Budgets are based on many assumptions and are estimates of what is likely to happen to achieve the organisation’s goals. Whilst a static budget will only predict one activity level, a flexible budget will include more than one activity level from within an organisation.
To prepare flexible budgets, fixed, variable and semi-variable costs must be categorised.
Fixed costs will stay constant in total during the budget period even if the level of activity changes. This includes expenses such as building insurance, rent and depreciation.
Variable costs will change based on the activity on each level, e.g. production, sales, commission and raw materials.
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Examples of fixed and variable costs are set out below:
- Fixed costs remain constant during the budget period and are independent of activity changes, particularly in the short term.
Example
A factory’s annual rent is $100,000, over which time 10,000 units are produced.
Cost per unit is $100,000/10,000 = $10
If annual rent remains the same, but 12,500 units are produced, the cost per unit is $100,000/12,500 = $8.
However, if sales and production increase, more buildings and storage space may be required, and fixed costs may change over time.
Example 22: Fixed cost calculation
- Variable costs are those costs that are affected by changes in activity levels such as sales or production. Variable costs include raw materials, direct labour and commission.4
Example
Raw materials are budgeted at $20,000 for producing 5,000 units. However, if 10,000 units are produced, these costs will escalate to $40,000.
Note, however, the cost of the unit remains the same, e.g.:
$20,000/5,000 = $4; $40,000/10,000 = $4
Minor changes may occur where large volumes of raw materials can be purchased at a discount.
Example 23: Variable cost calculation
- Semi-variable costs are those that include a fixed component and a variable component. An example of a semi-variable cost is telephone costs, e.g. the fixed charge for the phone connection or line rental remains the same, but the total cost for calls will vary.1
When all costs are categorised into fixed and variable, a formula can be used to determine the total costs and variable costs per unit as follows:
Total costs = Fixed costs + (variable costs per activity unit x total activity units)
Variable cost per activity = Total variable costs of production / Number of units of production
Example
Fixed costs of production are $80,000, no of units produced is 10,000, and variable costs are $6.50 per unit:
Total cost: $80,000 + ($6.50 x 10,000) = $145,000
Example 24: Flexible budget equation
The same equation can be used to include manufacturing costs:
Example
Fixed costs are $80,000, direct materials $20, direct labour $15, variable costs are $6.50 per unit, no of units produced is 10,000.
Total cost: $80,000 + ($41.50 x 10,000) = $495,000
If 15,000 units were produced –
Total cost: $80,000 + ($41.50 x 15,000) = $702,500
This will result in an increase of $207,500. This amount represents the total variable costs for producing the extra 5,000 units, e.g.:
5,000 x $41.50 = $207,500
Example 25: Flexible budget equation including manufacturing costs
The contribution margin is the difference between sales revenue and the variable costs to produce and sell the product.
The contribution margin may also be referred to as the “marginal contribution” as the variable costs are marginal costs. For example, each additional unit produced and sold incurs additional marginal costs.
The format for an income statement showing the contribution margin for a static budget is set out as follows:
| Sales | $XX |
| Less variable costs | $XX |
| Contribution margin | $XX |
| Less fixed expenses | $XX |
| Net profit | $XX |
The format for an income statement showing the contribution margin for a flexible budget is set out as follows:
Example:
| 5,000 units $ | 6,000 units $ | 7,000 units $ | ||||
|---|---|---|---|---|---|---|
| Sales revenue | 750,000 | 900,000 | 1,050,000 | |||
| Less variable costs | ||||||
| Direct materials | 225,000 | 270,000 | 315,000 | |||
| Direct labour | 100,000 | 120,000 | 140,000 | |||
| Variable factory overhead | 60,000 | 72,000 | 84,000 | |||
| Variable operating expenses | 90,000 | 108,000 | 126,000 | |||
| Total variable cost | 475,000 | 570,000 | 665,000 | |||
| Contribution margin | 275,000 | 330,000 | 385,000 | |||
| Less fixed costs | ||||||
| Fixed factory overhead | 75,000 | 75,000 | 75,000 | |||
| Fixed operating expenses | 50,000 | 50,000 | 50,000 | |||
| Total fixed costs | 125,000 | 125,000 | 125,000 | |||
| Net profit | 150,000 | 205,000 | 205,000 | |||
The variable cost per unit is as follows:
| Direct material - | $45 |
| Direct labour - | $20 |
| Factory overhead - | $12 |
| Operating expenses - | $18 |
| Total variable cost - | $95 |
The variable cost per unit is the same for each level of activity, e.g.:
$95 ($475,000/5,000)1
Example 26: Contribution margins
