Question

Organizations use budgets to reach their financial goals. A planning budget is a detailed financial plan that shows future income and expenses. For example, all of us sometimes create household budgets that plan projected income and expenses for food, clothing, housing, etc. At the end of the budgeting period, we compare what we earned and our expenses to the planning budget to make sure we followed the plan. For example, if we buy a boat and didn’t budget for that boat, what might happen? Organizations use budgets in a similar way.

We also create flexible budgets to help guide actual operations. For example, an organization’s actual expenses will rarely equal its budgeted expenses as estimated. Activities, such as sales, are rarely the same as budgeted. Many actual expenses and revenues will naturally differ from what was budgeted. A flexible budget is an estimate of what revenues and costs should have been, given the actual level of activity for the period. A flexible budget might help us to justify buying that boat!

Variance analysis evaluates and improves performance. A varianceis the difference between the actual amount and the amount budgeted in a certain time period. In other words, the amounts are different. Revenue variance is the difference between actual revenue and budgeted revenue. If the actual revenue is higher than budgeted revenue, the variance is labeled favorable. If actual revenue is less than budgeted, the variance is labeled unfavorable. Spending variances also occur. If the actual spending exceeds budgeted spending, the variance is unfavorable. If the actual spending is less than budgeted spending, the variance is favorable. As you can see, earning more than budgeted is good, but we should try to avoid spending more than what we budget. Think about the boat!

• Describe the budgeting process at your place of work. If you do not work or if this information is not available, you may describe the budgeting process you use in your personal life.
• Explain how using a flexible budget and variance analysis can help make the process you described above more effective.

Answer 1

A Master budget is a planning budget prepared at the beginning of the year for a fixed level of output or activity level. It is a static and rigid budget. But actual level of activity during the year can vary depending on different conditions. A Static budget does not help in meaningful comparison of actual results since the level of activity is different. Hence the Master budget should be flexed to ensure the comparison is like to like and get meaningful results. The variable costs are flexed to actual level of activity and fixed overheads are considered same as master budget. A flexible budget is more useful due to following reasons:

· It helps in estimating cost at various levels of activities. For example: Estimating cost at 10,000 machine hours in increments of 1,000 machine hours

· It helps in preparing profitablity statement at different levels of activities. For example: Different sales level can be established to determine the profitablity for each sales level.

· It helps in cost volume profitablity analysis and break even analysis. Breakeven point is the point at which there is no profit or no loss.

· It is helpful for performance evaluation of employees and departments. Performance appraisal is not meaningful when actual results are compared to static budget having different activity level.

· It is helpful for evaluation of new investments for new product launches and product pricing

· It is helpful for various operational and strategic decisions making like continue or discontinue products and services, make vs. buy, acceptance of special order, shut down vs. continue, product mix etc

· It helps in Cost management through cost control and cost reduction by regular management information system. For example: Flexible budget performance report helps in controlling cost.

· It helps in allocation of scarce resources for the optimum utilisation. For example: allocation of material, direct labor hours based on contribution margin per constraint resource.