What is Flexible budget and overhead variance?
Fixed or static budget
Meaning of fixed budget
A budget prepares for a predetermined activity and condition is called a static budget. It covers the difference activities related to production and sales under the given level of operation. Static budget is based on a single level of activity. It does not take into consideration any change in expenditure arising out of changes in the level of activity. It is a rigid budget and drawn on the assumption that there will be no charge in the level of activity. For example, a manufacturing concern plans to produce and sale 10, 000 units of goods for next year, the budget prepared for the units of goods is termed as a fixed budget. More precisely, the purchase budget, sales budget, cost of goods sold budget, cash budget etc made for the above are termed as fixed or static budget. A fixed or static budget will be useful only when the actual level of activity corresponds to the budgeted level of activity. A static budget is prepared under the following situations.
• The level of production and sales does not change even in long run.
• There is no necessity to produce new products.
• The changes in the needs and interest of the consumers do not affect the demand of the product.
However, due to the dynamism of business envinmont, the level of production and sales also fluctuates. Hence, a static budget does not facilitate planning and cost control which makes it necessary to prepare flexible budget.
Limitations of fixed budget
The following are the limitations of a fixed budget.
• A static budget assumes that there will not be any change in the working condition which is not a realistic assumption.
• It does not make any adjustments that arise due to the changes in production, sales and other activities.
• It hardly uses a mechanism of budgetary control as it does not make any distinction between fixed, variable and semi-variable costs.
• It does not have any mechanism of performance appraisal.
• A static budget is meaningless when the working conditions change.
• It does not provide any meaningful basis for comparison and control. It has a limited application and is not an effective tool for cost control.
• It is not helpful for the fixation of price and submission of tenders. If the budgeted and actual activities levels vary, the ascertainment of costs and fixation of prices becomes difficult.
Flexible budget
A budget that is prepared under difference level of activities is known as flexible budget. A flexible budget has difference budget costs for the difference level of activities. It is based on the assumption that there might be the changes in the production, sales and working conditions. Under flexible budget, difference levels of activities are planned are planned and the variable, semi variable and fixed costs ae calculated under those levels to calculated the profit or loss.
Institute of cost and management association (London) defines the flexible budget as ' A budget which by recognizing the difference between fixed and variable cost, designed to change in relation to each level of activities attained.
The chartered institute of management accountants, London defines "a flexible budget is a budget, which is designed to change in accordance which the level of activity actually attained."
In this way, a flexible budget gives difference budgeted costs for different levels of activities. A flexible budget is prepared after classifying the costs into fixed, variable and semi-variable as the effectiveness of a flexible depends upon the accuracy with which the expenses are classified.
Need and importance of flexible budget
The need and importance of flexible budget may be explained in the following ways.
• A flexible budget helps preparing a realistic budget.
• It assists in the smooth operation of a business even in a volatile environment.
• Since the costs are classified into variable, semi variable and fixed under flexible budget, the analysis and control of costs are easier.
• A flexible budget provides necessary information so that an effective system of performance appraisal can be enacted.
Distinction between fixed and flexible budget
The difference between fixed and flexible budget are given below.
Distinction between fixed and flexible budget
The difference between fixed and flexible budget are given below.
Preparation of flexible budget
The main objective of preparing a flexible is to control the cost. To prepare a flexible budget the following steps are to be considered.
a. Determine of the range of activity level: in to first step of preparation of flexible budget, the range of activity level should be determined. For example, if the normal capacity of a factory is 10,000 units, the probable range of activity levels would be 1,000 units, 2,000 units to 10,000 units.
b. Identification of cost behavior: the cost behavior refers to the determination of relationship between cost and activity. In other words, it is identifying the cost as variable, semi- variable and fixed.
c. Segregation of mixed cost: if the cost is semi variable, it has to be segregated into variable and fixed components. For this high-low cost or least square method can be adopted as mentioned in chapter2.
d. Preparation of flexible budget: after segregating the mixed costs into variable and fixed, flexible budget is prepared under difference levels of activity.
Flexible budget can be prepared by the following methods
i. Formula method
j. Tabulation method
Formula method
Under formula method, flexible budget is prepared considering the cost factors and their relationship. It can be explained as under.
Budgeted allowance= fixed cost + (unit variable cost x level of activity)
Or, BA = FC + (UVC X LA)
Tabulation method
We can prepare flexible budget by using tabulation as well. This can also be down in two ways as shown below.
a. Without showing the semi variable costs separately: under this, the semi variable costs are segregated into variable and fixed costs and shown them in their respective heading i.e. fixed and variable.
b. Showing the semi variable costs separately: under this, the semi variable costs are serrated into variable and fixed costs and the semi variable cost for difference levels are calculated shown under its heading as shown below:
Overhead variances analysis
Concept of overhead variance analysis
Overhead costs are the sum of indirect material, indirect labour cost and indirect expenses. These expenses are not directly absorbed by a product or service or department and cannot be easily identified to a unit cost. These are costs, which cannot be wholly debited or charged directly to a particular job, product or services.
For the purposes of controlling costs, certain standards are determined are determined in advance. After competing jobs, theses standards are compared with the actual costs as to find whether any difference between the standard and actual exists. The main purpose of such comparison is to ensure the work has been completed at the cost as determine in advance. Specifically, the difference between the standard overhead and the actual is called the overhead variance. The analysis of the differences between the standard overhead and actual overhead incurred is called the overhead variance analysis. It can be done in a number of ways as mentioned below.
Out of the above mentioned variance analysis, the three overhead variance analysis has been mentioned below:
Analysis of three overhead variance
Under this method, production volumes is expenses in units of hours and well examine three elements of the overhead cost variance-spending or expenditure variance, capacity variance and efficiency variance.
a. Overhead spending or expenditure variance: the most importance of the overhead costs variance is the spending or expenditure variance. This variance is the difference between the standard overhead allowed for a give level of output and the actual overhead costs incurred during the period. This measure the difference between the actual overhead costs incurred and the correct efficiency and inefficiency in spending because the variable overhead will vary with the number of actual hours worker rather that the standard. The spending variance is typically the manager. In many cases, much of the spending variance involves controllable overhead costs. For this reason, it sometimes is called the controllable variance. This variance Is found by using the following formula:
If the budgeted overhead costs exceed the actual overhead costs (positive result), the variance indicates favorable and vice-versa.
b. Overhead capacity variance: it is that portion for the overhead variance, which is due to the difference between the standard cost of overhead absorbed on actual output and standard overhead cost. It is that portion of the variance, which is due to working at higher or lower capacity that the budgeted capacity. In short, this variance arises due to more less working hours than the budgeted working hours. This variances is found the following formula:
If the standard overhead cost for standard hours produced exceeds the standard overhead cost of normal capacity (positive result), it indicates favorable variance and vice-versa.
c. Overhead efficiency variance: it is the variance, which is due to the difference between the budgeted efficiency of production and the actual efficiency achieved. This variable is related with the efficiency of workers and plant. Basically, it is the difference between the budgeted allowances of factory overheads for standards for standard hours applied and the budgeted allowance of such overhead for the actual used. Efficiency variance is only due to the under or over application of variable overheads, because of more or less use of productive hours does not change the total amount of fixed cost. Fixed overhead have no impact in efficiency variance. This variance is found by using the following formula:
If the standard overhead cost of standard hours produced exceeds the standard overhead cost of actual hour produced (positive result), the variance indicates favorable and vice-versa.
Calculation of overhead variances
Formula method
The way of calculating the overhead variance by using formula are given below.
a. Capacity variance= (standard hours x standard rate) – (fixed overhead + (standard variable overhead rate x standard hours))
CV= (SH X SR) – {FO + (SVOR X SH)}
b. Efficiency variance = standard variable overhead rate (standard hours – actual hours)
EV= SVOR (SR – AH)
c. Spending variance = budgeted overhead at actual hours – actual overhead incurred
SV= FO + (SVOR X AH) _ Actual overhead paid
Concept of overhead variance analysis
Overhead costs are the sum of indirect material, indirect labour cost and indirect expenses. These expenses are not directly absorbed by a product or service or department and cannot be easily identified to a unit cost. These are costs, which cannot be wholly debited or charged directly to a particular job, product or services.
For the purposes of controlling costs, certain standards are determined are determined in advance. After competing jobs, theses standards are compared with the actual costs as to find whether any difference between the standard and actual exists. The main purpose of such comparison is to ensure the work has been completed at the cost as determine in advance. Specifically, the difference between the standard overhead and the actual is called the overhead variance. The analysis of the differences between the standard overhead and actual overhead incurred is called the overhead variance analysis. It can be done in a number of ways as mentioned below.
Analysis of three overhead variance
Under this method, production volumes is expenses in units of hours and well examine three elements of the overhead cost variance-spending or expenditure variance, capacity variance and efficiency variance.
a. Overhead spending or expenditure variance: the most importance of the overhead costs variance is the spending or expenditure variance. This variance is the difference between the standard overhead allowed for a give level of output and the actual overhead costs incurred during the period. This measure the difference between the actual overhead costs incurred and the correct efficiency and inefficiency in spending because the variable overhead will vary with the number of actual hours worker rather that the standard. The spending variance is typically the manager. In many cases, much of the spending variance involves controllable overhead costs. For this reason, it sometimes is called the controllable variance. This variance Is found by using the following formula:
If the budgeted overhead costs exceed the actual overhead costs (positive result), the variance indicates favorable and vice-versa.
b. Overhead capacity variance: it is that portion for the overhead variance, which is due to the difference between the standard cost of overhead absorbed on actual output and standard overhead cost. It is that portion of the variance, which is due to working at higher or lower capacity that the budgeted capacity. In short, this variance arises due to more less working hours than the budgeted working hours. This variances is found the following formula:
If the standard overhead cost for standard hours produced exceeds the standard overhead cost of normal capacity (positive result), it indicates favorable variance and vice-versa.
c. Overhead efficiency variance: it is the variance, which is due to the difference between the budgeted efficiency of production and the actual efficiency achieved. This variable is related with the efficiency of workers and plant. Basically, it is the difference between the budgeted allowances of factory overheads for standards for standard hours applied and the budgeted allowance of such overhead for the actual used. Efficiency variance is only due to the under or over application of variable overheads, because of more or less use of productive hours does not change the total amount of fixed cost. Fixed overhead have no impact in efficiency variance. This variance is found by using the following formula:
If the standard overhead cost of standard hours produced exceeds the standard overhead cost of actual hour produced (positive result), the variance indicates favorable and vice-versa.
Calculation of overhead variances
Formula method
The way of calculating the overhead variance by using formula are given below.
a. Capacity variance= (standard hours x standard rate) – (fixed overhead + (standard variable overhead rate x standard hours))
CV= (SH X SR) – {FO + (SVOR X SH)}
b. Efficiency variance = standard variable overhead rate (standard hours – actual hours)
EV= SVOR (SR – AH)
c. Spending variance = budgeted overhead at actual hours – actual overhead incurred
SV= FO + (SVOR X AH) _ Actual overhead paid
1. What is a flexible budget?
A budget that is prepared under different level of activities is known as flexible budget. A flexible has different budgeted costs for the different level of activities. It is based on the assumption that there might be the change in the production, sales and working conditions. Under flexible budget, different levels of activities are planned and the variable, semi variable and fixed costs are calculated under levels to calculate the profit or loss.
2. Write any five differences between static and flexible budget.
The difference between fixed and flexible budget are given below.
1. Level of activity: fixed budget is bases on only one level of budgeted activity. Under flexible budget, the budget is prepared at different levels of activities.
2. Flexibility: fixed budget is fixed, and does not change with the actual volume of output achieved but flexible budget it is flexible and can be prepared at any level of activity to be attained.
3. Comparison: comparison of actual and budget performance cannot be made correctly if the actual volume of output differs in fixed budget but comparisons are realistic as the planned figures can be compared against the actual.
4. Condition: fixed budget assumes that the working condition always remain the static where flexible budget assumes that the working condition change according to the change in external environment.
5. Cost classification: under fixed budget, there is no providing of cost classification but in flexible budget, costs are classified according to their variability i.e. variable, fixed and semi variable.
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