What is a flexible budget?
A flexible budget is a budget that adjusts for changes in the level of activity or output. Unlike a static budget, which is based on a fixed level of activity or output, a flexible budget is designed to be adaptable to changes in sales volume, production volume, or other measures of business activity.
A flexible budget is typically created by identifying the various costs and expenses that vary with changes in activity levels and calculating the expected cost or expense for each level of activity. For example, if a business sells widgets and the cost of producing each widget decreases as more are produced due to economies of scale, the flexible budget would reflect this by showing a lower cost per widget as production increases.
The benefit of a flexible budget is that it provides a more accurate picture of a business’s performance by adjusting for changes in activity levels. This can help businesses make better decisions about their operations, identify areas where they can improve efficiency or reduce costs, and better plan for future growth.
Differences between Flexible Budget and Static Budget
The main difference between a flexible budget and a static budget is that a flexible budget adjusts to changes in activity levels, while a static budget remains fixed regardless of changes in activity levels.
A static budget is typically based on a fixed level of activity or output and does not change with changes in sales volume, production volume, or other measures of business activity. It is often created at the beginning of the budget period and is not adjusted as the period progresses. A static budget is useful for providing a baseline for planning and evaluating performance, but it may not be as accurate as a flexible budget.
On the other hand, a flexible budget is designed to adjust to changes in activity levels. It takes into account how changes in activity levels affect costs and expenses, and provides a more accurate picture of a business’s performance. A flexible budget is typically created using a range of activity levels and estimates of the associated costs and expenses at each level. It can be adjusted as actual activity levels become known during the budget period.
Steps in Creating a Flexible Budget
- Identify the key drivers of your business- Determine what factors are driving your business, such as sales volume, production volume, or number of customers.
- Determine the activity levels- Decide on the range of activity levels that your business is likely to experience during the budget period, such as low, medium, and high levels of sales or production.
- Estimate costs for each activity level- Calculate the expected costs for each activity level by breaking down your costs into fixed costs and variable costs. Fixed costs, such as rent or salaries, will remain the same regardless of activity level, while variable costs, such as raw materials or labor costs, will change with activity level.
- Create a flexible budget spreadsheet- Organize the costs by activity level in a spreadsheet or budgeting software. Use formulas or functions to automatically calculate the expected costs for each activity level.
- Compare the flexible budget to actual results- Once the budget period begins, track your actual results and compare them to the flexible budget. This will allow you to see where your actual results differ from your expectations and identify any areas where you need to adjust your operations.
- Revise the flexible budget as needed- If you find that your actual results are significantly different from your flexible budget, revise the budget to reflect the new information. This will allow you to make more accurate forecasts for future periods.
The 3 Levels of Flexible Budget
1) Basic Flexible Budget
This is the simplest form of a flexible budget, and it alters those expenses that vary directly with revenues. For example, finance can build a percentage into the basic flexible model, which they multiply by actual revenues to determine the expenses at a specified revenue level. It doesn’t provide the full level detail that a flexible budget would, but it does provide flexibility and a more accurate, up-to-date budget than a static budget.
2) Intermediate flexible budget
A flexible intermediate budget takes into account expenses that go beyond a company’s revenue. Revenue is constantly changing and is the most important factor in business decisions, but the intermediate flexible budget includes costs that vary based on other activity measures such as salaries and benefits based on the number of employees in the company.
3) Advanced Flexible Budget
A flexible budget adjusts for changes in activity levels for all costs, including both fixed and variable costs. This type of flexible budget takes into account how changes in activity levels affect all costs and provides the most accurate picture of expected costs at different levels of activity.
Example of a Flexible Budget
Let’s say a restaurant has a fixed budget of $10,000 for food expenses for the month, which is based on an expected number of customers served. However, the restaurant experiences a significant increase in customer traffic during a particular week, resulting in higher food costs.
To account for this increase, the restaurant creates a flexible budget based on the actual number of customers served. Here’s how the flexible budget might look:
- Food Expenses: $1.50 per customer x 3,000 customers = $4,500
- Labor Expenses: $3,000
- Rent and Utilities: $2,000
- Marketing and Advertising: $1,000
- Other Expenses: $1,000
Total Flexible Budget: $11,500
As you can see, the flexible budget adjusts the expected food expenses based on a higher cost per customer, resulting in an extra $1,500 in the overall budget. This allows the restaurant to better manage its expenses and make informed decisions about future pricing and menu offerings, potentially leading to a better allocation of resources and seizing the opportunity of the increase in customers to make a higher profit.
Advantages of a Flexible Budget:
- Accuracy- A flexible budget can provide a more accurate picture of a company’s expenses since it adjusts for changes in activity levels.
- Flexibility- A flexible budget can adapt to changes in the business environment, such as changes in sales volumes or unexpected expenses, making it easier to manage operations and make informed decisions.
- Motivation- A flexible budget can motivate employees since it allows for adjustments in spending to achieve their goals.
- Better Decision-making- A flexible budget allows for more informed decision-making, especially in situations where there are significant changes in the business environment.
Disadvantages of a Flexible Budget:
- Complexity- A flexible budget can be more complex to create than a fixed budget, requiring more time and resources to prepare.
- Difficulty in Comparison- A flexible budget can be more difficult to compare with actual results since it involves a range of activity levels and expected expenses.
- Higher Costs- A flexible budget can be more costly to implement, especially if it requires additional resources or software to track expenses accurately.
- Time-consuming- A flexible budget can be more time-consuming to manage, requiring ongoing updates and adjustments as activity levels change.
Overall, a flexible budget is suitable for businesses with variable or unpredictable expenses and those that need to adjust quickly to changes in the business environment in order to take advantage of the windows of opportunity. By understanding the advantages and disadvantages of a flexible budget, businesses can make an informed decision about which budgeting approach is best for their needs.
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