Flexing Your Budget: When Plans Change
Regardless of how carefully you budget, plans may change. Assume you plan a cross-country family camping trip. You diligently create a budget spreadsheet based on your research and assumptions. Unfortunately, nearly everything costs more than you estimated.
A 30-percent increase in the price of gas adds more than $1,000 to the cost of the trip. And although you timed the trip to drive 600 miles per day, you don’t take into account stops for coffee, restrooms, or motion sickness.
As the road trip attests, budgets don’t have to be set in stone.
Controlling your business
Budgeting helps you plan your business’s operations. However, you also need to control your business — to monitor what’s actually happening. Controlling involves constantly comparing actual activity to your budget and carefully analyzing and understanding any differences. To accomplish this task, you need budget reports that compare your budgets (what should have happened) to what actually happened.
For example, suppose your company budgeted $100,000 for sales in the first quarter. Actual sales for the quarter fall short, at only $70,000. First, call the sales manager to find out what happened. (Maybe a computer snafu accidentally canceled customer orders.) Then, take corrective action. (Fix your computer and call your customers to apologize.) Finally, adjust your future plans. (Cut next quarter’s production estimates.)
With a static budget, a $30,000 difference throws off more than just your sales budget. It also necessitates changing your production, purchases, direct labor, overhead costs, and selling and administrative expenses, ruining the entire planning process and making it impossible for you to make future comparisons between your budgets and actual results.
Enter the flexible budget. As activity levels change, you can easily adjust a flexible budget and continue to use it to plan and control your business.
Dealing with budget variances
One of the benefits of flexible budgeting is that it helps you to understand the reasons for your company’s variances, the differences between actual and budgeted amounts.
Always indicate whether a variance is favorable or unfavorable. A variance is usually considered favorable if it improves net income and unfavorable if it decreases income. Therefore, when actual revenues exceed budgeted amounts, the resulting variance is favorable.
When actual revenues fall short of budgeted amounts, the variance is unfavorable. On the other hand, when actual expenses exceed budgeted expenses, the resulting variance is unfavorable; when actual expenses fall short of budgeted expenses, the variance is favorable.
Management should investigate the cause of significant budget variances. Here are some possibilities:
Changes in conditions: For example, a supplier may have raised prices, causing the company’s costs to increase.
The quality of management: Special care to reduce costs can result in favorable variances. On the other hand, management carelessness can drive up unfavorable variances.
Lousy budgeting: An unrealistically ambitious budget is likely to cause unfavorable variances.
Many managers use a system called management by exception. They investigate the largest variances, whether favorable or unfavorable, and ignore the rest. This strategy helps managers prioritize potential problem areas in operations.