Flexible Budget Practical Problems and Solutions Examples
What adjustments does a company have to make in order to compare the actual numbers to budgeted numbers when evaluating results? If production is higher than planned and has been increased to meet the increased sales, expenses will be over budget. To account for actual sales and expenses differing from budgeted sales and expenses, companies will often create flexible budgets to allow budgets to fluctuate with future demand.
Flexible budgeting can be used to more easily update a budget for which revenue or other activity figures have not yet been finalized. Under this approach, managers give their approval for all fixed expenses, as well as variable expenses as a proportion of revenues or other activity current ratio formula measures. Then the budgeting staff completes the remainder of the budget, which flows through the formulas in the flexible budget and automatically alters expenditure levels. At its simplest, the flexible budget alters those expenses that vary directly with revenues.
After you adjust for the change in production level, Skate’s variance is suddenly favorable. Actual overhead of $355,000 was $7,500 less than the $362,500 flexible budget. To prepare a flexible budget, you need to have a master budget, really understand cost behavior, and know the actual volume of goods produced and sold. Budget reports can be a useful tool for evaluating a manager’s effectiveness only if they contain the appropriate information. When preparing budget reports, it is important to include in the report the items the manager can control. If a manager is only responsible for a department’s costs, to include all the manufacturing costs or net income for the company would not result in a fair evaluation of the manager’s performance.
How to Implement a Flexible Budget
Both static and flexible budgets are designed to estimate future revenues and expenses. For example, telephone expenses may vary with changes in headcount. If so, one can integrate these other activity measures into the flexible budget model.
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- It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.
- Flexible budgets offer close monitoring of expenses versus revenue, and they allow for the opportunity to test things out and see what might work and what won’t without rigid financial constraints.
- A flexible budget will show the variance in both revenue and spending.
If a budget is prepared assuming 100 customers will be served, how will the managers be evaluated if 300 customers are served? Similar scenarios exist with merchandising and manufacturing companies. To effectively evaluate the restaurant’s performance in controlling costs, management must use a budget prepared for the actual level of activity. This does not mean management ignores differences in sales level, or customers eating in a restaurant, because those differences and the management actions that caused them need to be evaluated, too.
Accounting Principles II
A company wants to prepare a budget based on a scheduled activity level of 70% of the production capacity, where the number of units designed is 7000. The variable costs and fixed costs are $7,000 and $10,000, respectively. In order to correctly assess the impact of such changes on the implementation of budgets, flexible budgets are used, which are the link between the planned budget and the actual results achieved. When creating a flexible budget, money (costs as well as prices) are taken as planned, and volumes are taken as actual. This type of budget would be created if management knew the future actual sales with certainty, but these are unknown and this is where a flexible budget comes in.
Company
This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales. Flexible budgets are prepared at each analysis period (usually monthly), rather than in advance, since the idea is to compare the operating income to the expenses deemed appropriate at the actual production level. Flexible budgets are one way companies deal with different levels of activity. A flexible budget provides budgeted data for different levels of activity. Another way of thinking of a flexible budget is a number of static budgets. For example, a restaurant may serve 100, 150, or 300 customers an evening.
Categories of Expenses in a Flexible Budget
By the fourth quarter, sales are expected to be strong enough to pay back the financing from earlier in the year. The budget shown in Figure 7.25 illustrates the payment of interest and contains information helpful to management when determining which items should be produced if production capacity is limited. Instead, they vary based on other measures, such as electricity expenses based on consumed units. A flexible intermediate budget considers changes in costs based on such other activity measures. Thus, it provides a more accurate reflection of how costs and revenues change with fluctuations in activity.
Performance Measurement
This approach varies from the more common static budget, which contains nothing but fixed amounts that do not vary with actual revenue levels. This means that the variances will likely be smaller than under a static budget, and will also be highly actionable. ABC Company has a budget of $10 million in revenues and a $4 million cost of goods sold. Of the $4 million in budgeted cost of goods sold, $1 million is fixed, and $3 million varies directly with revenue. Thus, the variable portion of the cost of goods sold is 30% of revenues. Once the budget period has been completed, ABC finds that sales were actually $9 million.
Step 2: Identify fixed and variable costs for the period
While preparing any budget at all is always better than not having one, a static budget does not prepare you for revenue and expense changes in real time. Changing costs in the manufacturing process can severely impact your profit margin. Any unexpected market shifts may find a material essential to your production line suddenly costing more than three times the original budgeted amount. Creating a business budget, particularly a flexible budget, requires some familiarity with the accounting process and is best left to experienced accountants and bookkeepers with knowledge of cost accounting.
However, this approach ignores changes to other costs that do not change in accordance with small revenue variations. Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs. By incorporating these changes into the budget, a company will have a tool for comparing actual to budgeted performance at many levels of activity. Over time, though, your actual production, sales, and revenue will change. These changes can be due to variations such as changing inventory costs, supply chain concerns, and market conditions.
Total net income changes as the amount for each line on the income statement changes. Following are some of the advantages and problems of a flexible budget. Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
A flexible budget cannot be preloaded into the accounting software for comparison to the financial statements. Only then is it possible to issue financial statements that contain budget versus actual information, which delays the issuance of financial statements. It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.
Flexible budgets can also be used after an accounting period to evaluate the successful areas and unsuccessful areas of the last period performance. Management carefully compares the budgeted numbers with the actual performance statistics to see where the company improved and where the company needs more improvement. Though the flex budget is a good tool, it can be difficult to formulate and administer. One problem with its formulation is that many costs are not fully variable, instead having a fixed cost component that must be calculated and included in the budget formula. Also, a great deal of time can be spent developing cost formulas, which is more time than the typical budgeting staff has available in the midst of the budget process. All of the different budget models have their benefits and drawbacks – even flexible budgets…as amazing as they sound.