Companies create planning budgets in order to forecast their financial position for some period in the future. This type of budget is referred to as a master or static budget. After the period has passed, a flexible budget can be constructed that shows the difference between projected and actual revenue and costs.
A flexible budget model, which is used to create a flexible budget, consists of formulas that generate expected costs based on assumptions used to create the master budget. Any difference between the flexible budget and actual costs and revenue is referred to as a flexible budget variance.
Types of Flexible Budget Variances
There are two main reasons for a company's actual performance to be different from the master budget forecast: differences in spending and differences in revenue activity, which often is based on sales volume. To understand differences in spending, or costs, these flexible budget formulas are used:
- Per-unit variable cost – the cost to produce a single unit.
- Per-unit revenue – the amount charged per unit.
- Total fixed cost – a fixed amount added to the budget regardless of the number of units produced or sales activity.
A master budget is rarely perfect. When actual costs are known, problems with the master budget can be found and analyzed by comparing figures obtained using the flexible budget formulas to actual costs. Any difference found is referred to as a spending variance, while a difference between the volume of sales in the master budget and the actual sales volume is an activity variance. Spending variances help explain how changes to the selling price per unit, variable cost per unit and total fixed costs affected revenue. Activity variances can help explain how revenue was affected by changes in sales volume.
Flexible Budget Formula Example
As an example, take a company with a master budget that projects production of 10,000 units. It turns out that 2,000 more units were produced than expected, for an actual total of 12,000 units. That number can be plugged into a flexible budget formula to make adjustments to the forecasts for sales and revenue due to the change in volume. So, if the flexible budget predicts that the total cost to produce 10,000 units is $50,000, then the cost to produce 12,000 units should be $60,000.
If the company finds that its actual expense to produce the 12,000 units was $75,000, there is a $15,000 spending variance. It could represent a cost overrun or it could be due to a variable cost that was estimated as fixed. This is an unfavorable variance because the actual cost is greater than expected at the actual activity level.
A favorable variance occurs when the actual cost is less than the expected cost at the actual level of activity. The flexible budget formula provides a way to compute expected costs at different levels of activity in order to make meaningful comparisons.
Preparing a Flexible Budget
An understanding of how a company's revenue and costs are affected when activity changes within a specific time period is required to prepare a flexible budget based on a master budget. From this understanding, formulas are created that capture cost and revenue behavior in the master budget. Before costs can be added in, they should be classified correctly as variable or fixed.
When the actual number of units produced and sold is known, they can be plugged into the flexible budget formulas. The results are the flexible budget, which can be directly compared to actual costs. Variances are calculated by looking at differences between the two. The advantage of comparing actual results to the flexible budget is that it helps pinpoint inaccuracies in the master budget.