Flexible budgets are dynamic systems which allow for expansion and contraction in real time. They take into account that a business is an organic, growing system and that life is not predictable. They allow managers to predict the effect that changes will have on their company’s income statement and balance sheet while still being able to reflect actual figures. It helps to provide accurate forecasts without using theoretical data since they are based on what occurred.
Companies develop a budget based on their expectations for their most likely level of sales and expenses. Often, a company can expect that their production and sales volume will vary from budget period to budget period. They can use their various expected levels of production to create a flexible budget that includes these different levels of production. Then, they can modify the flexible budget when they have their actual production volume and compare it to the flexible budget for the same production volume. A flexible budget is more complicated, requires a solid understanding of a company’s fixed and variable expenses, and allows for greater control over changes that occur throughout the year.
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- This represents your best guess at what will be spent and what will be earned.
- Now let’s illustrate the flexible budget by using different levels of volume.
- Creating a business budget, particularly a flexible budget, requires some familiarity with the accounting process and is best left to experienced accountants and bookkeepers with knowledge of cost accounting.
For example, suppose a proposed sale of items does not occur because the expected client opted to go with another supplier. In a static budget situation, this would result in large variances in many accounts due to the static budget being set based on sales that included the potential large client. A flexible budget on the other hand would allow management to adjust their expectations in the budget for both changes in costs and revenue that would occur from the loss of the potential client. The changes made in the flexible budget would then be compared to what actually occurs to result in more realistic and representative variance. This ability to change the budget also makes it easier to pinpoint who is responsible if a revenue or cost target is missed.
Separate fixed and variable costs
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- Spending variance is the difference between what you should have spent at your actual production level and what you did spend.
- Flexible budgets are prepared at each analysis period (usually monthly), rather than in advance, since the idea is to compare the operating income to the expenses deemed appropriate at the actual production level.
- Static budgets are often used by non-profit, educational, and government organizations since they have been granted a specific amount of money to be allocated for a period.
- Unlike a static budget, a flexible budget changes or fluctuates with changes in sales, production volumes, or business activity.
Let’s suppose the production machinery had to operate for 4,500 hours during February. Let’s imagine that a manufacturer has determined what its electricity and supplies costs are for the factory. Flexible budgets can be very useful, but they do have some downsides.
This represents your best guess at what will be spent and what will be earned. A flexible budget is a budget that changes based on your actual production or revenue. Unlike a static budget, it adjusts your original budget projection in using your actual sales or revenue. Static budgets may be more effective for organizations that have highly predictable sales and costs, and for shorter-term periods.
Static vs. Flexible Budgeting
Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
A sophisticated flexible budget will change the proportions for these expenditures if the measurements they are based on exceed their target ranges. A flexible budget will show the variance in both revenue and spending. Flexible budgets are usually prepared at each business analysis period (either monthly or quarterly), rather than in advance. Static budgeting is constrained by the ability of an organization to accurately forecast its needed expenses, how much to allocate to those costs and its operating revenue for the upcoming period.
Why a Flexible Budget May Be a Good Option for Your Business
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. Let’s assume a company determines that its cost of electricity and supplies will vary by approximately $10 for each machine hour (MH) used. It also knows that other costs are fixed costs of approximately $40,000 per month. Typically, the machine hours are between 4,000 and 7,000 hours per month.
The pay-yourself-first budget is another simple budgeting method focusing primarily on savings and debt repayment. With this method, you set aside a specific amount from each paycheck for savings and debt payments, spending the rest as you see fit. Expenses such as rent, management salaries, and marketing costs remain static and do not change based on production.
Definition and Examples of a Flexible Budget
One problem with its formulation is that many costs are not fully variable, instead having a fixed cost component that must be calculated and included in the budget formula. Also, a great deal of time can be spent developing cost formulas, which is more time than the typical budgeting staff has available in the midst of the budget process. Accountants enter actual activity measures into the flexible budget at the end of the accounting period. It subsequently generates a budget that ties in specifically with the inputs. The columns would continue below with fixed and variable expenses, allowing you to see how your net profit changes based on changes in actual production and revenue. A budget can help you track where your money goes while giving you more control over your financial health.
How Does a Flexible Budget Work?
However, if actual performance in a given month or quarter is different from the planned amount, it is difficult to determine whether costs were controlled. Flexible budgeting can be used to more easily update a budget for which revenue or other activity figures have not yet been finalized. Under this approach, net investment definition managers give their approval for all fixed expenses, as well as variable expenses as a proportion of revenues or other activity measures. Then the budgeting staff completes the remainder of the budget, which flows through the formulas in the flexible budget and automatically alters expenditure levels.
Spending variance is the difference between what you should have spent at your actual production level and what you did spend. If it is favorable, you spent less than your actual production level should have required. Revenue variance is the difference between what revenue should have been for the actual production activity and what the actual revenue you take in is. It may be favorable (higher than it should have been for actual production activity) or unfavorable (lower than it should have been).