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.
- The company also knows that the depreciation, supervision, and other fixed costs come to about $35,000 per month.
- For costs that vary with volume or activity, the flexible budget will flex because the budget will include a variable rate per unit of activity instead of one fixed total amount.
- To determine whether a cost is variable or fixed, think about the nature of the cost.
- Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
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. Favorable variances are usually positive amounts, and unfavorable variances are usually negative amounts. Some textbooks show budget reports with “F” for favorable and “U” for unfavorable after the variances to further highlight the type of variance being reported.
For example, a widget company might start out the year with a static planning budget that assumes that the cost to produce 10 widgets is $100, and the company will produce 100 units per month. Each unit will bring in a net profit of $50, so the net profit per month will be 100 X 50, or $5,000. Flexible budgets are usually prepared at each business analysis period (either monthly or quarterly), rather than in advance. Static budgeting is constrained by the ability of an organization to accurately forecast its needed expenses, how much to allocate to those costs and its operating revenue for the upcoming period. When using a static budget, a company or organization can track where the money is being spent, how much revenue is coming in, and help stay on track with its financial goals.
However, a flexible budget allows managers to assign a percentage of sales in calculating the sales commissions. The management might assign a 7% commission for the total sales volume generated. Although with the flexible budget, costs would rise as sales commissions increased, so too would revenue from the 3.4 journal entries additional sales generated. Unlike a static budget, a flexible budget changes or fluctuates with changes in sales, production volumes, or business activity. A flexible budget might be used, for example, if additional raw materials are needed as production volumes increase due to seasonality in sales.
If 5,000 machine hours were necessary for the month of January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH). If the machine hours in February are 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH). If March has 4,100 machine hours, the flexible budget for March will be $81,000 ($40,000 fixed + $10 x 4,100 MH). Fixed expenses such as rent, utilities, equipment costs, and salaries usually make up a significant portion of any business budget. While it’s possible that these costs will change slightly, most businesses simply budget for them upfront.
Pros and Cons of Flexible Budgets
All of the different budget models have their benefits and drawbacks – even flexible budgets…as amazing as they sound. This is where a flexible budget comes into play justifying the cost increase based on the actual earned revenue. A flexible budget, while much more time-intensive to create and maintain, offers an incredibly precise picture of your company’s performance. Due to the ability to make real-time adjustments, the results present great detail and accuracy at the end of the year. 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.
It subsequently generates a budget that ties in specifically with the inputs. The columns would continue below with fixed and variable expenses, allowing you to see how your net profit changes based on changes in actual production and revenue. However, much to the disappointment of Steve and Kira, the overhead budget report reported major overruns.
Let’s face it – business moves fast, and we have to be flexible for what is thrown at us. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Let’s suppose the production machinery had to operate for 4,500 hours during February. Let’s imagine that a manufacturer has determined what its electricity and supplies costs are for the factory. For control purposes, the accountant then compares the budget to actual data. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
- This means that the variances will likely be smaller than under a static budget, and will also be highly actionable.
- Then, they can modify the flexible budget when they have their actual production volume and compare it to the flexible budget for the same production volume.
- For example, the volume of the company’s activities (planned revenue) may change significantly under the influence of not always predictable external factors.
- Using the following information, prepare a flexible budget for the production of 80% and 100% activity.
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. For example, your master budget may have assumed that you’d produce 5,000 units; however, you actually produce 5,100 units. The flexible budget rearranges the master budget to reflect this new number, making all the appropriate adjustments to sales and expenses based on the unexpected change in volume.
What is a Flexible Budget?
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. Flexible budgets do not fix variances, they help to better plan for the future.
Not All Costs Are Variable
However, before deciding to switch to the flexible budget, consider the following countervailing issues. If you don’t want to spend hours tracking and forecasting your budget in spreadsheets, check out our financial modeling tool. Finmark is everything you need to build an accurate, customized financial model. No matter which type of budget model you choose, tracking your finances is what matters most. Flexible budgets take time to maintain, with routine monthly reviews and edits. It’s also important to request accountability for all changes made to this budget in order to keep it working for you.
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On the other hand, some overhead costs, such as rent, are fixed; no matter how many units you make, these costs stay the same. To determine whether a cost is variable or fixed, think about the nature of the cost. 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. These points make the flexible budget an appealing model for the advanced budget user.
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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. If, however, the manager is the Chief Executive Officer, the entire income statement should be used in evaluating performance. A static budget based on planned outputs and inputs for each of a company’s divisions can help management track revenue, expenses, and cash flow needs.
So if the initial static budget called for 25% to be spent on marketing, the flexible budget will maintain that same percentage for marketing whether the budget increases or decreases. These variances are used to assess whether the differences were favorable (increased profits) or unfavorable (decreased profits). If an organization’s actual costs were below the static budget and revenue exceeded expectations, the resulting lift in profit would be a favorable result.
Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
While accounting software is an important part of tracking all of your financial transactions, many software applications simply don’t have the capability of preparing a flexible budget. Expenses such as rent, management salaries, and marketing costs remain static and do not change based on production. A flexible budget is best used in a manufacturing environment where the budget is able to be based on production volume.