When and why to use flexible budgets

December 28, 2015

What is a flexible budget? When would management prepare and use a flexible budget? In this article, we will look for answers to these questions.

1. How budgets are prepared

Budgeting is usually viewed as a planning and control tool.† Management prepares budgets to show what the future may look like based on the company strategy.† When the future comes and actual numbers become available, they are compared to the budget; differences are analyzed to identify any deviations from the budget (strategy) and take corrective actions (if needed).

Budgets are prepared before the relevant reporting period starts.† For example, a budget for calendar year 20X6 will be prepared during calendar year 20X5.

Budget numbers are prepared using assumptions about what the future may look like and what management hopes to achieve.† For instance, a company hopes to generate $10,000,000 in monthly sales during 20X6.† This level of revenues will require certain level of expenses.† Expenses can be variable or fixed (and some are step-variable).† Usually, variable expenses will be estimated as a percent of planned sales and fixed expenses will be determined based on their nature and historical data.† Letís take a look at an example:

Budget Line

Monthly
Budget

Calculation Method

Revenues

$†† 10,000,000

 
     

Cost of goods sold

   

    Materials

3,000,000

30% of revenues

    Labor

1,000,000

10% of revenues

    Variable overhead

500,000

5% of revenues

    Fixed overhead

1,000,000

Estimated based on nature

Total cost of goods sold

5,500,000

 
     

Operating expenses

   

    Variable expenses

$750,000

7.5% of revenues

    Fixed expenses

$2,500,00

Estimated based on nature

Total operating expenses

$3,250,000

 
     

Total expenses

$8,750,000

 
     

Net income (loss)

$1,250,000

 

In the table above, the company estimates that raw materials (a variable expense) will represent 30% of the revenue amount; so, the cost of raw materials is calculated to be $3,000,000 (i.e., $10,000,000 x 30%).† For fixed expenses, using a percent of revenues is not appropriate because fixed expenses donít change with changes in revenues; instead, the company can estimate such expenses based on their nature and historical data.

When the actual information becomes available for the first month in 20X6, management performs a budget to actual analysis:

Budget Line

Monthly
Budget

Monthly
Actual

Variance
($)

Variance
(%)

Revenues

$ 10,000,000

$ 9,500,000

(500,000)

-5%

         

Cost of goods sold

       

    Materials

3,000,000

2,700,000

(300,000)

-10%

    Labor

1,000,000

950,000

(50,000)

-5%

    Variable overhead

500,000

490,000

(10,000)

-2%

    Fixed overhead

1,000,000

1,050,000

50,000

5%

Total cost of goods sold

5,500,000

5,190,000

(310,000)

-6%

         

Operating expenses

       

    Variable expenses

750,000

700,000

(50,000)

-7%

    Fixed expenses

2,500,000

2,300,000

(200,000)

-8%

Total operating expenses

3,250,000

3,000,000

(250,000)

-8%

         

Total expenses

8,750,000

8,190,000

($560,000)

-6%

         

Net income (loss)

$ 1,250,000

$ 1,310,000

$ 60,000

5%

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