LO 7.4 Prepare Flexible Budgets

A company makes a budget for the smallest time period possible so that management can find and adjust problems to minimize their impact on the business. Everything starts with the estimated sales, but what happens if the sales are more or less than expected? How does this affect the budget? 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. But is this bad? 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.

Static versus Flexible Budgets

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. 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.

But, what if BBB can only sell 300 units in 2029 quarter 1, or 800 units or 1,200 units?

Budget with Varying Levels of Production

Companies develop a budget based on their expectations for their most likely level of sales and expenses. Often, a company can expect that their production and sales volume will vary from budget period to budget period. They can use their various expected levels of production to create a flexible budget that includes these different levels of production. 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. A flexible budget is more complicated, requires a solid understanding of a company’s fixed and variable expenses, and allows for greater control over changes that occur throughout the year. 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 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.

Remember we were wondering what if BBB could only sell 300 units in 2029 quarter 1, or what if it could sell 800 or 1,200 units?  Here is a flexible budget that let’s see what net income (or net loss) would be with these various potential sales volumes (see below).

Finally, let’s look at the flexible budget that BBB prepared after 2029 quarter 1 ended, so BBB knows the actual number of units sold and the actual selling price per unit and the actual costs.  See below.

Notice that BBB actually sold 1,100 units in 2029 quarter 1.  So the flexible budget is prepared based on 1,100 units.  Since actual selling price and costs are now known, we can display them, alongside the flexible budget amounts, and we can calculate the differences (called variances) between flexible budget and actual amounts.  More about variances in a later section.