How To Create a Flexible Budget with Example

Sales-activity variances measure how effective managers have been in meeting the planned sales objective. In Evergreen Co., sales activity fell 2,000 units short of the planned level. The sales-activity variances (totaling Br. 18,400 U) are unaffected by any changes in unit prices or variable costs. Because the same budgeted unit prices and variable costs are used in constructing both the flexible and master budgets.

Contribution to overhead and profit—the direct costs and revenues that each manager controls in the short run. Both the president and the financial vice president of Corcom readily admit that having so many budgets creates confusion as to which one is most important in evaluating results. The period covered can range from three to six months in very small companies to two or three years in large corporations. Operating budgets usually cover one year, although some companies also include a general forecast for the second year. Such forecasts normally do not involve the same commitment as operating budgets.

How To Create a Flexible Budget (with Example)

It also depends upon the factors of the production, which are not in the hands of the management. Therefore the predictions can be inaccurate due to these conditions. The availability of skilled workers becomes a challenge for the industry. Therefore, many Industries and companies can’t use this budget despite its enormous advantages.

If you manage a high-level production environment, creating a flexible budget can help mitigate the typical variances found on static budgets. What is the department total budgeted cost, assuming that the department uses flexible budgeting? The budget is prepared for each level of https://simple-accounting.org/ activity selected by associating the activity level with corresponding costs. Every start-up, from Silicon Valley to your local mom and pop business should be implementing a budget to keep of what they earn, what they spend, and as a way to keep track of their business goals.

Definition of Flexible Budget

Using a flexible budget will immediately alert you to any changes that are likely to impact your bottom line, allowing you to make changes proactively instead of reactively. This budget is useful for monitoring costs and evaluating performance. It can direct, guide, and reward operating managers and form a basis for performance evaluation. When individuals are given a goal that is a bit beyond what they initially expect, they will often accept the goal as achievable and then work hard to attain it. But if the goal is set too high, they will probably reject it as unattainable and perform poorly. In budgeting, then, a key question is how tight a manager can set a budget and still make it useful in encouraging good performance. The higher sales of department A increased corporate overhead charges and reduced profits.

On an income statement budget report, think of how the variance affects net income, and you will know if it is a favorable or unfavorable variance. If the actual results cause net income to be higher than budgeted net income , the variance is favorable. If actual net income is lower than planned (lower revenues than planned and/or higher costs than planned), the variance is unfavorable. So higher revenues cause a favorable variance, while higher costs and expenses cause an unfavorable variance. Although the budget report shows variances, it does not explain the reasons for the variance. The budget report is used by management to identify the sales or expenses whose amounts are not what were expected so management can find out why the variances occurred. By understanding the variances, management can decide whether any action is needed.

Flexible Budget Advantages

A performance report comparing the actual production costs and sales amount with the planned is given in Exhibit 2-1. If, however, the cost was identified as a fixed cost, no changes are made in the budgeted amount when the flexible budget is prepared. Differences may occur in fixed expenses, but they are not related to changes in activity within the relevant range.

You would then take your static, or master, budget and adjust the numbers based on your actual revenue. Company B has budgeted for $5 million in revenue and $1 million in cost of goods sold. The company has determined that $400,000 of the $1 million of the cost of goods sold is fixed and $600,000 of the cost A Small Business Guide To Flexible Budgets of goods sold will vary based on its revenue. This means that the variable, or flexible, the amount of cost of goods sold is 12% of the company’s revenue. At the end of the accounting period, Company B determines that it actually had sales that equaled $6 million, which is $1 million more anticipated.

Analyzing flexible budget variance

We have identified flexible budget variance and activity level variance. The activity level variance measures the organizations effectiveness and the flexible budget variance is often a measure of efficiency though it is also affected by changes in prices and unit costs. To create a meaningful performance report, actual revenues and costs and expected revenues and costs must be compared at the same level of activity.

• Exhibit 2.3 shows a condensed result of the static budget variance, the sales activity variance, and the flexible-budget variance.
• Actual sales volume normally will vary from the original static budget because more or fewer units are usually sold than projected.
• Here’s a quick punch list of the pros and cons of flexible budgets.
• This does not always happen but is why flexible budgets are important for giving management an indication of what questions need to be asked.
• Note that, in addition to the above, all variances are affected by the care used in formulating credible budgeting or standard amounts.

The conclusion seems to be that all losses were due to a decrease in sales volume. Because of uncertainties in demand, Corcom cannot project revenues accurately very far into the future. It can only watch carefully what is going on and try to react rapidly.

Increased cost controls

Here you’ll plan out how much profit you plan to make based on your projected revenue, expenses, and cost of goods sold. If the difference between revenue and expenses (aka “profit margins”) aren’t where you’d like them to be, you need to rethink your cost of goods sold and consider raising prices. The only exception to this approach should be during business cycles when your company manages to strictly adhere to the original static budget.

Thus, if the actual expenses exceed $8,880 by $X in the month with an 80% activity level, it would mean that the company has not saved any money but has overspent $X more than the budgeted amount. A flexible budget is much more realistic than fixed budgets since it gives emphasis on cost behavior at different levels of activity. A flex budget uses percentages of revenue or expenses, instead of fixed numbers like a static budget. This approach means you’ll easily be able to make changes in the budgeted expenses that are directly tied to your actual revenue. In order to predict how changes in costs are likely to affect output, a business must be able to identify fixed and variable costs. In this case, variable costs must appear as a percentage of the total revenue or constant rate per unit. In this, one prepares different budgets for varied activity levels.