BackToBasics
Flexed budgets
Flexing budgets enables businesses to gain insights into costs and savings, and make more informed decisions in future
Words Nick Craggs, First Intuition Illustration Jackie Parsons
Budgets are used as part of the internal controls of a business. They allow companies to plan how they are going to operate and allocate resources when planning. They also allow companies to retrospectively analyse performance and investigate reasons as to why it differed from what they expected. If a company has spent more money than it budgeted, that is a bad thing; if a company has spent less money than it budgeted, that is a good thing. However, it is not always as simple as that.
When the budget is created it is unlikely that the company will know exactly what the level of production will be in the coming period. It is more than likely that the number of units sold will be more or less than the budgeted level of production. It would be unfair to suggest that the production manager had been wasteful if they had used more material than was budgeted for, provided the company had sold more units than it expected. If you make more goods, you need more material, so you would expect costs to rise.
To allow us to fairly assess the performance of the business, we will flex the budget to the actual level of production. Basically, this is recreating the original budget, using the same assumptions, but now you happen to know the level of production and can match the budget to this.
Key point
Flexing your budget enables more meaningful decision-making and more informed choices.
When the budget is created it is unlikely that the company will know exactly what the level of production will be in the coming period.
Why flex?
Let’s assume that we thought we would make 8,000 units, but we have had a good year and sold 10,000. This means that we should expect costs to go up by 25%, based on the extra 2,000 units sold divided by the original budget of 8,000 units. If the material had been budgeted to be £20 per unit, the original budget for materials would have been £160,000. All things being equal, if we produced 10,000 units we would expect the material cost to rise to £200,000. We can then compare this to the actual cost for materials to make a fair comparison. If we have spent more than £200,000 to produce 10,000 units then we have an adverse variance; if we have spent less than £200,000 then we have a favourable variance. If we have a variance, we can then investigate why the variance has occurred. It is as important to investigate a favourable variance as it is to investigate an adverse one as this might indicate problems in the future. For example, if you saved money by buying cheaper materials you might find that you have a lot of returns or warranty claims.
Fixed and variable costs
When we are flexing a budget, we need to be conscious of cost behaviour. If we double the number of units we sell, it would be reasonable to expect the material costs to double as well. But there are some costs that you would expect to stay at the same amount irrespective of the changes to production volume. Your landlord is not going to put your rent bill up just because you sold more units. When we flex a budget we would not change rent, or any fixed costs, due to volume. The production volume would need to change so much that we would have to rent a larger factory for the rent to change.
There are other cost types we need to adjust when flexing a budget. Some costs have a fixed element and a variable element. An example of this might be electricity where you pay a standing charge that stays the same no matter how much you use. There will also be a charge for the actual electricity used that will go up and down with production. When flexing the budget, we would flex the variable element of the electricity with volume, but we won’t change the fixed element.
We may also need to look at stepped costs. These are costs that stay at the same level until a certain point when they rise to a new level. For example, machinery hire costs stay at the same level until we need to hire another machine. If we hire a machine for £10,000 that can produce 1,000 units, our costs will be £10,000 whether we produce one unit or 999 units. However, as soon as we need to produce 1,001 units we need to hire second machine, so our machinery hire costs will now be £20,000 for the two machines. It will stay at £20,000 until we need to produce 2,001 units.
Flexing the budget allows us to make more meaningful decisions and make more informed choices going forward. But remember the golden rule: we don’t change any of our assumptions from when we created the budget other than we now know the production volume.
