The flexible budget shows an even higher unfavorable variance than the static budget. This does not always happen but is why flexible budgets are important for giving management an indication of what questions need to be asked.
The flexible budget uses the same selling price and cost assumptions as the original budget. Variable and fixed costs do not change categories. The variable amounts are recalculated using the actual level of activity, which in the case of the income statement is sales units. Each flexible budget line will be discussed separately.
Sales. The original budget assumed 17,000 Pickup Trucks would be sold at $15 each. To prepare the flexible budget, the units will change to 17,500 trucks, and the actual sales level and the selling price will remain the same. The $262,500 is 17,500 trucks times $15 per truck. The variance that exists now is simply due to price. Given that the variance is unfavorable, management knows the trucks were sold at a price below the $15 budgeted selling price.
Cost of Goods Sold. Using the cost data from the budgeted income statement, the expected total cost to produce one truck was $11.25. The flexible budget cost of goods sold of $196,875 is $11.25 per pick up truck times the 17,500 trucks sold. The lack of a variance indicates that costs in total (materials, labor, and overhead) were the same as planned.
Selling Expenses. The original budget for selling expenses included variable and fixed expenses. To determine the flexible budget amount, the two variable costs need to be updated. The new budget for sales commissions is $10,500 ($262,500 sales times 4%), and the new budget for delivery expense is $1,750 (17,500 units times 10%). These are added to the fixed costs of $12,500 to get the flexible budget amount of $24,750.
General and Administrative Expenses. This flexible budget is unchanged from the original (static budget) because it consists only of fixed costs which, by definition, do not change if the activity level changes.
Income Taxes. Income taxes are budgeted as 40% of income before income taxes. The flexible budget for income before income taxes is $20,625, and 40% of that balance is $8,250. Actual expenses are lower because the income before income taxes was lower. The actual tax rate is also 40%.
Net Income. Total net income changes as the amount for each line on the income statement changes. The net variance in this example is mainly due to lower revenues.
The important thing to remember in preparing a flexible budget is that if an amount, cost or revenue, was variable when the original budget was prepared, that amount is still variable and will need to be recalculated when preparing a flexible budget. If, however, the cost was identified as a fixed cost, no changes are made in the budgeted amount when the flexible budget is prepared. Differences may occur in fixed expenses, but they are not related to changes in activity within the relevant range.
Budget reports can be a useful tool for evaluating a manager's effectiveness only if they contain the appropriate information. When preparing budget reports, it is important to include in the report the items the manager can control. If a manager is only responsible for a department's costs, to include all the manufacturing costs or net income for the company would not result in a fair evaluation of the manager's performance. If, however, the manager is the Chief Executive Officer, the entire income statement should be used in evaluating performance.