increases net income ○ Higher revenues than planned ○ Lower costs or expenses than planned • An unfavorable variance decreases net income ○ Lower revenues than planned ○ Higher costs or expenses than planned So: • Higher sales revenue → Favorable • Higher expenses or costs → Unfavorable Favorable variances are usually shown as positive numbers , while unfavorable variances are shown as negative numbers . Some textbooks also label variances with F or U to make them easier to identify. What Budget Reports Do (and Do Not) Show Budget reports clearly show where differences occurred , but they do not explain why those differences happened. Management uses budget reports to: • Identify unexpected results • Ask questions • Investigate causes • Decide if action is needed For example, when net income is lower than expected, management may ask: • Were more or fewer units sold than planned?

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    Study Guide • Was the selling price different? • Were costs higher than expected? 1. Analyzing the Pick Up Trucks Company Budget From the static budget report, actual net income is unfavorable compared to the budget. However, the report alone does not explain the reasons. Further analysis shows: • 17,500 trucks were sold instead of the planned 17,000 • The average selling price was $14.80 , not the expected $15.00 • The cost per truck was $11.25 , exactly as budgeted This tells management that: • Sales volume increased • Selling price decreased • Production costs were controlled 2. Static Budgets A static budget is prepared for one specific level of activity . It works best when: • Actual activity matches the planned activity, or • The budget is used mainly for fixed costs However, when actual activity is higher or lower than planned, static budgets make it difficult to evaluate cost control fairly. Why Flexible Budgets Are Needed A flexible budget adjusts budgeted amounts to match the actual level of activity . In simple terms, it answers the question: “What should the costs and revenues have been at the actual level of activity?”

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    Study Guide Another way to think about a flexible budget is that it is many static budgets , each prepared for a different activity level. Example: • A restaurant plans for 100 customers • Actually serves 300 customers • Managers should be evaluated using a budget prepared for 300 customers , not 100 This allows management to separate: • Performance due to volume changes • Performance due to cost control 3. Static vs. Flexible Budget: Pick Up Trucks Company The original budget report for Pick Up Trucks Company is a static budget because it was not adjusted for the higher sales volume. If the budget had been adjusted for the actual sales level of 17,500 trucks , the report would look like this:

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    Study Guide Interestingly, the flexible budget shows an even larger unfavorable variance than the static budget. This does not always happen, but it shows why flexible budgets are valuable — they highlight different questions management needs to investigate . 4. Preparation of a Flexible Budget When preparing a flexible budget: • Selling prices and cost assumptions stay the same • Variable costs remain variable • Fixed costs remain fixed • Only activity levels change

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    Study Guide Below is an explanation of each line item in the flexible budget. 5. Sales The original budget assumed: • 17,000 trucks × $15 = budgeted sales The flexible budget uses: • 17,500 trucks × $15 = $262,500 The remaining variance is due entirely to selling price , not volume. Because the variance is unfavorable, management knows the trucks were sold below the planned price . 6. Cost of Goods Sold The budgeted cost per truck was $11.25 . Flexible budget calculation: • 17,500 trucks × $11.25 = $196,875 There is no variance , which means production costs were exactly as planned. 7. Selling Expenses Selling expenses include both variable and fixed costs . Variable costs are recalculated: • Sales commissions: 4% × $262,500 = $10,500 • Delivery expense: 17,500 units × 10% = $1,750 Add fixed costs of $12,500 : • Flexible budget selling expenses = $24,750

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    Study Guide 8. General and Administrative Expenses These expenses are entirely fixed , so they do not change with activity level. Therefore, the flexible budget amount is the same as the original budget . 9. Income Taxes Income taxes are calculated as 40% of income before taxes . • Flexible budget income before taxes: $20,625 • Income taxes: 40% × $20,625 = $8,250 Actual taxes are lower because actual income before taxes was lower, but the tax rate remained the same . 10. Net Income Net income changes as each line item changes. In this example, the main reason for the unfavorable net income variance is lower sales revenue , not poor cost control. 11. Key Rule for Flexible Budgets The most important rule to remember: • If a cost was variable in the original budget, it stays variable • If a cost was fixed in the original budget, it stays fixed Fixed costs may still show variances, but those variances are not caused by changes in activity level (within the relevant range). 12. Using Budget Reports to Evaluate Managers Budget reports are only fair and useful when they include items the manager can control . • Department managers should be evaluated on their department’s costs • It would be unfair to judge them using total company net income

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