Companies will frequently design flexible budgets to allow budgets to adjust with future demand in order to account for real sales and expenses diverging from anticipated sales and expenses. What exactly is a flexible budget? This article will provide an answer to that query. In this essay, we’ll also go over the flexible budget variance.
What is a Flexible Budget?
A flexible budget is one that adapts to changes in actual revenue levels. Once an accounting period is concluded, actual revenues or other activity metrics are entered into the flexible budget, and it constructs a budget that is tailored to the inputs. For control purposes, the budget is then compared to actual expenses. The following steps are required to create a flexible budget:
- Identify and separate all fixed costs in the budget model.
- Determine how much all variable costs vary as activity measures change.
- Create a budget model in which fixed expenses are “hardcoded” and variable costs are expressed as a percentage of the appropriate activity measures or as a cost per unit of activity measure.
- After an accounting period has ended, enter the actual activity metrics into the model. The variable costs in the flexible budget are updated as a result.
- In the accounting system, enter the resultant flexible budget for the completed period for comparison to actual spending.
This technique differs from the more conventional static budget, which contains only predetermined numbers that do not change in response to real revenue levels. Budget vs actual reports provided by a flexible budget tends to produce considerably more meaningful deviations than those generated by a static budget because both the planned and actual expenses are based on the same activity measure. This means that deviations will be fewer than in a static budget and will be highly actionable.
A flexible budget with several levels of sophistication can be built. Several variations on the theme are shown below. In summary, it provides a mechanism for comparing actual to budgeted performance at various levels of activity.
Basic Flexible Budget
At its most basic, the flexible budget modifies spending that fluctuates directly with revenues. A percentage is often included in the model and multiplied by real revenues to determine what expenses should be at a given revenue level. In the case of the cost of products sold, a cost per unit rather than a percentage of sales may be employed.
Intermediate Budget Flexibility
Some expenditures differ from revenue in terms of other activity indicators. Telephone expenses, for example, may vary with changes in headcount. If this is the case, these additional activity measurements can be incorporated into the flexible budget model.
Advanced Budget Flexibility
Only within specified ranges of revenue or other activities may expenditures vary; outside of those areas, a different proportion of expenditures may apply. If the measures on which these expenditures are based exceed their target ranges, a smart flexible budget will adjust the proportions for these expenses.
The Benefits of Flexible Budgeting
The thought of a flexible budget is enticing. Several benefits are listed below.
#1. Application in a Variable Cost Environment
The flexible budget is especially effective in industries whose costs are tightly matched with the level of company activity, such as retail, where overhead can be split and treated as a fixed cost, while goods costs are directly related to revenues.
#2. Performance Evaluation
Because the flexible budget restructures itself based on activity levels, it is an excellent instrument for assessing management performance – the budget should closely coincide with expectations at any number of activity levels.
#3. Budgeting Effectiveness
Flexible budgeting can be used to more readily adjust a budget that has not yet been finalized in terms of revenue or other activity figures. Managers offer their permission for all fixed expenses, as well as variable expenses as a percentage of revenues or other activity measurements, under this strategy. The remainder of the budget is then completed by the budgeting staff, which flows through the formulas in the flexible budget and automatically modifies expenditure amounts.
These benefits make the flexible budget interesting to expert budget users. However, before making the switch to a flexible budget, consider the following considerations.
The Drawbacks of Flexible Budgeting
At first glance, the flexible budget looks to be an ideal approach to overcome many of the problems associated with a static budget. However, it has a number of major flaws, which we will discuss below.
#1. Formulation
Although the flex budget is a useful tool, it can be challenging to develop and use. One flaw in its formulation is that many costs are not totally variable, but rather include a fixed cost component that must be computed and incorporated in the budget calculation. Furthermore, constructing cost formulas can take a significant amount of time, which is more time than the normal budgeting team has available throughout the budget process.
#2. Delay in Closing
A flexible budget cannot be downloaded into accounting software to be compared to financial figures. Instead, the accountant must wait until the end of a financial reporting period before entering revenue and other activity metrics into the budget model, extracting the findings, and loading them into the accounting software. Only then can financial statements with budget versus actual information be issued, which delays the issuance of financial statements.
#3. Comparison of Revenues
There is no comparison of budgeted to actual revenues in a flexible budget because the two amounts are the same. The methodology is intended to correlate actual spending to anticipated expenses rather than to compare revenue levels. There is no way to tell whether real revenues are more or lower than expected.
#4. Applicability
Some businesses have so few variable costs of any kind that creating a flexible budget is pointless. Instead, they have a tremendous fixed overhead that does not change in response to any form of activity. Consider a web store that provides software downloads to its clients; a certain amount of investment is required to run the business, but there is basically no cost of goods sold, other than credit card costs. In this case, creating a flexible budget is pointless because it will not differ from a static budget.
In summary, a flexible budget takes more time to create, delays the release of financial statements, does not account for income variances, and may not be suitable in some budget models. These are severe concerns that tend to limit its application.
Flexible Budget Variance
Any disparity between the outcomes provided by a flexible budget model and the actual results is referred to as a flexible budget variance. If actual revenues are used in a flexible budget model, any variance will be between budgeted and actual expenses, not revenues. When actual unit sales are entered into a flexible budget model, there may be differences between the standard revenue per unit and the actual revenue per unit, as well as between the actual and budgeted expense levels.
Because the unit volume or income level in a flexible budget model is changed to reflect real outcomes, the total variance should be less than the total variance created by a fixed budget model (which is not the case in a fixed model). If there is a significant flexible budget variance, it may indicate that the budget model’s formulas should be changed to more precisely represent real results.
Example of a Flexible Budget Variance
A flexible budget model, for example, is created with the expectation that the price per unit will be $100. In the most recent month, 800 units were sold at a cost of $102 per unit. This indicates there is a $1,600 revenue flexible budget variance (calculated as 800 units x $2 per unit). Furthermore, the model assumes that the cost of products sold per unit will be $45. The actual cost per unit is $50 at the end of the month. This translates to a $4,000 adverse flexible budget variance linked to the cost of goods sold (calculated as 800 units x $5 per unit). In total, this amounts to a $2,400 negative variance.
Flexible Budget and Sustainability
The ability to generate flexible budgets can be crucial in new or developing organizations when projecting revenue or use accuracy may be lacking. Organizations, for example, frequently report on their sustainability efforts and may have some items that demand more electricity than others. The reporting of energy per unit of output has occasionally been incorrect, which can lead to management making decisions that may or may not benefit the organization. For example, based on the reported energy per unit, management may opt to adjust the product mix, the quantity outsourced, and/or the amount produced. If the energy output is incorrect, the decisions may be incorrect and have a negative influence on the budget.
Causes of Flexible Budget Variance
A departure from the flexible budget can be caused by a number of circumstances. Furthermore, these factors might be controlled or uncontrolled by the organization. These factors’ specifics are as follows:
Controllable Factors
#1. Inadequate Planning and Control
A company’s budgeted results may be significantly off due to poor planning and control of its critical activities. Sales and other operations that affect cost drivers may not go as well as intended.
#2. Incorrect Sales and Cost Estimation
Revenue estimates from sales and service operations may be incorrect. Furthermore, adjustments in the business’s fixed and variable costs are likely. For example, manufacturing numbers may differ from expectations, the sales team may underperform, or labor charges may increase, and so on.
#3. Budgeting with Incomplete and Incorrect Data
Management may have failed to collect all relevant data or may have relied on outdated information. As a result, budgets might have been created based on the available, inadequate information.
All of these things are within the organization’s control. These can be regulated or corrected by the management team’s effective planning and implementation.
Uncontrollable Factors
#1. Change in Economic Conditions
Economic conditions have an impact on organizations and their functioning. A recession (or slow down) in the economy can have a significant impact on sales figures. In the event of an unexpected economic boom, the situation will be the inverse.
#2. Industry Segment Transformation
The demand-supply status of the company’s products may alter abruptly. Increased competition in the company’s industry segment of operation.
#3. Input Price Variation
A company’s input pricing and raw materials may fluctuate as a result of a sudden rise in demand or a supply constraint. Furthermore, as labor laws and minimum wage requirements change, the cost of labor rises.
Aside from the aforementioned reasons, there are numerous others that can change during the budget period, such as operational regulation changes, taxation changes, import or export limitations, interest rate changes, dumping duties, quota restrictions, currency rate variation, and so on. All of these circumstances are outside the organization’s control. As a result, management estimates can be inaccurate, resulting in budget variations.
In Conclusion,
A flexible budget is not difficult to create in theory because variable expenses change with production but fixed costs remain constant. However, meeting an organization’s goals can be challenging if there are few variable costs, cash inflows are largely fixed, and fixed costs are considerable. For example, according to this article, certain large U.S. cities confront challenging budgeting due to significant fixed costs.
Frequently Asked Questions,
What is the flexible budget formula?
Flexible budget=Â Fixed cost + (actual unit of activity x variable cost per unit of activity)
What is the difference between the fixed budget and the flexible budget?
A fixed budget is one that does not alter according to changes in activity or output levels. A flexible budget is one that adjusts depending on the level of activity or unit production. The fixed budget is constant and does not change.
