There are several accounting tools that businesses can use to plan for and track their monetary activity. One tool that many companies find helpful is the flexible budget. This type of budgeting changes with a company's level of activity or volume and is especially useful for businesses that see a lot of variations in cost-related activities throughout the year.
In this article, we will explore what a flexible budget is, the advantages and disadvantages of flexible budgeting and how you can create this type of budget for your business.
What is a flexible budget?
A flexible budget is a budget that adjusts to the activity or volume levels of a company. Unlike a static budget, which does not change from the amounts established when the budget was created, a flexible budget continuously "flexes" with a business's variations in costs. This type of budgeting often includes variable rates per unit rather than a fixed amount, which allows a company to anticipate potential increases or decreases in monetary needs.
This type of budget is most often based on changes in a company's actual revenue and uses percentages of revenue rather than static numbers. For example, a flexible budget may allot 25% of a company's revenue to salary as opposed to allotting $100,000 to salary in a given year. This accounts for any changes in both the company's revenue and staff that may occur throughout the year.
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Types of flexible budgets
A company can produce several variations of a flexible budget that range from basic to sophisticated depending on the company's needs. The following are the three types of flexible budgets most commonly used:
Basic flexible budget
This type of budget flexes with a company's expenses that change directly in relation to its revenue. A basic budget may build in a percentage that varies based on revenue. This type of budget is typically used to denote cost per unit or percentage of sales.
Intermediate flexible budget
An intermediate flexible budget takes into account expenses that go beyond a company's revenue. Typically, this budget includes costs that are related to activity in addition to or rather than revenue. For example, a business's insurance policy costs may vary based on how many employees the company has and may increase if the company hires new employees.
Advanced flexible budget
This type of budget takes into account the variation and ranges of expenses based on each category of a company's budget. An advanced flexible budget will also change based on the actual expenses for each category.
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Advantages of a flexible budget
A flexible budget can have many advantages for companies. The following are a few of the benefits that a business may experience when using a flexible budget:
Adjustments based on profit margins and costs
A flexible budget enables companies to have a more realistic idea of their budgets based on changing costs and profit margins. Whereas a static budget remains the same when the budget is creating at the onset of a new year, a flexible budget accounts for decreased or increased costs and helps businesses make adjustments to compensate.
Potential to maximize revenue
Whereas static budgets do not change to reflect an increase in sales, flexible budgets do. As a result, a company may better be able to see where they can increase marketing or other efforts when they experience increased revenue.
Increased cost controls
A flexible budget allows a company to see when changes to certain costs should be made. For example, if projected sales are less than what was anticipated, a flexible budget will show updated percentages of each category that enable a company to make the needed adjustments to its spending to compensate for decreased sales.
Disadvantages of a flexible budget
Like many accounting tools, a flexible budget can also come with disadvantages. Understanding the disadvantages of this type of budgeting can help you determine if a flexible budget is right for your company. The following are a few downsides that may result from a flexible budget:
Lack of revenue comparison
Because a flexible budget adjusts regularly to reflect a company's current revenue, this type of budget cannot be used to compare actual expenses or revenue to expected expenses or revenue. This can make it difficult to determine if a company's revenue is above or below what was expected.
A flexible budget can be difficult to formulate. This is because not all costs a company may incur are variable and must be input into the budget as a fixed cost. Calculating each category and determining the type of cost it requires can be difficult and take time.
Not always applicable
A flexible budget may not benefit certain companies, especially companies that have a majority of fixed overhead costs. For example, a company that has little to no cost of goods sold and has a set overhead cost each month will likely not benefit from a flexible budget plan.
How to create a flexible budget
The following are steps you can take to create a flexible budget for your business:
1. Identify which costs are variable and which costs are fixed
Fixed costs typically include expenses such as rent and monthly marketing costs. Once you have determined which costs are fixed and which are variable, separate them on your budget sheet.
2. Divide the budget
Divide the budget you plan on spending on variable costs by your estimated production. This will provide a starting budget for cost per unit.
3. Create your budget with set fixed costs
Create your budget with set fixed costs that will not change and variable costs depicted as percentages that can be adjusted based on actual revenue.
4. Update the budget
Once an accounting period is over, update your budget with the actual revenue and/or activity measurements. This will adjust the variable costs based on accurate data from the accounting period.
5. Input and compare
Input the final flexible budget from an accounting period into your accounting software to compare it to the expenses you initially anticipated.
Example of a flexible budget
The following is an example of how flexible budgeting may be used by a business
Company B has budgeted for $5 million in revenue and $1 million in cost of goods sold. The company has determined that $400,000 of the $1 million of the cost of goods sold is fixed and $600,000 of the cost of goods sold will vary based on its revenue. This means that the variable, or flexible, the amount of cost of goods sold is 12% of the company's revenue. At the end of the accounting period, Company B determines that it actually had sales that equaled $6 million, which is $1 million more anticipated.
Using the flexible budget, the fixed cost of goods would remain at $400,000, while the variable portion of the cost of goods would have been adjusted to $720,000 to reflect the 12% designated for this portion of the cost of goods. As a result, the company would have been able to incorporate an additional $120,000 into its variable cost of goods budget to account for the increased sales.