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What is a flexible budget?
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What Is A Flexible Budget
A flexible budget is a type of budget that is adjusted based on a company’s actual revenues.
In other words, unlike a static budget that remains fixed for a period of time, the flexible budget figure will vary as the actual results are determined.
This type of budgeting system works by taking a percentage of revenues and expenses and creating a budget based on that.
As such, as the revenues and expenses vary, the budget percentage used will provide a different budget output.
With a flexible budget, your budget is continually pegged to your actual figures.
For example, if a company’s labor costs represent 30% of its revenues, an increase or decrease in revenues can signal to the company how much to budget for labor costs.
If the company’s revenues increase, the company should ensure that it increases its labor capacity to meet the demand but ensure not to exceed 30% of the overall spend.
Why Use Flexible Budget
The main reason why flexible budgets are used is to have a budget that is fully aligned with the company’s actual activity levels.
Companies that like to have a budget that is very close to activity levels will want to use a flexible budgeting system to ensure they are planning as best as possible to the actuals.
For example, companies producing large volumes of goods in a stable and mature market may want to use a flexible budget to ensure that they are constantly producing and planning based on their actual sales volumes.
Companies that do not want to purchase too much or too little raw materials, components, or resources to produce their goods can use flexible budgets to align their business operations as much as possible to the realities in the field.
In some cases, using flexible budgets can help companies make budgeting decisions in a more timely and efficient manner.
For instance, when companies do not have the final figures on their activity levels, managers can approve a budget as a proportion of revenues or business activity so the business can move forward.
Another reason why flexible budgets are used is to evaluate company managers’ performance.
In some companies, managers are evaluated based on their ability to ensure the business operations operate as close to the actuals.
How To Create A Flexible Budget
A flexible budget is created by following a few steps.
The first step is to analyze your company operations to identify your fixed costs and your variable costs.
Then, you’ll need to analyze your variable costs to identify what triggers variability in these costs.
For example, the cost of goods sold varies based on production levels or sales figures.
Once you have how your variable costs vary as business activity changes, you will now need to create your budget.
In your budget, you will need to include your fixed costs as hard costs that do not vary.
Then, you’ll include your variable costs and determine the percentage of the actuals.
For example, a company having a cost of goods sold of $5 million over total revenues of $10 million will assign a 50% percentage to account for variations in overall revenues.
Once your model is created, you will then need to input the actual figures so you can compute your budget at regular intervals.
When you’re choosing your budgeting period, keep in mind that some variable costs vary at different rates.
Flexible Budget Disadvantages
Although there are important benefits to using flexible budgets, you should also be mindful of its drawbacks.
The main disadvantage of a flexible budget is that not all costs are variable.
In other words, some costs may fluctuate based on sales volume or other factors but other costs are not variable.
As such, important fixed costs that companies should account for in their budget is not captured in a flexible budget.
Another disadvantage of a flexible budget is that it may take a lot of time to create a budget that accounts for the potential step costs.
Managers are busy and companies need to operate, spending too much time on developing a budget may not be feasible in all instances.
As a result, companies may take short-cuts and only include a few step costs in their budget.
Another drawback in using a flexible budget is that it may be difficult to compile the actual figures in a timely fashion to have an accurate picture of the budget.
In this context, if variable changes have not been recognized but there has been a significant increase or decrease in sales volume or costs, the company will not have accounted for that.
In addition to that, different types of variable costs will vary at different rates, such as factory overhead costs having different variation rates than sales commissions paid or labor costs.
Flexible Budget Example
Let’s look at an example of a flexible budget to better understand how it works.
Let’s assume that a manufacturing company generates $100 million in revenues.
The company’s cost of goods sold represents $50 million, which is half of its revenues.
The company’s fixed costs represent $25 million, which is 25% of its total revenues.
In this example, this company has 25% fixed costs and 50% variable costs.
Now, if the company’s revenues were to go up by 10%, using a flexible budget, the company will budget for an increase of $5 million in its variable costs.
Since the company’s revenues have gone up to $110 million, the company will have a $55 million cost of goods sold as it’s 50% of the sales.
However, the company’s fixed cost of $25 million does not change.
For a 10% increase in the company’s revenues, the company must plan an additional $5 million budget for to cost of goods sold.
So there you have it folks!
What does a flexible budget mean?
In a nutshell, a flexible budget is a type of budget where the budgeted figures adjust based on the company’s actual revenues and expenses.
Typically, flexible budgets are determined as a percentage of different company performance measures.
For instance, a company may have a flexible budget to account for the increases in production costs for increases in its sales volumes.
A flexible budget can be used for any type of business activity, large or small.
A company may use flexible budgets to account for the variable costs in the operation of a plant or equipment.
For example, a company may budget for electricity and supplies costs for operating a machine based on the number of hours it’s in operations.
Flexible budgeting works well for manufacturing companies or companies that have revenues based on seasonality for instance.
Now that you know what flexible budgets are and how they work, good luck with your research!
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