Management Accounting 101: Budgeting and Forecasting - Flexible Budgets and Static, Budgets

What This Is

Flexible budgets and static budgets are two types of budgets used by managers to plan and control costs. A static budget is a budget that remains unchanged, regardless of changes in production or sales volume. In contrast, a flexible budget is a budget that adjusts to changes in production or sales volume. For example, Toyota uses flexible budgets to adjust its production costs based on changes in demand for its vehicles.

Key Frameworks & Metrics

• Flexible Budget: a budget that adjusts to changes in production or sales volume, allowing managers to compare actual costs to planned costs at different levels of activity.
• Contribution Margin Ratio = (Selling Price - Variable Costs) / Selling Price: measures the proportion of sales revenue that contributes to fixed costs and profit.
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit: tells you how many units must be sold to cover all costs.
• Contribution Margin per Unit = Selling Price - Variable Costs per Unit: measures the profit contribution of each unit sold.
• Variable Costs per Unit = Total Variable Costs / Number of Units Produced: measures the cost of producing one unit.
• Fixed Costs per Unit = Total Fixed Costs / Number of Units Produced: measures the fixed cost per unit, which remains constant regardless of production volume.
• Margin of Safety = (Actual Sales - Break-Even Sales) / (Break-Even Sales - Budgeted Sales): measures the amount by which sales can decrease before the company breaks even.
• Economic Value Added (EVA) = NOPAT - (Capital Invested × WACC): measures true economic profit after charging for the cost of capital.
• Return on Investment (ROI) = Net Income / Total Assets: measures the return on investment, but does not consider the cost of capital.
• Residual Income = Net Income - (Capital Invested × WACC): measures the return on investment after charging for the cost of capital.

Step-by-Step Process

1. Determine the relevant range: identify the range of production or sales volume over which the budget is valid.
2. Estimate variable costs: estimate the variable costs per unit, including direct materials, direct labor, and variable overhead.
3. Estimate fixed costs: estimate the fixed costs, including salaries, rent, and fixed overhead.
4. Calculate the contribution margin: calculate the contribution margin per unit by subtracting variable costs from selling price.
5. Calculate the break-even point: calculate the break-even point by dividing fixed costs by the contribution margin per unit.
6. Create a flexible budget: create a flexible budget that adjusts to changes in production or sales volume.

Common Mistakes

• Mistake: Treating all costs as relevant when making a decision.
• Correction: Identify avoidable costs and consider strategic factors when making a decision.
• Mistake: Ignoring qualitative factors in make-or-buy decisions.
• Correction: Consider both quantitative and qualitative factors when making a make-or-buy decision.
• Mistake: Using ROI alone without considering residual income or EVA.
• Correction: Use ROI in conjunction with residual income or EVA to evaluate investment opportunities.

Decision-Making Tips

• When faced with a 'make-or-buy' decision, always isolate avoidable costs and consider strategic, not just quantitative, factors.
• When evaluating investment opportunities, use ROI in conjunction with residual income or EVA to get a complete picture of the investment's potential.
• When creating a flexible budget, consider both variable and fixed costs to ensure accurate planning and control.

Quick Practice Scenario

A company produces 10,000 units per month, with a selling price of $100 and variable costs of $60 per unit. The company wants to know its margin of safety if sales decrease to 8,000 units per month. What is the margin of safety?

Answer: Margin of safety = (8,000 - 6,667) / (6,667 - 10,000) = 1,333 / -3,333 = -0.40 or 40% decrease in sales before breaking even.

Last-Minute Cram Sheet

• Flexible budget: adjusts to changes in production or sales volume.
• Static budget: remains unchanged, regardless of changes in production or sales volume.
• Contribution margin ratio: measures the proportion of sales revenue that contributes to fixed costs and profit.
• Break-even point: the point at which total revenue equals total fixed and variable costs.
• Margin of safety: measures the amount by which sales can decrease before the company breaks even.
• Economic value added (EVA): measures true economic profit after charging for the cost of capital.
• Return on investment (ROI): measures the return on investment, but does not consider the cost of capital.
• Residual income: measures the return on investment after charging for the cost of capital.
• 'Fixed costs' are only fixed in the short run within a relevant range – outside that range, they can change.
• 'Variable costs' are costs that change with changes in production or sales volume.