When and why to use flexible budgets
2. The nature of flexible budgets and when to use them
Sometimes the budgeted and actual numbers differ greatly. For instance, the company in our example budgeted to have $10,000,000 in monthly sales. Suppose that the demand for the company products increased dramatically during the second month of calendar year 20X6 and sales were $20,000,000. If the company continues to use the original budgeted amounts, the budget to actual comparison will be hard to analyze because the budgeted revenues were $10,000,000 and budgeted expenses were estimated using the budgeted revenues. All variances will be large. In fact, the budget to actual analysis may be meaningless in this instance.
What can help in this scenario is a flexible budget. A flexible budget takes into account significant changes in activities during the period to adjust the budget numbers. In our example, the significant change is the revenue increase from $10,000,000 to $20,000,000. To adjust the budget numbers for the second month of calendar year 20X6, management can recalculate the budgeted expenses using the original percentages/assumptions and the actual sales of $20,000,000. Recall that variable expenses were calculated as a percent of revenues and fixed ones were determined based on their nature and historical data. Let’s recalculate the budget using $20,000,000 in sales:
Budget Line |
Monthly |
Calculation Method |
Revenues |
$ 20,000,000 |
|
Cost of goods sold |
||
Materials |
6,000,000 |
30% of revenues |
Labor |
2,000,000 |
10% of revenues |
Variable overhead |
1,000,000 |
5% of revenues |
Fixed overhead |
1,000,000 |
Estimated based on nature |
Total cost of goods sold |
10,000,000 |
|
Operating expenses |
||
Variable expenses |
1,500,000 |
7.5% of revenues |
Fixed expenses |
2,500,000 |
Estimated based on nature |
Total operating expenses |
4,000,000 |
|
Total expenses |
14,000,000 |
|
Net income (loss) |
$ 6,000,000 |
Now, let’s prepare the budget to actual using the flexible budget and actual numbers:
Budget Line |
Monthly |
Monthly
|
Variance |
Variance |
Revenues |
$ 20,000,000 |
$ 20,000,000 |
$ 0 |
0% |
Cost of goods sold |
||||
Materials |
6,000,000 |
5,400,000 |
(600,000) |
-10% |
Labor |
2,000,000 |
2,100,000 |
100,000 |
5% |
Variable overhead |
1,000,000 |
950,000 |
(50,000) |
-5% |
Fixed overhead |
1,000,000 |
900,000 |
(100,000) |
-10% |
Total cost of goods sold |
10,000,000 |
9,350,000 |
(650,000) |
-7% |
Operating expenses |
||||
Variable expenses |
1,500,000 |
1,600,000 |
100,000 |
7% |
Fixed expenses |
2,500,000 |
3,000,000 |
500,000 |
20% |
Total operating expenses |
4,000,000 |
4,600,000 |
600,000 |
15% |
Total expenses |
14,000,000 |
13,950,000 |
(50,000) |
0% |
Net income (loss) |
$ 6,000,000 |
$ 6,050,000 |
$ 50,000 |
1% |
As you can see, using a flexible budget provides a good way to account for significant changes in activities which were not incorporated in the original budget. The budget to actual analysis using the flexible budget numbers is more meaningful and easier to interpret.
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