Flexible budget

When performing a target to actual comparison, cost center managers should be able to check monthly as to whether or not costs they can manage themselves are “under control”. Given that the annual plan is approved by the organization’s management who releases the cost center budgets, the budget must be adhered to. However, during the year various factors can deviate from the plan, including:

- Sales and production quantities,
- Purchase prices,
- Manufacturing processes efficiencies, and
- Employees retention rate.

A simple comparison between planned and actual costs does not help cost center managers in their search for possible corrective measures because they lack a reference to the actual performance of the period under review. As a benchmark the flexible budget of the cost center should be calculated:

Flexible budget costs =

actual activity x proportional planned cost rate + planned fixed costs.

The flexible budget shows the planned cost of work actually performed in a period. If the activity performed in the period under review deviates from the planned activity, the proportional costs of the cost center will change, but the planned fixed costs should not. In the example below, actual employment is slightly less than planned employment. Therefore, the proportional plan costs is less than the annual plan, but the planned activity capacity (fixed) costs remain the same.

The flexible budget cost is thus the cause-related yardstick for assessing the total costs actually incurred by the cost center. If the cost center managers keep to their flexible budget, they will have achieved their cost target. If negative variances from the target costs occur, ways must be found to cumulatively reach the flexible budget again in the following months.

If cost centers perform activities that are not directly caused by a production order, a customer order, or by internal projects (e.g. research and development), they also have no planned or actual activity and consequently only fixed costs. In these cases, the flexible budget corresponds to the planned costs.

For the wire bending cost center in the example company the annual plan is as follows:

The installed capacity of the production equipment is 7,264 hours, which is sufficient for the planned production time.

The cost center has a planned workforce of 4 people who are planned to work a total of 6,800 net hours. This includes the working time of the cost center manager for planning and controlling the cost center.

The complete planned personnel costs of the cost center totals 387,600. The average hour worked (including the cost center manager) will thus cost 57.00 per hour (presence time).

According to production planning 5,870 employee hours will be necessary to execute the planned activity. This means that 5,870 hours at 57.00 per hour will “slip” into the products to be manufactured. This corresponds to 334,590 planned proportional personnel costs. The 53,010 difference between the planned personnel costs represents the costs for work not directly related to the products, i.e. the planned fixed personnel costs for the year.

In line with this, the other planned costs were divided into their proportional and fixed portions. Dividing the proportional budgeted cost of 363,940 by the planned activity of 5,870 hours yields a budgeted hourly proportional cost rate of 62.00 for wire bending. This rate is used to calculate the proportional costs of all products that will be processed in this cost center (see the post “Standard Cost Calculation of Products”).

If the activity of the issuing cost center is caused by a direct order of the receiving cost center or by its activity, there is a direct cause-and-effect link between the serving and the receiving centers. The planned proportional cost-rates can thus be charged to the receiving cost centers. The issuing cost center has its own planned and actual activity. The activities it performs for other cost centers can be measured. (Examples include repair and maintenance shop, laboratory, and energy cost centers). Thus, the respective cost center also has a proportional plan cost rate and its flexible budget is dependent on the activity performed for others during the period.

If the activities of a cost center are performed for the entire company, there is no direct cause-and-effect relationship between the producer of the activity and the users of the output. Therefore, the costs of such cost centers cannot be allocated to other cost centers according to their cause (e.g. reception, personnel administration, internal training, sales, production planning, finance, the majority of IT costs and top management). The IT costs for the ERP- or for the management accounting system are incurred for all cost center managers who use ERP data. The costs of generally used services cannot be charged to the users according to their origin (forced consumption). Due to this lack of causation, the allocation of fixed costs to other cost centers makes no sense. In other words, fixed costs should not be allocated to other cost centers, cost center managers should assume responsibility for their own flexible budget.

Flexible budgets are thus a prerequisite for the introduction of a Resource Consumption Accounting system RCA and for Contribution Accounting.

Proportional and Fixed Costs

Applying the cost cube from the previous post means that for decision support all costs have to be split into their proportional and fixed portion, since proportional is the consequence of units produced and sold, fixed is the consequence of management decisions. The point is to correctly represent the principle of cause and effect in cost center planning. This splitting is done in the planning process.

- An employee in a production center can work on production orders (setup, production, monitor quality, pack finished parts into transport containers). These are tasks that are causally necessary for the creation of a defined product. Without them, the product cannot be created. They are incurred proportionally to the quantity produced. The same employee can organize, take part in further training, attend meetings, clean up the workplace or, hopefully in rare cases, wait for work. The latter activities are determined by the organization of the cost center. They are incurred independently of the quantity produced and are therefore part of the cost center’s fixed costs.
- The consumption of electrical energy in a production cost center is mainly determined by the type of product to be manufactured and the quantity produced. Electricity is also consumed for lighting, air conditioning, and the operation of auxiliary equipment such as computers. The consumption for production is causally necessary for the creation of the product and must therefore be planned proportionally. The rest of the electricity consumption is again the part of the capability to perform.
- Maintenance work on the machines installed in the cost center can be caused by the operation of the equipment, e.g. after 200 hours of operation the rollers have to be replaced because they are no longer flat. Other maintenance work (technical inspections, functional checks) is due after a predetermined period of time, for example, annually, regardless of the quantities produced, to ensure operational readiness.

The examples show that different cost elements in a cost center must be planned with a proportional and a fixed portion. The following section shows how the necessary cost splitting can be largely automated. The example of the Stamping cost center is reused for this purpose.

Proportional and Fixed Costs in 220 Stamping

In comparison to the initial situation in the post “Planning Cost Centers”, the columns proportional, fixed and value consumption per RFU have been added.

The procedure for automated cost splitting using the example of personnel costs: The annual budget for personnel costs is 337,560. This amount divided by the normal capacity of the employees (408,000 Pmin) results in the average presence time rate per minute of 0.82735. This is the average cost per minute “been there” of any employee in this cost center. The 0.82735 are multiplied by the planned activity level of 338,855 Pmin. The planned proportional personnel costs are thus 280,353. The fixed costs are the difference to the planned amount (57,207).

For the other cost types the cost center manager considers for each of these what portion of the planned amount depends on the cost center’s activity. In the example, these are the consumption of auxiliary and operating materials, external maintenance, other expense, and energy. The manager derives this proportional share from his planning documents (maintenance contracts, consumption tables for energy, material costs that only arise from productive work). By dividing the amount by the planned activity he receives the consumption per reference factor unit (RFU, entry in last column). Since the RFU in the stamping shop is the minute, this naturally results in very low rates. The calculation method is then analogous to the splitting of the personnel costs.

Tip for practical implementation: Do not use percentages when splitting the proportional from the fixed amount. Always use the proportional rate per RFU. If the planned activity level has to be adjusted due to a changed production plan, the proportional plan cost rate of the cost center would change when using percentages. This is unrealistic because it is still the same product with the same work plan.

Cost splitting is a prerequisite for the calculation of proportional planned product costs. In order to be able to process if-then questions, the manager must know which costs are directly caused by the product (proportional planned production costs) and which cost blocks are the result of structural and capacity decisions (fixed costs). The latter change as shown in the cost cube through management decisions while the proportional product costs per unit remain the same as long as the product unit has the same bill of materials and work plan.

If the planned activity level, the planned cost amounts per cost type and the consumption per RFU are known for each cost center, cost splitting can be completely automated. Proof of this is provided in the simulation model of the book Management Control with Integrated Planning – Models and Implementation for Sustainable Coordination.

Cost splitting is not necessary in structure cost centers since these areas work for the products and not on the products. Consequently, only fixed costs can be planned in these cost centers.