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Curriculum Center Browse Bibliography Build EPacket Pricing Structure Distribution Process Management Control in Nonprofit Organizations
 
Note on Flexible Budgeting and Variance Analysis
Author(s):
Young, David W.
Functional Area(s):
   Management Control Systems
Setting(s):
   For Profit
Difficulty Level: Beginner
Pages: 11
Teaching Note: Not Available. 
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First Page and the Assignment Questions:

Among other things, managers are paid to make decisions. Ordinarily, an informed decision is better than an uninformed one. The difference, of course, is information. For this reason, the measurement and reporting phase of the management control process is a critical aspect of the design effort.1 In many respects, it is in this phase that managers’ needs and accountants’ skills merge. Managers must be able to communicate their information needs to the accounting staff. Otherwise, the accounting staff will not be able to design a measurement system that captures the appropriate information.

This note discuss one some important aspects of the measurement phase: (1) the importance of aligning responsibility with control, (2) flexible budgeting, and (3) variance analysis.

Aligning Responsibility with Control

Most costs in an organization are controllable by someone. As a consequence, the management control system must be designed so that different managers are held responsible for controlling different costs. Ideally, the system is designed so that each manager is held responsible only for those costs over which he or she exercises a reasonable degree of control.

In part, this alignment between responsibility and control is attained via the choice of responsibility centers.2 In addition, however, the management control system must attempt to assign only controllable costs (and sometimes revenues) to each responsibility center. This can be quite difficult, frequently requiring that the organization’s costs be measured in ways that differ from those used for other types of cost calculations.

In addition, if managers are to be asked to control costs, they must receive the information pertaining to their responsibility centers on reports that are both useful and timely. This may mean augmenting the cost-collection process, or it may simply mean that data already being collected for full cost or other purposes must be restructured for management control purposes. In all cases, the way information is presented on the reports sent to a responsibility center manager is an important aspect of the management control system.

In the context of measuring controllable costs, two techniques stand out as particularly relevant and important: flexible budgeting and variance analysis. Both techniques have been used extensively in many organizations, and can be quite useful to managers at all decision-making levels.

FLEXIBLE BUDGETING

The concept of flexible budgeting is derived from the distinction between controllable and noncontrollable costs. In standard expense centers, individual department managers typically exert a great deal of control over both their department’s fixed costs and the variable costs per unit of activity, but almost no control over the total units of activity. As a result, they exercise little control over total variable costs. The management control solution to this problem is a budget that is adjusted for volume changes prior to measuring a manager’s performance. This adjusted budget is known as the flexible budget.

A flexible budget contrasts with a fixed budget, which is a budget with no variable expense component. A fixed budget typically is used in a discretionary expense center. In a discretionary expense center, the manager is held responsible for spending no more than the originally budgeted amount each month (or other reporting period). This is usually the case unless there are compelling reasons to change the budget, such as a labor strike, a fire in the plant, or some other similarly catastrophic event.

A flexible budget is developed by classifying a responsibility center’s expenses into their fixed and variable elements. Rather than being a fixed amount, a flexible budget, is expressed as a cost formula using agreed-upon fixed expenses and agreed-upon variable expenses per unit. An expected level of volume is specified to make sure the fixed expenses are within their relevant range. This gives rise to the original budget. The original budget is then “flexed” each month (or other reporting period) by applying the actual volume of activity to the cost formula . . .


1 For a discussion of the management control cycle, see Anthony, Robert N., and David W. Young, Management Control in Nonprofit Organizations, Burr Ridge, IL, Irwin-McGraw Hill, Inc., 7th edition, 2003.
2 For a discussion of responsibility center choices, see Anthony and Young, op. cit.