Accounting Principles II – Flexible Budgets and Standard Costs | Accounting

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Study GuideAccounting Principles II–Flexible Budgets and StandardCosts1.Flexible BudgetsAbudget reportcompares what actually happened in a business to what was originally planned inthe budget. It helps managers understand how well the company performed during a period, such asa month or a quarter.A typical budget report includes:•Actual amounts•Budgeted amounts•Variances(the differences between actual and budgeted figures)A variance can befavorableorunfavorable.

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Study Guide1.Understanding Favorable and Unfavorable VariancesTo decide whether a variance is favorable or unfavorable, always think aboutnet income.•Afavorable varianceincreases net income○Higher revenues than planned○Lower costs or expenses than planned•Anunfavorable variancedecreases net income○Lower revenues than planned○Higher costs or expenses than plannedSo:•Higher sales revenue →Favorable•Higher expenses or costs →UnfavorableFavorable variances are usually shown aspositive numbers, while unfavorable variances are shownasnegative numbers. Some textbooks also label variances withForUto make them easier toidentify.What Budget Reports Do (and Do Not) ShowBudget reports clearly showwhere differences occurred, but they donot explain whythosedifferences happened.Management uses budget reports to:•Identify unexpected results•Ask questions•Investigate causes•Decide if action is neededFor 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 BudgetFrom the static budget report, actual net income isunfavorablecompared to the budget. However,the report alone does not explain the reasons.Further analysis shows:•17,500 truckswere sold instead of the planned17,000•Theaverage selling pricewas$14.80, not the expected$15.00•Thecost per truckwas$11.25, exactly as budgetedThis tells management that:•Sales volume increased•Selling price decreased•Production costs were controlled2.Static BudgetsAstatic budgetis prepared forone specific level of activity. It works best when:•Actual activity matches the planned activity, or•The budget is used mainly forfixed costsHowever, when actual activity is higher or lower than planned, static budgets make it difficult toevaluate cost control fairly.Why Flexible Budgets Are NeededAflexible budgetadjusts budgeted amounts to match theactual level of activity. In simple terms, itanswers the question:“Whatshouldthe costs and revenues have been at the actual level of activity?”

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Study GuideAnother way to think about a flexible budget is that it ismany static budgets, each prepared for adifferent activity level.Example:•A restaurant plans for 100 customers•Actually serves 300 customers•Managers should be evaluated using a budget prepared for300 customers, not 100This allows management to separate:•Performance due tovolume changes•Performance due tocost control3.Static vs. Flexible Budget: Pick Up Trucks CompanyThe original budget report for Pick Up Trucks Company is astatic budgetbecause it was notadjusted for the higher sales volume.If the budget had been adjusted for the actual sales level of17,500 trucks, the report would look likethis:

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Study GuideInterestingly, theflexible budget shows an even larger unfavorable variancethan the staticbudget. This does not always happen, but it shows why flexible budgets are valuable—they highlightdifferent questions management needs to investigate.4.Preparation of a Flexible BudgetWhen preparing a flexible budget:•Selling prices and cost assumptions stay the same•Variable costs remain variable•Fixed costs remain fixed•Onlyactivity levels change

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Study GuideBelow is an explanation of each line item in the flexible budget.5.SalesThe original budget assumed:•17,000 trucks × $15 = budgeted salesThe flexible budget uses:•17,500 trucks × $15 = $262,500The remaining variance is due entirely toselling price, not volume. Because the variance isunfavorable, management knows the trucks were soldbelow the planned price.6.Cost of Goods SoldThe budgeted cost per truck was$11.25.Flexible budget calculation:•17,500 trucks × $11.25 =$196,875There isno variance, which means production costs were exactly as planned.7.Selling ExpensesSelling expenses include bothvariable and fixed costs.Variable costs are recalculated:•Sales commissions: 4% × $262,500 =$10,500•Delivery expense: 17,500 units × 10% =$1,750Add fixed costs of$12,500:•Flexible budget selling expenses =$24,750

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Study Guide8.General and Administrative ExpensesThese expenses areentirely fixed, so they do not change with activity level.Therefore, the flexible budget amount isthe same as the original budget.9.Income TaxesIncome taxes are calculated as40% of income before taxes.•Flexible budget income before taxes:$20,625•Income taxes: 40% × $20,625 =$8,250Actual taxes are lower because actual income before taxes was lower, but thetax rate remained thesame.10.Net IncomeNet income changes as each line item changes. In this example, themain reason for theunfavorable net income variance is lower sales revenue, not poor cost control.11.Key Rule for Flexible BudgetsThe 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 fixedFixed costs may still show variances, but those variances arenot caused by changes in activitylevel(within the relevant range).12.Using Budget Reports to Evaluate ManagersBudget reports are only fair and useful when they includeitems the manager can control.•Department managers should be evaluated ontheir department’s costs•It would be unfair to judge them using total company net income

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