Comparing Performance: Budgets, Forecasts, and Flexible Budgets

Learning objectives

By the end of this chapter, you should be able to:

• Explain the purpose of budgets, forecasts, and flexible budgets in planning and performance evaluation.
• Prepare an original budget and a flexible budget for a given level of activity.
• Calculate key variances for revenue and costs by comparing a flexible budget with actual results.
• Interpret variances by identifying likely causes and appropriate follow-up actions.
• Distinguish between favourable and adverse variances and explain what each implies for profit and performance.

Overview & key concepts

Organisations compare planned and actual performance to understand whether results are on track and to identify where management attention is needed. Three closely related tools support this:

• Budgets: a quantified plan, usually set before the period starts, used to allocate resources and establish targets.
• Forecasts: updated expectations, revised as new information becomes available.
• Flexible budgets: budgets restated for the actual level of activity, allowing a fair comparison between “what should have happened at this activity level” and “what actually happened”.

In this chapter, the flexible budget is used as the benchmark for analysing controllable performance when actual activity differs from plan.

A key idea is to separate:

1. Volume effects(selling/producing more or fewer units than planned), and
2. Rate/price and efficiency effects(selling price changes, input price changes, wastage, productivity, overspend, and similar factors).

A flexible budget removes volume effects from the comparison by restating budgeted revenue and variable costs at the actual activity level.

Exam warning: If actual activity differs from plan, don’t assess cost control against the original budget. Flex the budget to the actual activity level first.

Budgets

A budget is a forward-looking financial plan for a defined period. It commonly includes expected:

• sales volumes and selling prices (or service levels and fee rates)
• variable costs driven by activity (materials, labour, variable overhead)
• fixed costs for the period (fixed overheads, fixed selling and administration costs)
• expected profit (or surplus/deficit)

Budgets support planning (setting targets), coordination (aligning departments), and control (comparing against actual results).

Budgets and the accounting records

Budgets are not accounting transactions. Preparing a budget does not create journal entries, and nothing is posted to the ledger simply because a budget exists. The ledger records actual transactions (cash and credit sales, purchases, payroll, accruals, and so on). Budgets are used to prepare expected financial statements and to analyse variances once actual results are known.

Forecasts

Forecasts are revised expectations based on the most recent information. A forecast typically changes when assumptions change, such as:

• demand levels
• selling prices
• input costs (materials, labour rates, energy)
• capacity constraints and staffing

Forecasts are useful for decision-making because they reflect current conditions rather than original targets. For performance evaluation, it is important to be clear about the benchmark being used:

• Budget vs actualassesses performance against targets.
• Forecast vs actualassesses how well the organisation anticipated conditions and adapted during the period.

Flexible budgets

A flexible budget restates the budget for the actual activity level, using the original budgeted rates:

• Budgeted revenue is recalculatedusing the budgeted selling price (or fee rate) multiplied by actual volume.
• Variable costsare recalculated using budgeted variable cost rates multiplied by actual activity.
• Fixed costsremain at the budgeted total for the period.

Fixed costs are assumed constant within the relevant range unless the question indicates a capacity step (for example, an extra shift, supervisor, or facility rental).

Flexible budgets improve comparability. If sales volumes fall, profit will usually fall even if efficiency is unchanged. A flexible budget shows what profit should have been at the lower volume, leaving the remaining differences as variances to investigate.

Variances

A variance is the difference between a benchmark figure and an actual result. In this chapter, the benchmark is the flexible budget (budget restated for actual volume).

Variances are described as:

• Favourable (F): increases profit compared with the benchmark (for example, higher revenue than expected, or lower costs than expected).
• Adverse (A): reduces profit compared with the benchmark (for example, lower revenue than expected, or higher costs than expected).

Sign conventions

Different textbooks use different sign conventions (especially for costs). The method below is acceptable as long as it is applied consistently and the variance is labelled F/A by profit effect.

A simple discipline avoids confusion:

1. CalculateActual − Flexible budget.
2. If the result increases profit, label itF; if it reduces profit, label itA.

Revenue and cost variances: what they usually mean

When comparing flexible budget to actual results:

• Revenue variance: once volume is flexed, remaining revenue differences reflectselling price and/or mix effects, depending on how the flexible budget is constructed.
• Variable cost variances: often reflect changes in input prices, usage efficiency, wastage, downtime, or overtime premiums.
• Fixed cost variance: reflects over/underspend relative to the budgeted fixed total for the period, and may be caused by timing, one-off items, or weak cost control.

Controllable costs

A cost is controllable if the manager being assessed can influence it within the relevant timeframe. Controllability depends on:

• authority (what decisions the manager is allowed to make)
• timing (what can realistically be changed within the period)
• constraints (contracts, capacity limits, regulation)

A variance may still be worth investigating even if it is not controllable by the manager being assessed, but performance evaluation should be fair and based on what the manager could reasonably influence.

Exception reporting

Exception reporting focuses attention on variances that are large enough to matter. This normally involves:

• setting thresholds (for example, amounts, percentages, or both)
• investigating significant variances first (while still learning from favourable variances)
• identifying root causes and actions rather than treating the variance itself as the problem

Thresholds should reflect materiality for the organisation and the purpose of the analysis.

Core approach

1) Building the original budget

An original budget is typically prepared using:

• expected volume (units sold/produced, labour hours, machine hours, service jobs)
• budgeted selling price or fee rate
• budgeted variable cost per unit (or per hour)
• budgeted fixed costs for the period

A common structure is:

• Contribution= Revenue − Variable costs
• Profit= Contribution − Fixed costs

This structure makes it easier to flex the budget later.

2) Updating expectations through forecasting

Forecasting approaches vary, but exam-style scenarios commonly rely on:

• rolling forecasts (regular updates for a constant time horizon)
• sensitivity analysis (what happens if volume/price/cost assumptions change)
• scenarios (best case / expected case / worst case with consistent assumptions)

A forecast should be internally consistent: if sales volume changes, variable costs driven by that volume should change as well.

3) Preparing a flexible budget

To flex a budget:

1. Identify the activity driver (for example, units sold).
2. Recalculatebudgeted revenueat actual activity using the budgeted selling price (or fee rate).
3. Multiply budgetedvariablerates by theactualactivity level.
4. Keep budgetedfixedcosts unchanged for the period (unless a capacity step is indicated).
5. Recalculate contribution and profit.

The flexible budget then represents the expected result at the actual activity level, assuming the original rate assumptions held.

4) Analysing variances

When comparing actual results to the flexible budget:

• Revenue variance highlights selling price and/or mix effects (volume effects removed).
• Variable cost variances highlight spending and efficiency issues.
• Fixed cost variance highlights over/underspend against the budgeted fixed total.

In some questions, variances are split further (for example, materials price vs materials usage, labour rate vs labour efficiency). That requires additional information (such as standard quantities for actual output). Where that information is not provided, a single flexible-budget variance is still meaningful.

Worked example

Narrative scenario

A small manufacturing company, ABC Ltd, produces widgets and budgets for 10,000 units in April. The budget assumptions include a selling price of £25 per unit, variable costs of £8 for materials, £6 for direct labour, and £2 for variable overhead per unit. Fixed overheads are budgeted at £45,000 for the month.

Actual results show that 9,000 units were sold at an average price of £24.50 per unit. Actual costs incurred were £75,600 for materials, £55,800 for direct labour, £18,900 for variable overhead, and £46,200 for fixed overhead.

Required

1. Prepare the original budget for 10,000 units.
2. Flex the budget to the actual volume of 9,000 units.
3. Summarise the actual results for 9,000 units.
4. Compute variances between the flexible budget and actual results.
5. Interpret the variances and suggest possible causes.

Solution

1) Original budget (10,000 units)

Revenue: 10,000 × £25 = £250,000

Variable costs

• Materials: 10,000 × £8 =£80,000
• Direct labour: 10,000 × £6 =£60,000
• Variable overhead: 10,000 × £2 =£20,000

Fixed overhead: £45,000

Profit
Profit = £250,000 − (£80,000 + £60,000 + £20,000 + £45,000)
Profit = £250,000 − £205,000 = £45,000

2) Flexible budget (9,000 units)

Revenue: 9,000 × £25 = £225,000

Variable costs

• Materials: 9,000 × £8 =£72,000
• Direct labour: 9,000 × £6 =£54,000
• Variable overhead: 9,000 × £2 =£18,000

Fixed overhead: £45,000

Profit
Profit = £225,000 − (£72,000 + £54,000 + £18,000 + £45,000)
Profit = £225,000 − £189,000 = £36,000

3) Actual results (9,000 units)

Revenue: 9,000 × £24.50 = £220,500

Costs

• Materials:£75,600
• Direct labour:£55,800
• Variable overhead:£18,900
• Fixed overhead:£46,200

Profit
Profit = £220,500 − (£75,600 + £55,800 + £18,900 + £46,200)
Profit = £220,500 − £196,500 = £24,000

4) Presentation layout tip

A clear way to earn marks is to show Flexible budget, Actual, Variance in one layout before discussing causes.

Check: Total profit variance equals revenue variance minus total cost variances:
(4,500) − (3,600 + 1,800 + 900 + 1,200) = (12,000) adverse.

5) Interpretation of the results

Before explaining causes, confirm the figures are reliable (correct coding, cut-off, and unit volumes). Then interpret the variances and link follow-up actions to the most likely owners.

Revenue variance: £4,500 adverse
Budgeted revenue at 9,000 units is £225,000. Actual revenue is £220,500.
The shortfall is consistent with a selling price reduction of £0.50 per unit:
£0.50 × 9,000 = £4,500 adverse.
Likely owners: pricing and sales management.
Possible causes: discounting to defend volume, competitive pressure, weaker demand, or an unfavourable change in sales mix (in multi-product settings).

Materials variance: £3,600 adverse
Actual materials cost per unit = £75,600 ÷ 9,000 = £8.40 per unit, compared with the budget rate of £8.00.
Likely owners: procurement and production quality control.
Possible causes: higher supplier prices, weaker purchasing terms, lower-quality inputs causing more waste, increased scrap/rework, or production disruption.

Direct labour variance: £1,800 adverse
Actual labour cost per unit = £55,800 ÷ 9,000 = £6.20 per unit, compared with £6.00.
Likely owners: production supervision and staffing.
Possible causes: overtime premiums, lower productivity, training time, absenteeism, or downtime increasing idle labour cost.

Variable overhead variance: £900 adverse
Actual variable overhead per unit = £18,900 ÷ 9,000 = £2.10 per unit, compared with £2.00.
Likely owners: operations and facilities teams.
Possible causes: higher energy/consumable rates, inefficient usage, or indirect activity increasing with inefficiency (for example, more rework driving more variable overhead).

Fixed overhead variance: £1,200 adverse
Fixed overhead exceeded budget by £1,200.
Likely owners: departmental budget holders (depending on the cost).
Possible causes: one-off repairs, unexpected service costs, or timing differences in accruals. Follow-up should separate recurring overspend from non-recurring items.

Overall conclusion
Profit is £12,000 below what would have been expected at 9,000 units under the original assumptions. The shortfall is driven by a reduced selling price and higher unit costs. Priority investigation areas are pricing discipline, purchasing and waste control, and labour productivity.

Common pitfalls and misunderstandings

Diagnostic checklist: why your variance analysis might be misleading

1) Comparability check (are we comparing like with like?)

• If activity differs from plan, flex the budget first; otherwise volume effects will be mixed with rate/efficiency effects.
• Confirm the same time period, consistent product/service definition, and consistent cut-off for accruals.

2) Model check (is the flexible budget built on sensible behaviour assumptions?)

• Re-check which costs are truly variable with the chosen activity driver and which are fixed within the relevant range.
• If capacity changes in steps (extra shift, extra supervisor, additional facility), reflect the step change rather than assuming a smooth pattern.

3) Data check (are the numbers reliable?)

• Validate quantities, prices/rates, and coding of costs before explaining causes.
• A miscode can create a “variance” that is not operational at all.

4) Interpretation check (are we jumping to conclusions?)

• Treat variances as prompts for questions, not answers: consider pricing, supplier terms, waste, downtime, overtime, quality, and scheduling.
• Prioritise using thresholds so effort goes to items that are big enough to matter.

5) Behaviour and accountability check (is the analysis fair and useful?)

• Link each variance to the manager/team who can influence it in the timeframe.
• Learn from favourable variances too—some reflect repeatable improvements, others are one-offs that will not recur.

Summary and further reading

Budgets set targets and allocate resources. Forecasts update expectations as conditions change. Flexible budgets restate budgeted revenue and variable costs at the actual activity level so performance can be evaluated fairly when volume differs from plan.

Variance analysis compares actual results with the flexible budget to highlight differences that require investigation. A strong interpretation focuses on whether the cause is price/rate, efficiency/usage, mix, or fixed cost control, and assigns practical follow-up actions to the most appropriate owners.

For further study, review cost behaviour, contribution analysis, and variance analysis methods that split total variances into price/rate and efficiency/usage components when additional information is provided.

FAQ

What is the primary difference between a budget and a forecast?

A budget is a pre-set plan and performance target for a future period. A forecast is a revised expectation that changes as new information becomes available. Budgets are often used to assess performance against targets, while forecasts support decision-making by reflecting current conditions.

How does a flexible budget improve performance evaluation?

A flexible budget recalculates budgeted revenue and variable costs for the actual activity level using budgeted rates, while keeping fixed costs at the budgeted total (unless a capacity step is indicated). This removes volume effects and focuses attention on price/rate, efficiency/usage, and cost control.

Why is variance analysis important in performance management?

Variance analysis highlights where results differ from expectations and provides a structured basis for investigation. It supports learning, pricing decisions, resource allocation, and operational improvements by identifying the most significant drivers of performance.

What are common pitfalls in variance analysis?

Common pitfalls include failing to flex when activity differs, misclassifying costs as variable or fixed, using inconsistent assumptions, relying on poor-quality data, and overreacting without identifying root causes or materiality.

How can managers respond effectively to variances?

Confirm the data is accurate and comparable, then identify the most likely drivers. Prioritise significant variances, focus on what is controllable, and assign actions to the right owners (sales, procurement, operations, or budget holders). Track outcomes so learning feeds into future budgets and forecasts.

Exam focus recap

• Use the flexible budget as the benchmark when activity differs from plan.
• Recalculate budgeted revenue at actual volume using the budgeted selling price (or fee rate).
• Flex variable costs using budgeted rates; keep fixed costs constant within the relevant range unless a step is indicated.
• Use one sign convention consistently and label F/A by profit effect.
• Interpret variances by linking causes to owners and validating data before drawing conclusions.

Glossary

Budget
A quantified plan for a future period used to set targets and allocate resources.

Forecast
An updated estimate of expected results prepared using the latest information and assumptions.

Flexible budget
A budget restated for the actual activity level by recalculating budgeted revenue and variable costs using budgeted rates, while keeping fixed costs at the budgeted total (unless a capacity step is indicated).

Variance
The difference between an actual result and a benchmark figure used for comparison.

Favourable variance
A variance that increases profit relative to the benchmark (for example, higher revenue or lower costs than expected).

Adverse variance
A variance that reduces profit relative to the benchmark (for example, lower revenue or higher costs than expected).

Controllable cost
A cost that a specified manager can influence within the relevant timeframe.

Exception reporting
A reporting approach that highlights variances exceeding agreed thresholds so attention is focused where it matters most.

Activity level
The volume measure used to flex a budget (for example, units sold, labour hours, or machine hours).

Master budget
A coordinated set of budgets (such as sales, production, labour, overhead, and cash budgets) forming an overall plan for the organisation.