FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity

<< Production & Sales Budget:Illustration 1, Production budget

FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses >>

Cost & Management Accounting (MGT-402)

LESSON 36 & 37

FLEXIBLE BUDGET

When a company's activities can be estimated within close limits, the fixed budget is satisfactory.

However, completely predictable situations exist in only a few cases. If business conditions change

radically, causing actual operations to differ widely from fixed budget plans, this management tool

is not reliable or effective. The fact that costs and expenses are affected by fluctuations in volume

limits the use of the fixed budget and leads to the use of the flexible budget. To illustrate, the cost

of operating an automobile per mile depends on the number of miles driven. The more a car is

used per year, the more it costs to operate it but the less it costs per mile. If the owner prepares an

estimate of the total cost and compares actual expenses with the budget at year-end, success in

keeping expenses within the allowed limits cannot be determined without accounting for the

mileage factor. The reason for this lies in the nature of the expenses, some of which arc fixed while

others are variable or semi variable. Insurance, taxes, registration, and garaging are fixed costs,

which remain the same whether the car is operated 1,000 or 20.000 miles. The costs of tires, gas,

and repairs are variable costs, which depend largely upon the miles driven. Obsolescence and

depreciation result in a semi-variable cost. Which fluctuates to some degree but does not vary

directly with the usage of the car?

The underlying principle of a flexible budget is the need for some norm of expenditures for any

given volume of business. This norm should be known beforehand in order to provide a guide to

actual expenditures. To recognize this principle is to accept the fact that every business is dynamic,

ever changing, and never static. It is erroneous, if not futile, to expect a business lo conform to a

fixed, preconceived pattern.

The preparation of a flexible budget results from the development of formulas for each department

and for each account within a department or cost center. The formula for each account indicates

the fixed amount and/or a variable rate. The fixed amount and variable rate remain constant within

prescribed ranges of activity. The variable portion of the formula is a rate expressed in relation to a

base such as direct labor hours, direct labor cost or machine hours.

The application of the formulas to the level of activity actually experienced produces the allowable

expenditures for the volume of activity attained. These budget figures are compared with actual

costs in order to measure the performance of each department. This ready-made comparison

makes the flexible budget a valuable instrument for cost control, because it assists in evaluating the

effects of varying volumes of activity on profits and on the cash position,

Originally, the flexible budget idea was applied principally 10 the control of departmental factory

overhead. Now however, the idea is applied lo the entire budget. So that production as well as

marketing and administrative bud-gels is prepared on a flexible budget basis.

Capacity and volume

The discussion of the actual preparation of a flexible budget must be preceded by a basic

understanding of the term "capacity." The terms "capacity" and "volume" (or activity) are used in

connection with the construction and use of both fixed and flexible budgets. Capacity is that fixed

amount of '

"plant and machinery and number of personnel for which management has

committed itself and with which it expects to conduct the business. Volume is the variable factor

in business. It is related to capacity by the fact that volume (activity) attempts to make the best use

of existing capacity.

209

Cost & Management Accounting (MGT-402)

Any budget is a forecast of sales, costs, and expenses. Material, labor, factory overhead, marketing

expenses, and administrative expenses must be brought into harmony with the sales volume. Sales

volume is measured not only by sales the market could absorb, but also by plant capacity and

machinery available to produce the goods. A plant or a department may produce the goods. A

plant or department may produce 1,000 units or work 10.000 hours, but this volume (or activity)

may not be ' compatible with the capacity of the plant or department. The production of

1.000'units or the working of 10.000 hours may be greater or smaller than the amount of sales the

company can safely expect to achieve in a given market during a given period.

The following terms are used in referring to capacity levels' theoretical practical, expected actual,

and normal. Current Internal Revenue Service regulations permit the use of practical, expected

actual or normal capacity in assigning factory overhead costs to inventories.

Theoretical Capacity. The theoretical capacity of a department is its capacity to produce at full

speed without interruptions. It is achieved if the plant-or department produces at 100 percent of its

rated capacity,

Practical Capacity. It is highly improbable that any company can operate at theoretical capacity.

Allowances must be made for unavoidable interruptions, such as time lost for repairs,

inefficiencies, breakdowns, setups. failures, unsatisfactory materials, delays in delivery of materials

or supplies, labor shortages and absences, Sundays, holidays, vacations, inventory taking, and pat-

tern and model changes. The number of work shifts must also be considered. These allowances

reduce theoretical capacity to the practical capacity level. This reduction is caused by internal

influences and does not consider the chief external cause, lack of customers' orders. Reduction

from theoretical to practical capacity typically ranges from 15 percent to 25 percent, which results

in a practical capacity level or 75 percent lo 85 percent of theoretical capacity.

Expected Actual Capacity. Expected actual capacity is based on a short-range outlook. The use

of expected actual capacity is feasible with firms whose products are of a seasonal natureČ and

market and style changes allow price adjustments according to competitive conditions and

customer demands.

Normal Capacity. Firms may modify the above capacity levels by considering the Utilization of

the plant or various departments in the light of meeting average sales demands over a period long

enough to level out the peaks and valleys which come with seasonal and cyclical variations. Finding

a satisfactory and logical balance between plant capacity and sales volume is one of the important

problems of business management.

Once the normal (or average) capacity level has been established, overhead costs can be estimated

and factory overhead rates computed. The use of these rates will cause all overhead of the period

to be absorbed, provided normal capacity and normal expenses prevail during the period.

Purposes of Establishing Normal Capacity. Although there may be some differences between a

normal long-run volume and the sales volume expected in the next period, normal capacity is

useful in establishing sales prices and controlling costs. It is the basis for the entire budget system,

and it can be used for the following purposes and aims:

1. Preparation of departmental flexible budgets and computation of predetermined factory

overhead rates,

2. Compilation of the standard cost of each product.

3. Scheduling production.

210

Cost & Management Accounting (MGT-402)

4. Assigning cost to inventories.

5. Measurement of the effects of changing volumes of production.

6. Determination of the break-even point.

Although other capacity assumptions are sometimes used due to existing circumstances, normal

capacity fulfills both long- and short-term purposes. The long-term utilization of the normal

capacity level relates the marketing phase and therewith the pricing policy of the business 10 the

production phase over a long period of time, leveling out fluctuations that are of short duration

and of comparatively minor significance. The short-term utilization relates to management's

analysis of changes or fluctuations that occur during an operating year. This short-term utilization

measures temporary idleness and aids in an analysis of its causes.

Factors Involved in Determining Normal Capacity. In determining the normal capacity of a plant,

both its physical capacity and average sales expectancy must be considered; neither plant capacity

nor sales potential alone is sufficient. As previously mentioned, sales expectancy should be

determined for a period long enough to level out cyclical variations rather than on the sales

expectancy for a short period of time. It should also be noted that outmoded machinery and

machinery bought for future use must be excluded from the considerations which lead to the

determination of the normal capacity level-Calculation of the normal capacity of a plant requires

many different judgment factors. Normal capacity should be determined first for the business as a

whole and then broken down by plants and departments. Determination of a departmental

capacity figure might indicate that for a certain department the planned program is an overload

while in another ii will result in excess capacity. The capacities of several departments will seldom

be in such perfect balance as to produce an unhampered flow of production. For the department

with the overload, often termed the "bottleneck" department, actions such as the following might

have to be taken;

Working overtime.

Introducing an additional shift.

Temporarily transferring operations to another department where spare capacity is available.

Subcontracting the excess load.

Purchasing additional equipment.

On the other hand, the excess facilities of other departments might have to be reduced. Or the

safes department might be asked lo search for additional orders to utilize the spare capacity in

these departments.

The effect of the various capacity levels on predetermined factory overhead rates is illustrated

below. If the 75 percent capacity level is considered to be the normal operating level, the

overhead rate is $2.40 per direct labor hour.

211

Table of Contents: