Chapter 7 - Flexible Budgeting and Performance Evaluation
Summary :Cost and Revenue Formulas: Variable, Fixed, and Mixed
Every budget is built from cost and revenue formulas that predict what an amount should be at a given level of activity, and those formulas depend on whether the underlying item behaves as variable, fixed, or mixed. A variable formula is a constant amount per unit multiplied by the activity driver - shipping cost of $5 per unit sold would be written as $5Q, where Q is quantity. A fixed formula is a flat lump sum that does not change with activity at all, such as $2,000 in monthly rent, though the per-unit rent allocation still shrinks as volume rises. A mixed formula combines both: a fixed base amount plus a variable rate per unit, such as a utility bill written as $50 plus $0.25 times kilowatt-hours used. These formulas are the building blocks for every budget discussed in this chapter, from the original planning budget through to the flexible budget used for performance evaluation.
Preparing a Planning Budget - A Worked Example
Consider PureBrew Coffee Co., run by owner Devon, who sells cold brew kits for $40 per unit. Devon's cost formulas are: cost of goods sold at $18 per unit (variable), shipping at $4 per unit (variable), wages of $6,000 per month (fixed), rent of $1,800 per month (fixed), insurance of $400 per month (fixed), utilities of $120 plus $0.15 per unit (mixed), and office expenses of $500 plus $0.50 per unit (mixed). Devon plans to sell 600 units this month. Applying the formulas: sales revenue is 600 times $40, or $24,000; cost of goods sold is 600 times $18, or $10,800, leaving a gross margin of $13,200. Shipping is 600 times $4, or $2,400; utilities are $120 plus (600 times $0.15), or $210; and office expenses are $500 plus (600 times $0.50), or $800. Total operating expenses are $2,400 shipping plus $6,000 wages plus $1,800 rent plus $400 insurance plus $210 utilities plus $800 office, or $11,610. Subtracting that from the $13,200 gross margin gives a planned net operating income of $1,590 for the month.
Why Planning Budgets Fall Short for Performance Evaluation
A planning budget is prepared before the period begins and is built entirely around estimated activity, which makes it useful for scheduling operations and setting spending limits in advance. But it is a poor tool for evaluating performance after the fact, because actual activity almost never exactly matches the planned quantity, and if planned and actual results are based on different quantities, the two figures are not directly comparable. If Devon's actual sales for the month turn out to be higher or lower than the planned 600 units, both revenue and every variable and mixed cost will differ from the plan simply because volume differed - not necessarily because anything was managed well or poorly. Comparing a planning budget built on 600 units against actual results built on a different quantity conflates the effect of volume with the effect of genuine cost control, which is exactly the ambiguity a flexible budget is designed to remove.
Preparing a Flexible Budget
A flexible budget solves this problem by reforecasting the same cost and revenue formulas at the actual level of activity instead of the originally planned level, which makes it directly comparable to actual results since both are now based on the same quantity. Suppose PureBrew actually sold 640 units for the month rather than the planned 600. Applying the identical formulas at 640 units: sales revenue is 640 times $40, or $25,600; cost of goods sold is 640 times $18, or $11,520, leaving a gross margin of $14,080. Shipping is 640 times $4, or $2,560; utilities are $120 plus (640 times $0.15), or $216; office expenses are $500 plus (640 times $0.50), or $820; and the three fixed costs (wages, rent, insurance) stay at $6,000, $1,800, and $400 regardless of volume, since fixed costs by definition do not change with activity. Total flexible-budget operating expenses are $2,560 plus $6,000 plus $1,800 plus $400 plus $216 plus $820, or $11,796, leaving a flexible budget net operating income of $14,080 minus $11,796, or $2,284.
Activity Variances
An activity variance is the difference between the planning budget and the flexible budget, and it isolates exactly one thing: the effect of selling a different quantity than originally planned, since both budgets use the same cost and revenue formulas and differ only in the quantity plugged in. Comparing PureBrew's planning budget net operating income of $1,590 to its flexible budget net operating income of $2,284 gives an activity variance of $694, and because actual volume (640 units) exceeded planned volume (600 units) and each additional unit contributed positively to profit, this variance is favorable. Activity variances require careful interpretation, though: a variable cost showing an unfavorable activity variance simply because more units were sold is not really bad news, and a variable cost showing a favorable activity variance because fewer units were sold is not really good news - the variance is purely a mechanical consequence of the volume change, not a reflection of whether costs were managed efficiently.
Revenue and Spending Variances
A revenue and spending variance is the difference between the flexible budget and the actual results, and because both are based on the same actual quantity, this comparison isolates genuine performance - price, cost control, and efficiency - rather than the effect of volume. Suppose PureBrew's actual results for the 640 units sold were: sales revenue of $25,300 (a shortfall versus the $25,600 flexible budget, unfavorable), cost of goods sold of $11,700 (more than the $11,520 budgeted, unfavorable), shipping of $2,500 (less than the $2,560 budgeted, favorable), wages, rent, and insurance exactly on budget at $6,000, $1,800, and $400 (no variance, since these are fixed and unaffected by anything other than a change in the underlying agreement), utilities of $230 (more than the $216 budgeted, unfavorable), and office expenses of $840 (more than the $820 budgeted, unfavorable). Actual net operating income comes to $25,300 minus $11,700 minus $2,500 minus $6,000 minus $1,800 minus $400 minus $230 minus $840, or $1,830. Comparing this to the $2,284 flexible budget figure gives a revenue and spending variance of $454, unfavorable - meaning that even after adjusting for the extra volume PureBrew actually achieved, the combination of a small revenue shortfall and higher-than-budgeted costs cost the business $454 versus what the flexible budget said it should have earned at that volume, prompting Devon to investigate the specific line items driving the shortfall.
Quick Revision Summary
A planning budget is prepared before the period using estimated activity and is useful for planning and setting spending limits, but not for evaluating performance, since actual activity rarely matches the plan exactly. A flexible budget reforecasts the same cost and revenue formulas at the actual level of activity, making it directly comparable to actual results. An activity variance (planning budget versus flexible budget) isolates the effect of a different quantity than planned and should be interpreted cautiously, since it reflects volume, not efficiency. A revenue and spending variance (flexible budget versus actual results) isolates genuine performance, since both figures share the same quantity, and reveals whether prices, costs, and efficiency met, exceeded, or fell short of what the flexible budget predicted at that actual volume. Fixed costs never generate an activity variance, since the same fixed amount appears on both the planning and flexible budgets, but they can still generate a revenue and spending variance if actual fixed spending differs from budgeted fixed spending.