## When and why to use flexible budgets

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.  Let’s 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 don’t 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%
Not a member?