Ch. 9 Flexible Budgets and Performance Analysis

The most common errors in preparing performance reports are to implicitly assume that:

all costs are fixed or to implicitly assume that all costs are variable.

Flexible budgets take into account how changes in activity affect:

costs

Because of the existence of fixed costs, net operating income does not change in proportion to changes in the level of activity. There is a leverage effect. The percentage changes in net operating income are ordinarily larger than the percentage increases in activity.

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The activity variance for electricity is shown on the report as $10 U (unfavorable). Note that in this case, the label "unfavorable" may be a little misleading.

The electricity cost should be $10 higher because business was up by 100 client-visits; therefore, it would be misleading to describe this variance in negative terms given that it was a necessary cost of serving more customers. For reasons such as this, we would like to caution you against assuming that unfavorable variances always indicate bad performance and favorable variances always indicate good performance.

Companies use the variance analysis cycle to:

evaluate and improve performance

A static planning budget is suitable for planning but is inappropriate for:

evaluating how well costs are controlled.

Unfavorable activity variances may not indicate bad performance because:

increased activity should result in higher variable costs

flexible budget

is an estimate of what revenues and costs should have been, given the actual level of activity for the period.

planning budget

is prepared before the period begins and is valid for only the planned level of activity.

spending variance

is the difference between the actual amount of the cost and how much a cost should have been, given the actual level of activity. If the actual cost is greater than what the cost should have been, the variance is labeled as unfavorable. If the actual cost is less than what the cost should have been, the variance is labeled as favorable.

revenue variance

is the difference between the actual total revenue and what the total revenue should have been, given the actual level of activity for the period. If actual revenue exceeds what the revenue should have been, the variance is labeled favorable. If actual revenue is less than what the revenue should have been, the variance is labeled unfavorable.

Variances are more accurate when using:

multiple cost drivers

When a flexible budget is used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period rather than to the static planning budget.

true

fixed costs are often more controllable than

variable costs