LO 7.5 Explain How Budgets Are Used to Evaluate Goals

As you’ve learned, an advantage of budgeting is evaluating performance. Having a strong understanding of their budgets helps managers keep track of expenses and work toward the company’s goals. Companies need to understand their revenue and expense details to develop budgets as a tool for planning operations and cash flow. Part of understanding revenue and expenses is evaluating the prior year. Did the company earn the expected profit? Could it have earned a higher profit? What expenses or revenues were not on the budget? Critically evaluating the actual results versus the estimated budgetary results can help management plan for the future. Variance analysis helps the manager analyze its results. It does not necessarily find a problem, but it does indicate where a problem may exist. The same is true for favorable variances as well as unfavorable variances. A favorable variance occurs when revenue is higher than budgeted or expenses are lower than budgeted. An unfavorable variance is when revenue is lower than budgeted or expenses are higher than budgeted.

It is easy to understand that an unfavorable variance may be a problem. But that is not always true, as a higher labor rate may mean the company has a higher quality employee who is able to waste less material. Likewise, having a favorable variance indicates that more revenue was earned or less expenses were incurred but further analysis can indicate if costs were cut too far and better materials should have been purchased.

If a company has only a static budget, meaningful comparisons are difficult. Analyzing the sales for Bid Bad Bikes will illustrate whether there was a profit and how net income impacts the company. In the third quarter, Big Bad Bikes sold 1,400 trainers and had third quarter net income of $16,250 as shown below.

How do those results advise management when evaluating the company’s performance? It is difficult to look at one variance and make a conclusion about the company or its management. However, the variances can help narrow down the areas that need addressing because they differ from the budgeted amount. For example, looking at the variance when using a static budget does not indicate the amount of the variance results because they sold 100 fewer units than budgeted. The variance for direct labor is favorable, but it should be if production was less than the budget. A static budget does not evaluate whether costs for 1,400 were appropriate for production of those 1,400 units.

Using a static budget to evaluate performance affects the bottom line as well as the individual expenses. The net income for the sale of 1,400 units is less than the budgeted net income for 1,500 units, but it does not indicate whether expenses were appropriate for 1,400 units. If there had been 1,600 units sold, the expenses would be more than the budgeted amount, but sales would be higher. Would it be fair to evaluate a manager’s control over their expenses using a static budget?

Evaluating the expenses on a flexible budget computed for the number of units sold would provide an indication of management’s ability to control expenses. As shown below, some expenses have a favorable variance, while others have an unfavorable variance. This type of variance analysis provides more information than static budget variances to evaluate management and help prepare the next year’s budget. For example, the direct materials in the flexible budget comparison shows an unfavorable variance, meaning the actual direct materials expense was more than budgeted for the production of 1,400 units. What we don’t know is whether the unfavorable variance was caused by BBB having to pay more than $1.25 per unit of material, or if each unit of product required more than 3.2 pounds of material, or some combination of both.  Of course, we have tools to help us tease apart the components of the flexible budget variances.  More about this in another chapter.