Inside the CFO’s Toolbox: The Flexible Budget

Inside the CFO’s Toolbox: The Flexible Budget

Let’s talk about 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. A simple illustration should make this clearer.

If direct costs (Labor, Materials & Freight in this example) 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 cost.

The flexible budget determines "What should direct costs be for a given level of sales?" In our example above, we created our budget with an assumption that Materials costs are 50% of Sales. Since we will never hit our budgeted Sales level exactly, the variation in actual Sales vs. budget can cloud our assessment of how we performed against the direct cost budget. The larger the Sales variation, the more potential there is to reach an inaccurate conclusion on our performance in direct costs.

Table1_Inside_CFO_Toolbox

If we look at Materials costs, in the traditional B vs. A report, it looks like an unfavorable variance. 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 to show ACTUAL Sales x the budgeted PERCENTAGE of Sales. Under this method, 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 reprimanded to getting a bonus.

The flexible budget really brings clarity to management’s performance on variable costs and eliminates the co-mingling of sales and materials variances.

Note that both reports are useful for different types of analysis. But the Flexible Budget can be an important tool in the analysis toolbox.

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