When a business constructs a budget, it could construct one single budget which is known as a fixed budget. 

A fixed budget assumes one sales level with no flexibility. This rigid approach has a major flaw though, as at the end of the financial period it may be unrealistic to only have the one fixed budget to compare actual figures with (if we set a budget assuming a sales level of 1000 units and we actually sell 2000 units, is it realistic to compare our revenue and costs?).

Accounting professionals should be able to ‘flex’ budgets.  This process means changing a budget to allow for different sales levels and allows more realistic variance analysis at the end of the financial period in question. The reason it is more realistic is because it is a more ‘like for like’ comparison.

In order to flex a budget, an accomplished accounting professional must be well versed in cost behaviour analysis.

(Recap diagram below)

Flexing a budget (why not have a go yourselves before reading the analysis?):

Sales Revenue

Calculation:  If 1,000 units would give budgeted revenue of £25,000, we can derive a budgeted sales figure per unit of £25. We can apply this £25 sales price to the actual output level of 2,000 units and calculate that our flexed budget sales revenue figure would be £50,000 (2,000 x £25). The actual sales revenue figure of £48,000 is £2,000 less than this figure and is therefore an adverse variance of 2,000.

Analysis of variance: The budgeted sales price was £25 per unit, if we look at the actual figures the average sales price per unit was £24 (£28,000/2,000). Some suggested causes of a variance of this nature are:

• Customer received a discount, resulting in revenue being less than budgeted. This discount could be allowed because of the additional sales achieved, resulting in bulk discount.
• Exchange rates for the pound are weak (for businesses exporting goods). If £1 = $1 when the budget is set and we quote a selling price of $25 to an American customer, during the period the exchange rate could change to £1 = $0.80* the sales price of $25 is only bringing in £20 once it has been exchanged ($25 x £0.80 = £20)

*Currency and exchange rate are used here for demonstrational purposes only

• Damaged goods sold for a lower price
• Original sales price unrealistic and had to be lowered in order to remain competitive

Material

Calculation:  A variable cost such as this can be flexed in the same way as sales revenue. Assuming that 1,000 units will cost £3,600 in terms of materials (equating to £3.60 per unit) we can assume a budgeted cost of £7,200. The actual cost of £7,300 is £100 more than this flexed cost and is therefore a 100 adverse variance.

Analysis of variance:  The budgeted materials price was £3.60 per unit, if we look at the actual figures the average material price per unit was £3.65 (£7,300/2,000).  Some suggested causes of a variance of this nature:

• Change of supplier, increased purchase price or increased delivery costs
• Exchange rates for the pound are weak (for businesses importing goods). If £1 = $1 when the budget is set and during the period the exchange rate changes to £1 = $0.80* then an import price of $3.60 per unit will effectively become £4.50 for the same product ($3.60/0.80 = £4.50)

*Currency and exchange rate are used here for demonstrational purposes only

• Superior, more expensive material used
• Inferior, cheaper material used which increases wastage and requires more units to be reproduced
• Shortage of material worldwide, increasing price
• Shift in price index for materials
• Seasonal variation

Labour

Calculation:  A budgeted cost of £4,000 for 1,000 units would equate to a flexed cost of £8,000.  Compared with the actual cost of £7,600 we can see that labour was £400 cheaper than our flexed budget suggests.  As it was cheaper, this is a 400 favourable variance.

Analysis of variance:  The budgeted labour price was £4.00 per unit, if we look at the actual figures the average labour price per unit was £3.80 (£7,600/2,000).  Some suggested causes of a variance of this nature:

• New, cheaper staff (apprentices?)
• Outsourcing of labour to a cheaper location (abroad?)
• Staff worked more efficiently and saved time per unit, less hours = less expenditure
• Workforce restructure (some staff not required)

Energy

Calculation:  First we need to establish what the budgeted variable element per unit is.  Total budgeted cost for 1,000 units was £3,100.  We know that the fixed element was £500 meaning total variable cost was £2,600.  This equates to a budgeted variable element of £2.60 per unit.  The flexed budget for 2,000 units would give a budgeted energy cost of £5,700 (£500 fixed + £5,200 variable).  Compared to actual cost of £7,400 we can derive a variance of 1,700 adverse.

Analysis of variance:  This adverse variance would need a detailed analysis because there are a number of scenarios which could lead to this variance.  Some suggested causes would be:

• Supplier price change on either the fixed or variable element (or both)
• Energy prices increased nationally/globally
• Increased productivity has increased the requirement for machinery, increasing energy usage
• Work that would ordinarily be done on night shifts (cheaper electricity) is having to be done in the daytime

Equipment hire

Calculation:  A stepped cost which ‘steps’ for every 800 units means that the original budget required 2 pieces of equipment (1: 0-800 units, 2: 801-1600 units).  The budgeted cost of £7,000 equates to a budgeted cost of £3,500 per piece of equipment.  Our actual output of 2,000 units will require a third piece of equipment.  The flexed cost of equipment hire is therefore £10,500 (3 x £3,500).  We can see that this is the same as the actual cost, resulting in variance of zero.

This highlights the importance of why we, the accounting technician, need to be able to flex a budget.  If we simply compared the £10,500 actual cost with the £7,000 budgeted figure the comparison would not be an accurate or realistic one.  By flexing the budget we can see that actually costs operated exactly as our budget suggested.

Depreciation

Calculation:  Fixed costs are not affected by productivity, so the budgeted cost of £800 would theoretically apply for any output level (including the actual output level of 2,000 units).  Actual depreciation cost of £1,000 equates to a variance of 200 adverse.

Analysis of variance:  Some suggested causes would be:

• New machine resulting in increased depreciation (a new machine would have a higher rate of depreciation than an older one using the reducing balance method, or using straight line method if the machine was more expensive when purchased than the old machines)
• Change in depreciation basis (unit basis rather than machine hours)

Rent

Calculation:  Fixed costs are not affected by productivity, so the budgeted cost of £1,500 would theoretically apply for any output level (including the actual output level of 2,000 units).  Actual rent of £2,400 equates to a variance of 900 adverse.

Analysis of variance:  Some suggested causes would be:

• Landlord price increase implemented
• Change in location

Linking reasons for variances

Sometimes variances will affect one another.  This interdependence of variances will aid any analysis which is to take place.  A basic scenario could look like this

1. A production environment could employ cheaper, less skilled staff
2. Leading to more wastage of goods
3. Leading to more machine usage
4. Leading to higher energy costs

Completed flexed budget with variances

The process of flexing a budget involves identifying the behaviour of costs and revenue and applying these behaviours to different output levels.  Once a budget has been flexed it can then be compared with actual figures and used to calculate variances.

Variances can then be investigated and importantly can be communicated to relevant parties (managers will be very interested in variance analysis).  Students should always remember that the analysis of variances is extremely important, accountants are required to not only perform calculations but also interpret their findings accordingly.

Mathew Pickering is an AAT lecturer at The Sheffield College, part of the team which won Training Provider of the year (medium size provider) in 2015.