7 4 Prepare Flexible Budgets Principles of Accounting, Volume 2: Managerial Accounting

However, if actual performance in a given month or quarter is different from the planned amount, it is difficult to determine whether costs were controlled. The original budget for selling expenses included variable and fixed expenses. To determine the flexible budget amount, the two variable costs need to be updated. The new budget for sales commissions is $10,500 ($262,500 sales times 4%), and the new budget for delivery expense is $1,750 (17,500 units times 10%). These are added to the fixed costs of $12,500 to get the flexible budget amount of $24,750. In a flexible budget, there is no comparison of budgeted to actual revenues, since the two numbers are the same.

Disadvantages of Flexible Budgeting

For example, suppose a proposed sale of items does not occur because the expected client opted to go with another supplier. In a static budget situation, this would result in large variances in many accounts due to the static budget being set based on sales that included the potential large client. A flexible budget on the other hand would allow management to adjust their expectations https://www.bookkeeping-reviews.com/xero-service/ in the budget for both changes in costs and revenue that would occur from the loss of the potential client. The changes made in the flexible budget would then be compared to what actually occurs to result in more realistic and representative variance. This ability to change the budget also makes it easier to pinpoint who is responsible if a revenue or cost target is missed.

Revenue Comparison

A flexible budget created each period allows for a comparison of apples to apples because it will calculate budgeted costs based on the actual sales activity. A static budget is one that is prepared based on a single level of output for a given period. Flexible budgets are one way companies deal with different levels of activity. A flexible budget provides budgeted data for different levels of activity.

Static versus Flexible Budgets

Of course, if you sell 18,000 less units, you would expect profit to be less – this is where the flexible budget comes in. 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. 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.

1. This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales.
2. However, before deciding to switch to the flexible budget, consider the following countervailing issues.
3. Flexible budgets are one way companies deal with different levels of activity.
4. When preparing budget reports, it is important to include in the report the items the manager can control.

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. What is not known from looking at it is why the variances occurred. A flexible budget flexes the static budget for each anticipated level of production. 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. The flexible budget uses the same selling price and cost assumptions as the original 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. The advantage to a flexible budget is we can create a budget based on the ACTUAL level of production to give us a clearer picture of our results by comparing the flexible budget to actual results. This analysis would compare the actual level of activity so volume variances are not a factor and management can focus on the cost variances only. Big Bad Bikes is planning to use a flexible budget when they begin making trainers. The company knows its variable costs per unit and knows it is introducing its new product to the marketplace.

The expenses that do not change are the fixed expenses, as shown in Figure 7.23. We can calculate the flexible budget for https://www.bookkeeping-reviews.com/ any level of activity using these figures. Leed Company prepares a flexible budget for 70%, 80%, 90% and 100% capacity.

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. 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.

Its estimations of sales and sales price will likely change as the product takes hold and customers purchase it. Big Bad Bikes developed a flexible budget that shows the change in income and expenses as the number of units changes. It also looked at the effect a change in price would have if the number of units remained the same. The expenses that do not change are the fixed expenses, as shown in Figure 10.25. The flexible budget 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.

Early in the chapter, you learned that a budget should be adjusted for changes in assumptions or variations in the level of operations. A flexible operating budget is a special kind of budget that provides detailed information journal entry for cash and credit transactions about budgeted expenses (and revenues) at various levels of output. Big Bad Bikes used the flexible budget concept to develop a budget based on its expectation that production levels will vary by quarter.

Differences may occur in fixed expenses, but they are not related to changes in activity within the relevant range. This flexible budget is unchanged from the original (static budget) because it consists only of fixed costs which, by definition, do not change if the activity level changes. Using the cost data from the budgeted income statement, the expected total cost to produce one truck was $11.25.

The flexible budget variance isolates the difference between actual results and budget projections based on larger than expected or less than expected sales price (for revenues) and costs (for expenses). Managers use a technique known as flexible budgeting to deal with budgetary adjustments. A flexible budget adjusts to changes in actual revenue levels. Actual revenues or other activity measures are entered into the flexible budget once an accounting period has been completed, and it generates a budget that is specific to the inputs.

There were also fixed costs of $25,000 related to the factory and $25,000 related to selling and administration. Some companies have so few variable costs of any kind that there is little point in constructing a flexible budget. Instead, they have a massive amount of fixed overhead that does not vary in response to any type of activity.

A static budget is one that is prepared based on a single level of output for a given period. The master budget, and all the budgets included in the master budget, are examples of static budgets. Actual results are compared to the static budget numbers as one means to evaluate company performance. However, this comparison may be like comparing apples to oranges because variable costs should follow production, which should follow sales. Thus, if sales differ from what is budgeted, then comparing actual costs to budgeted costs may not provide a clear indicator of how well the company is meeting its targets.