Gordon knits wool caps for sale at the local ski resorts. He prepared a budget f

Question

Gordon knits wool caps for sale at the local ski resorts. He prepared a budget for the production and sale of 150 wool caps. Unfortunately, Gordon fell ill with a bad case of the flu and was able to make and sell only 125 wool caps. Here is Gordon's budget:

Sales Revenue 1,500.00

Variable costs:

Direct Material (yarn) 375.00

Direct Labor 750.00

Commission to Resort 112.50

Fixed costs 75.00

Net income 187.50

Prepare a flexible budget for Gordon based on the production and sale of 125 wool caps. Input all amounts as positive value. If required, round your final answers to two decimal places. Do not round your intermediate calculations.

Explanation / Answer

A traditional budget is often referred to as a “static budget.†A static budget is not designed to change with changes in activity level. Once sales and expenses are estimated, they become the relevant benchmarks.

A flexible budget is an alternative that has some compelling advantages. It relates anticipated expenses to observed revenue. To illustrate, if a business greatly exceeded the sales goal, it is reasonable to expect costs to also exceed planned levels. After all, some items like cost of sales, sales commissions, and shipping costs are directly related to volume. How ridiculous would it be to fault the manager of the business for having cost overruns? Conversely,
failing to meet sales goals should be accompanied by a reduction in variable costs. Certainly it would make no sense to congratulate a manager for holding costs down in this case! A flexible budget
is one that reflects expected costs as a function of business volume; when sales rise so do certain budgeted costs, and vice versa.

The flexible budget responds to changes in activity, and may provide a better tool forperformance evaluation. It is driven by the expected cost behavior. Fixed factory overhead is the same no matter the activity level, and variable costs are a direct function of observed activity. When performance evaluation is based on a static budget, there is little incentive to drive sales and production above anticipated levels because increases in volume tend to produce more costs and unfavorable variances. The flexible budget-based performance evaluation provides a remedy for this phenomenon.

A flexible budget is a budget that adjusts or flexes for changes in the volume of activity. The flexible budget is more sophisticated and useful than a static budget, which remains at one amount regardless of the volume of activity.

Assume that a manufacturer determines that its cost of electricity and supplies for the factory are approximately $10 per machine hour (MH). It also knows that the factory supervision, depreciation, and other fixed costs are approximately $40,000 per month. Typically, the production equipment operates between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be $40,000 + $10 per MH.

Now let’s illustrate the flexible budget by using some data. If the production equipment is required to operate for 5,000 hours during January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH). If the equipment is required to operate in February for 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH). If March requires only 4,100 machine hours, the flexible budget for March will be $81,000 ($40,000 fixed + $10 x 4,100 MH).

If the plant manager is required to use more machine hours, it is logical to increase the plant manager’s budget for the additional cost of electricity and supplies. The manager’s budget should also decrease when the need to operate the equipment is reduced. In short, the flexible budget provides a better opportunity for planning and controlling than does a static budget.

Related Questions

Navigate

• Browse (All)
• Browse G
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.