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Flexible Budget

Estimation of future levels of activity with any accuracy is extremely difficult in some businesses because of presence of external incontrollable influences. For example, a business which provides luxury goods & services may be very sensitive to changes occurred in the economic climate. Weather may affect some business & prediction of weather conditions is difficult. In such cases, if comparison is done between actual results & budgeted figures, the result may be extremely misleading. It would not be clear without making detailed investigation, for example, whether either because of overspending or merely because the business activity level was above the budgeted level or both, there had arisen a large adverse cost variance. As a result, it becomes really difficult to control & appraisal of performance.

With the preparation of a flexible budget the problem can be solved. Thus, a flexible budget can be defined as a range of budgets which covers a number of different expected levels of activity. It becomes possible to draw up an appropriate ‘flexible’ budget from the range once actual production is known, also the expenses can be set out which would be appropriate to the achieved level of activity.

The main requirement of a flexible budget is that the analysis of expenses should be done into three distinct categories:

1. Fixed expenses, i.e. irrespective of the levels of activity, these expenses would be remaining the same.

2. Variable expenses, i.e. with the change in levels of activity, these expenses would change in proportion to that level.

3. Semi-variable expenses, i.e. analysis of these expenses into fixed & variable elements are needed to be done.

As already stated, the advantage of flexing a budget is that, for the purposes of control & appraisal of performance, the comparison can be done of the actual performance with the flexed budget.

Illustration1: For the production of 10000 units of a product, the following are the budgeted expenses:
\$ (per unit)
Direct material                                                                                                30
Direct Labour                                                                                                  15
Variable expenses (direct)                                                                               2.50
Selling expenses (10% fixed)                                                                          7.50
Administration expenses (\$ 25000 rigid for all production levels)                   2.50
Distribution expenses (20% fixed)                                                                  2.50
Total cost of sale per unit                                                                               80.00
Prepare a budget for production of 12000, 14000 & 16000 units showing distinctly marginal cost & total cost.

Solution:                                             Flexible Budget
Per unit           12000 units      14000 units      16000 units
\$                      \$                      \$                      \$
Direct Material                        30                    360000            420000              48000
Direct Labour                          15                    180000            210000            240000
Direct Variable expenses          2.50                 30000              35000              40000

Production                          12.50               150000            175000           200000
Selling (Workings 1)              6.75                 81000               94500           108000
Distribution (Workings 2)      2.00                 24000               28000              32000
Marginal Cost           137.50               825000            962500            1100000
Fixed Production Overhead                             75000              75000               75000
Selling Overhead (Workings 1)                          7500                7500                 7500
Distribution Overhead (Workings 2)                  5000                5000                5000
Fixed Cost                                           112500            112500            112500
Total Cost                                            937500          1075000          1212500
Cost per unit                                        78.125               76.78                75.78

Workings:

(1) Selling Expenses:
Total for 10000 units is \$ 75000. 10% of this i.e. \$ 7500 is fixed & the balance of \$ 67500 is variable. Hence, variable cost per unit is \$ 6.75.
(2) Distribution expenses:
Total for 10000 units is \$ 25000. 20% of this i.e. \$ 5000 is fixed & the balance of \$ 20000 is variable. Hence, variable cost per unit is \$ 2.

Illustration 2:  At a capacity level of 2500 units for article P, the cost per unit is \$ 7.50. The details are given under A below.
A                                 B
Material cost                                                                           \$ 70000           100% varying
Labour cost                                                                             \$ 30000           100% varying
Power                                                                                      \$   4000             80% varying
Repairs                                                                                    \$   6000             75% varying
Stores                                                                                      \$   2000           100% varying
Inspection                                                                               \$   1200             20% varying
Depreciation                                                                            \$ 20000            100% fixed
Selling overhead                                                                     \$   6000__         50% varying
\$ 1500000

Calculate the cost per unit of the product, showing at production levels of 2000 units & 3000 units, the individual expenses.

Solution:                                             Flexible Budget

Per unit           2000 units        2500 units        3000 units
Production                              \$                           \$                   \$                       \$
Variable Cost:
Material                               28.00               56000              70000              84000
Labour                                 12.00               24000              30000              36000
Stores                                   0.80                 1600                2000                2400
Power (Workings 1)              1.28                 2560                3200                3840
Repairs (Workings 2)            1.80                 3600                4500                5400
Inspection (Workings 3)       0.096                 192                  240                  288
(Workings 4)                         0.864             1728                 2160                2592
(Workings 5)                          1.20               2400                 3000                3600
Total Variable Cost (a)         46.04__           92080            115100            138120

Fixed Cost:

Depreciation                                                  20000              20000              20000
Power (Workings 1)                                          800                  800                  800
Repairs (Workings 2)                                      1500                1500                1500
Inspection (Workings 3)                                   960                  960                  960
Selling Overhead (Workings 5)                      3000                3000                 3000
Total Fixed Cost (b)                                     34900              34900              34900
Total Cost (a +b)                                         126980            150000            173020

Cost per unit                                           63.49               60.00             57.673

Workings:

(1) Power:
Total for 2500 units is 4000. 80% of this i.e. \$ 3200 is variable & the balance 20%, i.e. \$ 800 is fixed. Variable cost per unit is \$ 1.28.

(2) Repairs:
Total for 2500 units is 6000. 75% of this i.e. \$ 4500 is variable & the balance 25%, i.e. \$ 1500 is fixed. Variable cost per unit is \$ 1.80.

(3) Inspection:
Total for 2500 units is 1200. 20% of this i.e. \$ 240 is variable & the balance 80%, i.e. \$ 960 is fixed. Variable cost per unit is \$ 0.096.

Total for 2500 units is 10800. 20% of this i.e. \$ 2160 is variable & the balance 80%, i.e. \$ 8640 is fixed. Variable cost per unit is \$ 0.864.

Total for 2500 units is 6000. 50% of this i.e. \$ 3000 is variable & the balance 50%, i.e. \$ 3000 is fixed. Variable cost per unit is \$ 1.20.

Illustration 3:

A single product is manufactured by PS ltd. which is facing severe competition in selling it at \$ 100 per unit. At 60% level of activity, the company is operating & at that level sales are \$ 2400000.Variable costs are \$ 60 per unit.  At \$ 180000, when output is nil, the semi-variable costs may be considered as fixed & the variable element is \$ 500 for each additional 1% level of activity. At the present level of activity, fixed costs are \$ 300000 but these costs are expected to increase by \$ 100000, if a level of activity of 80% or above are reached.

To cope with the competition, a proposal of reducing the selling price by 5% is being considered by the management of the company. You are required to prepare a statement showing the operating profit at level of activity of 60%, 70% & 80% assuming that:

1. the selling price remaining at \$ 100, &

2. there is a reduction in the selling price by 5%.

Also show the number of units which will be required to be sold for maintaining the present profits if the company decides to reduce the selling price of the product by 5%.

Solution:                                             Flexible Budget

Activity level                                                  60%                 70%                 80%
Sales units                                                      24000              28000              32000
\$                      \$                      \$
Variable costs \$ 60 per unit                            1440000          1680000          1920000
Add: \$ 500 for every 1% of activity                  30000              35000              40000
Total Variable costs                                        1470000          1715000          1960000

Fixed Costs (including fixed parts
Of semi-variable costs)             480000           480000            580000
Total costs                                                       1950000          2195000          2540000
Sales @ \$ 100 per unit                                    2400000          2800000          3200000
Profit                                                                 450000            605000            660000
Sales @ 95 per unit                                         2280000          2660000          3040000
Profit                                                                 330000            465000            500000

Volume of sales to maintain existing profit of \$ 450000 with reduced selling price of \$ 95.

Contribution per unit:                                                                         \$
Sales at 60% level                                                                               2280000
Variable costs                                                                                      1470000
Total contribution                                                                                 810000

Contribution per unit = \$ 810000 = \$ 16.875
24000

Volume of Sales required:                                                                   \$

Desired profit                                                                                      450000
Fixed costs                                                                                          480000
Contribution required                                                                         930000

Volume of sales required = Contribution required = \$ 930000 = 55111 units.
Contribution per unit      16.875

Illustration 4:

A factory is currently running at 50% capacity & produces 5000 units at a cost of \$ 90 per unit as per below details:

Material                                                           \$ 50

Wages                                                             \$ 15

Factory overheads                                           \$ 15 (40% fixed)

The current selling price is \$ 100 per unit. Material cost per unit, at 60% capacity, increases by 2% whereas selling price per unit falls by 2%. However, material cost per unit increases, at 80% capacity working, by 5% & selling price per unit falls by 5%.

Prepare a marginal cost statement showing for the three capacity levels, the total cost & profit. Also comment on the profitability at these levels of performance.

Solution:                                             Marginal Cost Statement
50% capacity               60% capacity               80% capacity
5000 units                     6000 units                  8000 units
Per unit     Total          Per unit     Total          Per unit   Total
\$                   \$          \$                      \$          \$                \$
Variable costs:
Materials                             50          250000          51          306000       52.50  420000
Labour                                15            75000          15            90000      15        120000
Factory Overheads              9            45000            9            54000       9           72000
Total Variable Costs            79          395000          80          480000     81.50    652000

Sales                                      100          500000          98          588000     95.00    760000
Contribution                            21          105000          18          108000     13.50    108000

Fixed Costs:
Total Fixed Costs                                    55000                         55000                     55000
Profit                                                      50000                          53000                     53000
% of profit on sale                                 10%                               9%                          7%

1. When the level of activity has been raised from 50% to 60%, profit increases from \$ 50000 to \$ 53000 whereas when the level of activity raised to 80% capacity, profit does not increase further.

2. % of profits on sales gradually decreases as the level of activity rises.

3. The increase of production up to 60% level of activity is profitable & not beyond that.

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