Flexible Budget Analysis Exercise

In order for the holding company to determine how the different franchises are
performing, it is important to come with a standard budget as the same could be used as a
benchmark of performance. Basing said standard budget on best practice can ensure that the
franchises are operating within standard.
However simply using the total of the standard budget and comparing it with the total of
the franchisee may give a certain amount of information but it does not give us a better picture of
what is happening. Consider the table below:
Table 1. Holding Company vs. Franchisee

Standard Budget vs Actual Performance


Holding Company Franchisee Variance

Sales $4,550,000 $4,160,000 ($390,000) U

Purchases $2,080,000 $2,067,000 ($13,000) U
Hourly Wages (variable) $1,202,500 $988,000 ($214,500) U
Franchise fee $136,500 $124,800 ($11,700) U
Advertising (fixed) $390,000 $364,000 ($26,000) U
Utilities (variable) $253,500 $224,900 ($28,600) U
Depreciation $162,500 $162,500 $0
Lease Expense $104,000 $104,000 $0
Salaries (fixed) $104,000 $106,600 $2,600 F
Total $4,433,000 $4,141,800 ($291,200) U

Income before Tax $117,000 $18,200 ($98,800) U
* F = Favourable result U = Unfavourable result
The difference between the performances of the franchisee against the standard budget
shows a number of unfavourable outcomes. This does give the real picture as some amounts may
not actually be necessary. For instance the franchise fee is given to be 3% of the sales. Thus
while the sales may not reach what was expected, the franchisee continues to pay the fee thus
this should not be an issue entirely for the franchisor.
Another problem with simply using the standard budget for comparison is that in this
particular example, the company operates two types of business: a restaurant and a drive-
through. By using the total actual amount, we are unable to see just how each segment performed
and would therefore be unable to assist the franchisee.
Thus while a standard budget or master budget can help the holding company, it has
some limitations when it comes to the franchises. One problem with a master budget is that
because it is confined to a single year of activity, the variance between the budget and the actual
results may differ. Even if the relationship between the sales and expenses are consistent, a static
budget will be unable to explain the fluctuations.
A good method to get a clearer picture would be to implement a flexible budget. This is a
type of budget that is designed to predict an outcome while taking into account the different
changes that is present. The main limitation of a flexible budget is that it is only as good as the
information provided. In the case of the holding company, it has to know and accurately identify
fixed and variable costs in order to determine the relevant range. Any such error in determining
the range could lead to a distortion in the evaluation resulting in making poor decisions.

Review of Current Data

For the holding company, it would be better to have a flexible budget using the different
segments instead of just having the total amount. Reviewing the data given however we
encounter a minor problem as it does not show any information regarding units sold. A minor
problem because in the case of the holding company it is very difficult to put focus on the
volume of customers as this may experience a large fluctuation depending on the location of the
franchise. What we can do is instead look at the different ratios.
The table below is taken from the standard budget on best practice.
Table 2. Holding Company Standard Budget

Sales Income before Tax %
Restaurant $3,250,000 $65,000 2%
Drive Through $1,300,000 $52,000 4%

We see from table 2 that based on the standard budget, the income before tax of the
restaurant segment is 2% of the sales whereas the drive through segment shows income before
tax is 4% of sales.



Table 3. Franchisee Results

Sales Income before Tax %
Restaurant $2,600,000 ($15,600) -1%
Drive through $1,560,000 $33,800 2%

From table 3, we can see that indeed both segments of the franchisee are experiencing
problems with the restaurant segment experiencing more of it considering that it is reporting net
losses. The drive through segment on the other hand, while showing positive results is still below
the expected output. In addition, from table 3, we can already pinpoint that while the downturn in
tourist may have resulted in lower sales, the issue is in the cost experienced by the franchisee.
Before we look at the costs though, it is important that we rearrange it so that we separate
the variable costs and the fixed costs. The reason we do this is because the franchisee has no
control over the fixed cost but it can do something about the variable costs. Table 4 shows the
different fixed and variable costs per segment of the franchisee. Note that while the Franchise
Fee is 3% of sales, we consider this as a variable cost since the actual value depends on the total
amount of sales.
Table 4. Variable and Fixed Costs
















Restaurant Drive through
Variable Costs

Purchases 1,053,000 1,014,000
Hourly Wages (variable) 912,600 75,400
Utilities (variable) 126,100 98,800
Franchise fee 78,000 46,800

Fixed Costs

Advertising (fixed) 221,000 143,000
Depreciation 97,500 65,000
Lease Expense 65,000 39,000
Salaries (fixed) 62,400 44,200
We now compare the variable costs of the franchisee with that of the standard budget.
Table 5. Variable Costs

Restaurant Drive through
Franchisee Standard
%
Difference Franchisee Standard
%
Difference
Variable Costs
Purchases $1,053,000 $1,300,000 -23% $1,014,000 $780,000 23%
Hourly Wages (variable) $912,600 $1,137,500 -25% $75,400 $65,000 14%
Utilities (variable) $126,100 $162,500 -29% $98,800 $91,000 8%
Franchise Fee $78,000 $97,500 -25% $46,800 $39,000 17%

The results from Table 5 are rather surprising. For the drive through segment, the reason
it is not reaching the expected values is that it is spending more. For the restaurant segment
however, it seems that it is actually spending less than expected. Thus the reason for the loss in
the restaurant segment is indeed the lower volume of sales. With all these information, we now
proceed to making the flexible budget for the franchisee. In order to have an effective flexible
budget analysis, we need to scale the costs as a percentage of actual sales and compare it with the
standard budget.
Table 6. Restaurant Segment
Restaurant Segment Standard Franchisee
Sales $3,250,000 $2,600,000

Variable Costs
Purchases $1,300,000 40% $1,053,000 41%
Hourly Wages (variable) $1,137,500 35% $912,600 35%
Utilities (variable) $162,500 5% $126,100 5%
Franchise Fee $97,500 3% $78,000 3%

Total Fixed Costs $487,500 15% $445,900 17%

Total Percentage of Costs to Sales 98% 101%

From Table 1 we know that there was a large amount when it came to comparison for
sales and costs. Looking at the percentages however from Table 6, we see that the franchisee was
in fact performing near the standard. One important piece of information obtained from Table 6
is that the franchisee has higher Purchases. It also has higher fixed costs which is surprising.

Table 7. Drive through Segment
Drive through Segment Standard Franchisee
Sales $1,300,000 $1,560,000

Variable Costs
Purchases $780,000 60% $1,014,000 65%
Hourly Wages (variable) $65,000 5% $75,400 5%
Utilities (variable) $91,000 7% $98,800 6%
Franchise Fee $39,000 3% $46,800 3%

Total Fixed Costs $273,000 21% $291,200 19%

Total Percentage of Costs to Sales 96% 98%

As with the result for the restaurant segment, we see that for the drive through segment,
the franchisee exceed its purchases. We also see that fixed costs were smaller.

Flexible Budget Analysis

The previous section showed us how the franchisee was performing compared to what
was expected of it. Since we do not have any data for units sold, we focus the flexible budget
analysis on the costs scaled on the level of sales achieved. This simply means that we use
percentage of cost to have a more meaningful comparison. The method we used therefore was to
get the percentage of sales based on the standard budget. Then we apply these percentages as the
flexible budget assuming the sales remains the same.









Table 8. Flexible Budget for Restaurant Segment
Standard Franchisee Flexible
Restaurant Restaurant Restaurant Variance
Sales $3,250,000 $2,600,000 $2,600,000

Purchases $1,300,000 40.00% $1,053,000 40.50% $1,040,000 40.00% ($13,000) F
Hourly Wages (variable) $1,137,500 35.00% $912,600 35.10% $910,000 35.00% ($2,600) F
Franchise fee $97,500 3.00% $78,000 3.00% $78,000 3.00% $0
Advertising (fixed) $260,000 8.00% $221,000 8.50% $208,000 8.00% ($13,000) F
Utilities (variable) $162,500 5.00% $126,100 4.85% $130,000 5.00% $3,900 U
Depreciation $97,500 3.00% $97,500 3.75% $78,000 3.00% ($19,500) F
Lease Expense $65,000 2.00% $65,000 2.50% $52,000 2.00% ($13,000) F
Salaries (fixed) $65,000 2.00% $62,400 2.40% $52,000 2.00% ($10,400) F
Total Costs $3,185,000 $2,615,600 $2,548,000 ($67,600) F

Income before Tax $65,000 ($15,600) $52,000

Table 8 shows Favorable results considering that the actual costs under the Flexible
budget went down compared to the actual costs.

Table 9. Comparison
Restaurant
Standard Flexible Actual
Total Costs $3,185,000 $2,548,000 $2,615,600
Difference $637,000 $67,600
F U

Table 9 shows the differences in the actual costs. We can see that in the Flexible budget,
the total costs were lower than the standard budget given. However the actual total costs was
higher than the total costs for the Flexible budget which resulted in an unfavourable rating.
What this means is that for the Restaurant segment, the variance is due to poor cost control an
example of which is spending too much. This is evidenced by the previous tables showing that
Purchases were rather high.



Table 10. Flexible Budget for Drive through Segment
Standard Franchisee Flexible

Drive
through
Drive
through
Drive
through Variance
Sales 1,300,000 1,560,000 $1,560,000

Purchases 780,000 60.00% 1,014,000 65.00% $936,000 60.00% ($78,000) F
Hourly Wages (variable) 65,000 5.00% 75,400 4.83% $78,000 5.00% $2,600 U
Franchise fee 39,000 3.00% 46,800 3.00% $46,800 3.00% $0
Advertising (fixed) 130,000 10.00% 143,000 9.17% $156,000 10.00% $13,000 U
Utilities (variable) 91,000 7.00% 98,800 6.33% $109,200 7.00% $10,400 U
Depreciation 65,000 5.00% 65,000 4.17% $78,000 5.00% $13,000 U
Lease Expense 39,000 3.00% 39,000 2.50% $46,800 3.00% $7,800 U
Salaries (fixed) 39,000 3.00% 44,200 2.83% $46,800 3.00% $2,600 U
Total $1,248,000 $1,526,200 $1,497,600 ($28,600) F

Income before Tax $52,000 $33,800 $62,400

Table 10 shows that even with majority of costs are rated as unfavourable, total costs
was favourable since the total variance in the purchases was rather large.

Table 11. Comparison
Drive through
Standard Flexible Actual
Total Costs $3,185,000 $2,548,000 $2,615,600
Difference $637,000 $67,600
F U

As with Table 9, we see that even the Drive through segment has a problem in the area of
cost control.







Benchmarking

The previous discussion showed that we can use the Standard Budget as the benchmark
for the performance of the franchisees. However we should not use the actual amounts but
instead focus on the percentage of costs to sales. This way it is easier and more efficient for the
franchisees to follow. Simply put, the goal is not to have the total cost exceed 100% as this well
result in a loss for the franchisee.
Table 12. Benchmark
Benchmark Restaurant Drive through
Variable Costs
Purchases 40.00% 60.00%
Hourly Wages (variable) 35.00% 5.00%
Utilities (variable) 5.00% 7.00%
Franchise Fee 3.00% 3.00%


Total Fixed Costs 15.00% 21.00%

% of Income before Taxes to Sales 2% 4%

The percentages shown in Table 12 are based on the Standard Budget. However since
they will not total 100%, this means the franchise has room to move with regards to the
benchmark. Since we do not want to change the fixed costs as much as possible, then we are left
with the variable costs.
For the Restaurant segment the percentage of total costs to sales is at 98%. At 100%, the
franchisee will be at breakeven. With the exception of the Franchise Fee, the three variable costs
will have a variance of . For the Drive through Segment it has an allowable variance of
. What this means is that if the percentage of Purchases to Sales for the Restaurant Segment
reaches 42%, then the Hourly Wages and Utilities should not increase otherwise it will result in a
loss. This means that if the Restaurant Segment is to be profitable, the percentage of Purchases to
Sales must be 40% or less.
In addition, based on the benchmark given, it is clear that the Restaurant Segment is
indeed losing since its percentage of Income before Taxes to Sales is 1% compared to the
benchmark of 2%. This means that the Restaurant Segment must find a way to cut costs which
was further evidenced by the Flexible Budget Analysis. The same is true for the Drive through
Segment despite it reporting positive results. This is because the Drive through Segment reported
2% Income before Taxes to Sales compared to the benchmark of 4%.