Financial professionals are familiar with the fact that real-world results almost never align perfectly with the budget, even when careful steps are taken to account for variables. This is why most businesses use a flexible budget. A flexible budget can be adjusted for real-world results, which allows businesses to analyze variances to and uncover insights about operations and costs.
A flexible budget model takes variable expenses into account and demonstrates differing levels of revenue and expenses based on activity levels. While a static budget remains the same even if the level of production changes, flexible budgets are more accurate because they can be changed based on actual output.
However, even when using a flexible budget, there can still be variance between predictions and results. Flexible budget variance is the difference between the predictions made by a flexible budget model and the actual results.
There are many causes of flexible budget variance, and they may be controllable or uncontrollable. Controllable causes include:
These factors can and should be avoided. However, there are also factors that can affect budgets beyond the control of the company. These include:
Additionally, flexible budget variance is called “favorable” or “unfavorable” depending on whether the company performed better or worse than the flexible budget predicted.
Generating and analyzing financial models is not an easy gig by any stretch, but examining flexible budget variance can help an organization understand where controllable or uncontrollable variables arose when results don’t match predictions. Once executives understand the cause of variance, they can work towards more accurate models and better strategic decisions to improve profitability.
A flexible budget and the resulting variance can be calculated based on revenue or units sold. When actual revenues are incorporated into a flexible budget model, any resulting variance arises from the difference between budgeted and actual expenses, not revenues. When the calculation is based on units sold, however, it may reveal differences in revenue and expenses per unit.
Budgets are created as a guide for decision-making, but they are rarely completely accurate. A flexible budget allows for more adjustment as changes in production occur.
For example, consider a manufacturing company that predicts its revenue for January will be $100,000. It plans to sell 100 units for $1,200 each. Fixed costs are $10,000 and each unit costs $100 to produce. At the end of the month, the company finds that actual revenue for January is $90,000. The price per unit increased to $200 due to an increase in the cost of a material used to create the product. This tells us that there is a negative variance due to uncontrollable variable costs.
While variance is usually out of a company’s control, it’s still useful information. In the example above, financial advisors can provide this information to executives, who may then find a less expensive vendor, increase the price of the product, or explore other solutions. The information can also be used to create a more accurate and reliable budget for the following month.
Analyzing flexible budget variance enables companies to carefully monitor margins and ensure revenue is optimized. It can uncover areas for improvement as well as calculation errors that will impact other areas of the business’s finances. It can also inform future goals, such as increasing sales goals if they were surpassed or decreasing margins if they are unexpectedly high.
Important variables factored into flexible budget variance include:
This tells financial advisors how changes to the price per unit, variable costs, and fixed costs affected revenue.
This is attributed to differences in units sold, which is accounted for upfront with a flexible budget.
It’s worth noting that since flexible budgets are adjusted for sales after the period concludes, sales are eliminated as a variable. This means that any variance uncovered points to a ****spending variance rather than an activity variance.
A favorable flexible budget variance is considered a positive outcome for the organization because it means that revenue was higher than expected.
If a company has a favorable flexible budget variance, executives may consider creating bigger goals for the team to push towards in the next budget period. It’s also important to examine where the higher margin came from. Was it due to industry factors, or innovation on the part of the company? A favorable variance may be a good outcome, but it may be difficult to replicate if it was due to uncontrollable factors.
If the flexible budget variance is negative, executives and stakeholders will want to know why. If reliable data was used to calculate fixed costs, a negative variance will most likely be due to variable costs. Perhaps a new product required more hours of labor than anticipated, or perhaps a completely unpredictable pandemic halted production.
Regardless of the cause, understanding the issue and whether or not it can be prevented or corrected in the future is key to recovery.
Using a flexible budget prevents incorrect conclusions about a business’s fixed and variable costs by adjusting for activity level. This enables a direct comparison between predicted and actual results that can help financial advisors uncover insights about how the company is performing and where improvements can be made.
The inputs can be a little difficult to pin down, though. After all, it’s a model capturing variance. It may be more efficient, accurate, productive to use a financial platform that can pull data from multiple sources and automatically build calculations for you. This may help identify flexible budget variance early and more accurately, leading to less loss in the case of a negative variance or more opportunity for positive variance.