Question

You work for a manufacturing company and have just completed the budget process for the upcoming business year. At the end of the first quarter you take the actuals and compare them to the budget. You notice there are differences which need explanation and create the static and flexible budget variances. You present this to management and they request you to explain the variances in more detail.

You go and create the Flexible Budget Performance Report and present this. You also need to explain the reasons for the variances and who is responsible. Explain the calculations used to create this report.

Explain why the variances using standard costs better reflect the actual variance and how to determine who is responsible for each variance

Answer 1

The Minuses of the Static Budget Approach

A static budget is planned ahead of time based upon your best educated guess about future actual activity. Static budgets are usually planned a year in advance, broken out into smaller reporting periods such as months and quarters.

A big disadvantage for new businesses is the lack of actual data upon which to build a budget. If actual data differ significantly from the static budget, there's no way to change the budget or to determine if the costs to produce the revenue were properly controlled. Instead, you must produce a forecast. The forecast is a new document that predicts the remainder of the reporting period's activity and compares it to the static budget and the actual.

Static Budgets Work

The best reason to use a static budget is the variance analysis. The variance analysis tells you how much your budget is over or under the original projections, via percentage and dollars. Even for new businesses, it may be easier to plan for future years when you know you have a comparison between what was expected and what actually occurred. In future years, you can adjust the budget up or down depending upon the variance percentages. Static budgets work best when you have a reasonable amount of certainty gauging what revenues and costs will be, barring extraordinary circumstances.

The Minuses of the Flexible Budget Approach

Flexible budgeting is a more sophisticated method because you can make changes to the budget in the middle of the reporting period. However, you may not have the time, experience or inclination to adjust the budget frequently. Also, there may be unexpected effects from an unexpected change in volume, for which you won't know to plan. Flexible budgets require knowing in advance which costs are fixed or variable, and how expenses are affected by changes in revenue.

Flexible Budgets Work

Because the flexible budget changes based upon volume, it provides a greater level of control. New businesses need to keep a tight lid on costs; capping certain flexible expenses to a percentage of volume helps accomplish this.

A new business could vary a great deal from what was originally planned, and flexible budgets offer a real-time view of a business's expenses and revenues. The savvy business owner may not have time to go through the trouble of issuing a forecast for the static budget. The flexible budget accomplishes the forecast in one step.