When does one shift budgeting methods? Read why Mr. Sonic says, “There is still unfavorable factory overhead variance for October! Whatever suggestions you have there to improve our performance, like a shift from static budget to another method, we will implement them right away!"
slide 1 of 8
Jay Walk Slippers, Inc., and Static Budgeting
Mr. Sonic, CEO of Jay Walk Slippers, Inc., asks Ms. Villa, accountant, the reason for obtaining an unfavorable factory overhead variance. Ms. Villa looks serious as she glances at the report on manufacturing operations for the current month of October. Actual factory overhead is bigger than the standard. Since last month, Mr. Sonic’s idea about the plant operations has always been negative. During that time, he planned to have the internet disconnected because of various complaints about employees playing online games even during regular daytime office hours and night shifts.
There are two material price increases during the month because of the recent oil increase. The plan to cut off internet connection was not pursued because management and staff agreed to minimize internet use for personal interest.
Miss Villa explains to the CEO that the variance is not a gross figure but a net difference. There might be an unfavorable production volume variance but this is offset with a favorable efficiency variance. But when unfavorable production volume is greater than the favorable efficiency variance, it results in a net unfavorable factory overhead variance. Such unfavorable volume variance exists because the planned production capacity is not fully utilized due to the unexpected price increase. Expected production for slippers has been 1,000 units, and only 900 were actually produced. However, efficiency variance is favorable because even when production expectation is not realized, there is an indication that the company is able to produce its actual target during the period.
Explaining further, she says, at standard, the company should have used 7,200 hours to produce 900 units of Jay Walk Slippers, but it has used only 7,000 hours. This is due to the manpower training that was sponsored by a foreign investor planning to buy its products at the middle of the year.
Mr. Sonic instructs her right away to analyze carefully the situation and whatever will be suggested as improvement will be implemented right away.
Miss Villa is trying to tell the CEO that the company is using static budgeting for overhead wherein no deduction for fixed overhead is made, because it cannot be adjusted even if the company produces less or more than the expected capacity. Static budgeting is also used in all its financial forecasts.
slide 2 of 8
What is a Static Budget?
Static budget is a budget intended for production that is based on one level of activity. It is usually a close approximation of the expected activity level. For instance, let us assume that the current activity level is 10,000 bottles. For this level, budgeted factory overhead costs are determined as follows:
Based on the production of 1,000 units, the following factory overhead is to be incurred: Indirect materials, $8,000; Indirect labor, $10,000; light and water, $6,000; depreciation of factory equipment, $3,000; factory insurance, $1,500; factory rent, $3,500; total budgeted factory overhead, $32,000; Per Unit ($32,000/1,000), $32/unit
As you can see from the above factory budget, at the planned or expected level of 1,000 units, the company should incur a total of $32,000 for factory overhead or $32.00 per unit. In that case, the standard cost of factory overhead per unit can be set at $32.00. This will show that fixed overhead cannot be reduced even if the actual production of the company (900 units) is less than the expected or planned activity of 1,000 units.
Please continue on Page 2 for more on Preparing a Static Budget
slide 3 of 8
Everyone in my department wanted a static budget for 2011 - a fixed budget because they have been doing that ever since. Do they know what to include or what to change? Read this article about preparing a static budget for more information.
slide 4 of 8
How are Static Budgets Developed?
Static budgets are used by entities that are not concerned with financial statement results, like government entities and charitable institutions, because most of the time they only have to compare budgets with actual figures at the end of the period. Static budgets are also used for companies that are already comfortable with fixed budgets and the constant use never bothers the smooth flow of the organization.
Static budgeting is applied to all financial forecasts like the items in the balance sheet and income statement. Below is an excerpt from the static budget prepared for Silver Moon Community Cooperative, the lending cooperative where I am working as an internal auditor (the name is changed). The cooperative has two branches (the details are not shown anymore):
Silver Moon Community Cooperative
Proposed on Operational and Capital Budget for the year 2010 (in millions)
Savings and Credit Services
Main Branch 1 Branch 2
Estimated Income from Loans $15.5 $ .800 $ .900
Estimated Operating Expenses $11.0 $.400 $.500
Estimated Net Income $4.5 $.400 $.400
Total Assets $200 $15 $10
Total Liabilities $50 $5 $4
Stockholders' Equity $150 $10 $6
The estimation for Silver's key accounts have one definite forecast and does not give approximations to changes that will be occurring during the year.
slide 5 of 8
Why Companies Use Static Budgets and What are the Consequences?
There are several reasons why companies prefer to use static budgets:
Since a fixed budget is for the entire period cited, say, for one year, it is a budget that is easy to prepare but carefully crafted to remain in place. This will ensure that all departments of the organization are always familiar with how much they have to spend at the beginning of the period and how much is remaining at any given point during the budgetary period. Problems arise if there are emergencies or new opportunities which need budgets. In my work as an auditor, every time my company needs to start a new project that was not earlier included in the budget, managers spend nights to study how they can go on with it without being warned of not following policies. Management always has the excuse of doing it constantly for practical reasons. They borrow funds from restrictions. But this is not supposed to be. I just told them, this might be all right if only a few areas will be affected.
Static budget is based on historical data and the current financial status of the entity. A budget committee will only have to look into the previous budget and set some changes--either increase or decrease the accounts. It is not unusual for the budget itself to include provisions for transferring funds from savings or other types of financial holdings in the event that income proves insufficient to cover all the line items within the budget. In the company that I serve as an auditor, this is happening at branches. They cope with finances until the time that they become self-liquidating. The main office usually extends help in order for them to survive.
For a company that utilizes this method, it is useful if it has reasonable control over any possible expenses and management can forecast with some degree of accuracy wherein potential costs may be computed accurately for a given period. Management will only have to be watchful of some variables to be inserted into the budget proposal like planned renovation costs for a building which the company does not have any previous experience. In cases like these, consultations must be made first with experts before inserting the intended budget figures into the master budget.
A company that has limited capacities will have the tendency to be attached to this method because it has no allowances for possible changes in its budgetary needs. However, sticking to this kind of method doesn’t have much success when the company has too many variables in its future expenses that can’t be predicted. In such cases any type of fixed budget would not serve as a realistic fiscal plan for that given company for its operating purposes.
Preparing a static budget does not account for inflation and a rise in costs. It won’t go as far as the previous years. It does not have any flexibility to deal with change in the environment, emergencies, personnel, or competitive pressures. The worst is that if competitors are aware of it, they might outspend the company.
Please continue on page 3 for more on Preparing a Static Budget
slide 6 of 8
My supervisor wanted a static budget to be submitted - a budget based on fixed cost. I told him, "This time we need a flexible one." This in-depth article on preparing a static budget explains the basics.
slide 7 of 8
Effective Steps for Preparing a Static Budget
There are several criticisms about static budgets but these budgets are effective if planned carefully with the following steps:
2. The objectives of each department or the users are stated properly. Forecast figures (integrated in the statement of objectives) should also come from them because it is they who are familiar with their area of responsibilities. In the past, it was the Board of Directors who would specify the sales targets of the branches in the company for which I am working as an auditor. This did not bring good results and everyone was frustrated. In one evaluation, we asked them about their own targets, and the branches mentioned that the targets they have set for themselves will motivate them to work harder. It did bring good results for the company after a year.
3. Each objective must be coupled with activities that will help proponents achieve them. These activities later on will become a part of the performance evaluation.
4. There must be clear output for each objective. Job performance evaluation will rely on the achievement of this output.
5. Management support.
6. After defining all things, the setting up of the budget must also be realistic and will be compared to the actual results. Variances then will be analyzed for appropriate actions.
slide 8 of 8
Companies usually start with static budgets because of their simplicity and easy-to-implement features. Since the static budget is historical, management can easily draft some changes because all it has to do is add or deduct from the previous balances based on expectations for the following year. This is true for businesses that have simple or usual transactions like service concerns, government entities, and trading companies.
When business processes become complicated, a company is recommended to shift from the traditional one to a more flexible method to give way for unexpected changes during the business year. Manufacturing companies are the ones that are doing this. They should simply adapt to the changes in the economy to accommodate the unexpected rising or lowering of sales targets because, in reality, they heavily rely on the sales units to estimate production.
The author is expecting that this article can help in determining when to undertake preparing a static budget or if there is a need to use other methods that are appropriate to one's activity.
Book and Image Credits:
Management Advisory Services by Rodelio S.. Roque 1990