Performance reports comparing your budget to the reality of income and expenses are an everyday part of business. Static budgets and reports that assume set figures for everything aren't as useful for reality checks as a flexible budget performance report. That's because the figures in a flexible budget adjust as sales or manufacturing outputs rise and fall.
A flexible budget projection adjusts non-fixed costs based on, say, the level of sales or the number of products you make. If raw materials costs are up because you doubled product output, the flexible budget acknowledges that. The performance report spots the variances that can't be explained by this formula.
When you draw up a static budget for the next quarter or year, you include fixed figures for everything, Accounting Coach says. For example, your budget for the next quarter might include entries for $30,000 for raw materials, sales revenue of $100,000 and cost of goods sold (COGS) of $35,000. When you and your management team review the performance report, you analyze and identify the reasons where the reality departed from the projections.
Advertisement Article continues below this adThe problem with a static budget is that the variation is often substantial. Static budgets work great, Cliff's Notes says, if your costs are fixed or your company's activity is exactly what you expected. If your sales activity is substantially greater, however, that's naturally going to affect other budget items such as sales commissions and COGS. That can generate a lot of white noise that a flexible budget would weed out.
The preparation of a flexible budget is built on a simple principle. Rather than use a set figure for, say, COGS, you review past figures and discovers it's typically 30 percent of sales revenue. Build that into the budget: If sales revenue is $100,000, COGS should be $30,000; if sales are $200,000, COGS should be $60,000; if sales are only $50,000, COGS should be $15,000. Use this sort of flexible budget formula with all your non-fixed figures.
The payoff for using the flexible budget formula comes when you go over the performance report. By taking non-fixed figures into account, you get a performance report that's much relevant to evaluating your financials, Accounting Tools says. A flexible budget performance report acknowledges variation - COGS goes up with sales, raw materials costs go up with increased outputs - which lets you ignore them and focus on the significant variances.
Advertisement Article continues below this adTo prepare a flexible budget performance report, you identify key figures based on the flexible budget formula. If your company's formula says, for example, that COGS should be 25 percent of sales and sales were $75,000 for the period, COGS should be $18,750. Alongside these figures, you report the reality: COGS was indeed $18,750 or $18,800 - or it's a substantially different figure, such as $25,000.
If you get $18,800, you know the budget projections were close to accurate. If it's $25,000, that indicates something went seriously wrong in your inventory process or your bookkeeping. You report this in your accounts as an unfavorable variance, and hopefully figure out where the problem lies.