Please explain: You are preparing a short presentation for a group who wants learn performance reporting issues. One question that was raised during the discussion is about measuring variances when the actual output (or activity) does not match with the budgeted output (or activity). How will you explain to the group that an approach called flexible budgets can answer many questions on what variances are telling them? Explain to the group why the favorable variance or unfavorable variances are giving ineffective signals.
To explain the concept of flexible budgets and why they can provide valuable insights into measuring variances, you can use the following explanation:
First, you can start by outlining the scenario in which the actual output or activity differs from the budgeted output or activity. This situation can arise due to various factors such as changes in market conditions, unexpected disruptions, or alterations in business strategies.
The main challenge in such cases is determining the significance of the variances between the actual and budgeted figures. Simply comparing the two numbers may not provide a complete understanding of the reasons behind these variances. This is where flexible budgets come into play.
Flexible budgets are a tool used to create a budget that adjusts for changes in activity levels. Unlike traditional static budgets that are based on fixed activity levels, flexible budgets allow for adjustments based on varying levels of activity. By incorporating different activity levels into the budgeting process, flexible budgets provide a more accurate reflection of expected costs and revenues.
Now, let's address why favorable or unfavorable variances may provide ineffective signals on their own. An entirely favorable variance may give a misleading sense of success, making it seem like everything is going smoothly. On the other hand, an unfavorable variance might create a sense of failure or underperformance.
However, these variances alone do not provide any context. For example, an unfavorable variance could be the result of increased production costs due to unforeseen circumstances, while a favorable variance might be a result of reduced activity levels that could negatively impact the overall performance of the business.
This is where flexible budgets come in handy. By incorporating various levels of activity and analyzing the variances in relation to these different activity levels, you can better understand the true impact of the variance. Through this approach, you can decipher whether the variance is due to volume-related factors, efficiency-related factors, or the result of external influences.
By combining the concept of flexible budgets with variance analysis, you can gain a more comprehensive understanding of the performance reporting issues. This approach allows you to identify the root causes of variances, make informed decisions, and take appropriate actions to improve future performance.