A flexible budget allows volume differences to be removed from the analysis by using the same actual level of activity for both budget and actual, which would leave us with a portion of the budget variance due solely to price and cost differences.

Let’s assume actual results for the year were as follows:

Actual Results
Variance
Static Budget

Units
          180,000
                        7,595
        172,405

Sales Revenue
$ 6,030,000
                  168,230
$ 5,861,770

Variable Costs
    3,420,000
                  199,475
    3,220,525

Contribution Margin
    2,610,000
                    (31,245)
    2,641,245

Fixed Costs
    2,650,000
                  197,306
    2,452,694

Operating Income
$  (40,000)Double line
                (228,551)
$   188,551Double line

 

Management is unpleasantly surprised at this point (and remember that these results would probably not be available until February or even March of the following year if this analysis was only being done on an annual basis).

Sales volume was 7,595 more than planned, which is 4.4% more than the budgeted volume, but operating income came in at a loss.

Fixed costs were certainly higher than expected, but let’s break this down further by creating a flexible budget that would reflect our plan if we had known the exact volume–in other words, a new static budget based on 180,000 units:

Actual Amounts per Unit
Actual Results

Flexible Budget
Budgeted Amounts per Unit

Units

          180,000

          180,000

Sales Revenue
$ 33.50
$ 6,030,000

$  6,120,000
$ 34.00

Variable Costs
$ 19.00
3,420,000

3,362,400
$ 18.68

Contribution Margin

2,610,000

2,757,600

Fixed Costs

2,650,000

2,452,694

Operating Income

$  (40,000)Double line

$    304,906Double line

 

If we had prepared the static budget based on all of our original assumptions except substituting 180,000 units for our original estimate of 172,405, we would have shown operating income of $304,906. No wonder management is upset. However, by re-calculating our static budget (now labeled as a flexible budget) we can see differences that arise solely due to cost and price differences:

Actual Amounts per Unit
Actual Results
Flexible Budget Variance

Flexible Budget
Budgeted Amounts per Unit

Units

          180,000

          180,000

Sales Revenue
$ 33.50
$ 6,030,000
$    (90,000)

$  6,120,000
$ 34.00

Variable Costs
$ 19.00
3,420,000
$      57,600

3,362,400
$ 18.68

Contribution Margin

2,610,000
$   (147,600)

2,757,600

Fixed Costs

2,650,000
  $     197,306

2,452,694

Operating Income

$  (40,000)Double line
$   (344,906)

$    304,906Double line

 

Even though the company sold more units, the average price per unit came in at $33.50 instead of the planned $34.00, causing a decrease of $90,000 in total sales revenue simply due to an overall price decrease. It could be that additional sales promotions during the year increased sales volume but decreased average price. We call this an unfavorable variance and will identify it with the letter U.

In addition, variable costs increased by $57,600 overall, due to some slight increases in actual variable manufacturing costs. Even though that is a positive number in our calculation, it is an unfavorable variance because it hurt the bottom line. Same with fixed costs, that appear to be our main culprit here. It’s possible that during the year since sales were robust, management chose to expand the selling, general, and administrative infrastructure (buying new equipment, doling out sales bonuses, etc.). The follow-up to this analysis would be to examine expense categories in more detail, using budget versus actual.

Actual Amounts per Unit
Actual Results
Flexible Budget Variance
F or U
Flexible Budget
Budgeted Amounts per Unit

Units

          180,000

          180,000

Sales Revenue
$ 33.50
$ 6,030,000
$    (90,000)
U
$  6,120,000
$ 34.00

Variable Costs
$ 19.00
3,420,000
$      57,600
U
3,362,400
$ 18.68

Contribution Margin

2,610,000
$   (147,600)
U
2,757,600

Fixed Costs

2,650,000
  $     197,306
U
2,452,694

Operating Income

$  (40,000)Double line
$   (344,906)
UDouble line
$    304,906Double line

 

In summary, the combination of increased costs and a slight decrease in the sale price per unit combined to create an overall unfavorable budget variance of $344,906, even if we had known in advance that we would sell 180,000 units and had budgeted accordingly.

Before we look at the sales volume variance, check your understanding of the flexible (cost and price) budget variance.