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.† Letís recalculate the budget using $20,000,000 in sales:

Budget Line

Monthly
Budget

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, letís prepare the budget to actual using the flexible budget and actual numbers:

Budget Line

Monthly
Flexible
Budget

Monthly
Actual

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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