Budgeting

For many years, I've been a fan of what is known as a Flexible Budget. This is not flexible budgeting in the sense that the government uses - "No money in the budget? Hey, we're flexible. Spend away!"

No, a flexible budget is actually a very useful management tool which brings a new level of clarity to budget-to-actual analysis. In essence, it allows a transparent look at budget-to-actual results for variable costs-generally "direct" costs - by eliminating the sales variance component.

If direct costs (Labor, Materials & Freight) are budgeted for on a percentage of sales basis, then we can easily create a Flexible Budget to analyze how well we performed in each class of direct costs.

Since we will never hit our budgeted Sales level exactly, the variation in actual Sales vs. budget can cloud our assessment of how we did on the direct cost budget. The larger the Sales variation, the more potential there is to reach an inaccurate conclusion.

The flex budget determines "What should direct costs be for a given level of sales?"

As an example, we'll create our budget with an assumption that Sales are projected to be $1,000 and Materials costs are 50% of Sales, or $500. At the end of the month, if actual Sales are $1,500 and Materials costs are $550, how did we do? If we look at Materials costs in the traditional Budget vs. Actual report, it looks like an unfavorable variance of (50). But how much of that is due to the Sales variance, and how much is truly a materials variance?

Using the Flex budget, we 'reset' the direct costs budget (it's flexible) to show ACTUAL Sales x the budgeted PERCENTAGE of Sales. Based on Sales of $1,500 our Materials budget changes to $750 instead of the original $500 - Sales were 50% higher than budget, so we should expect to use 50% more materials. Now we see the true materials variance is actually a Favorable $200, as opposed to an Unfavorable $50.

The Materials Manager just went from getting fired to getting a bonus.

The flex budget really brings clarity to management's performance on variable costs and eliminates the co-mingling of sales (volume) variances and usage or efficiency variances. Both reports are useful for different types of analysis. And the Flexible Budget can be an important tool in the analysis toolbox.