No one can predict the future. Organizations of all sizes have found the need to be more flexible and nimbler in their planning procedure. For instance, all planning and preparation can go southward in a global pandemic.
Flexible budgeting enables a company to accommodate its costs and needs as factors reflect either favorable or unfavorable variances during the accounting period. This could be an increased demand for goods and services or a temporary labor cost hike. This article will delve deeper into all you need to know about flexible budgeting.
Flexible budget definition
Flexible budgets are budget or financial plans that are prone to adjustment depending on changes in cost or revenue during an accounting period, which accounts for unpredictability. A company first prepares for fixed costs. Next, they prepare for fluctuating variable costs and periodically review costs to accommodate real-time adjustments in that accounting period.
There are modifications to a flexible budget due to fluctuations in total revenue or other related activities. This results in a budget that is aligned closely with the actual cost. This method differs from the typical static budget that contains only fixed costs.
The budgets are reviewed and modified based on your forecasted and actual revenue. A flexible budget uses the percentages of actual revenue for specific expected expenses. This results in endless modifications in the budgeted costs tied directly to the incurred revenue. Moreover, this flexible budgeting approach allows monthly changes to that budget percentage.
Flexible budget formula
A flexible budget allows for cost estimates at various activity levels. You should know that before preparing a budget, you should classify the expenses into separate categories of variable costs, semi-variable costs, and fixed costs.
Flexible budget= Fixed cost + (total variable cost per unit × activity level)
Flexible budget examples
A company creates a budget of about $15 million in revenues and a $9 million cost for goods sold. From the $9 million budgeted for the cost of goods sold, fixed costs are assigned $3 million, and variable costs $6 million, depending on revenue. That means 40% of its budget is for variable costs.
After the accounting period, the company realized sales were $12 million. If it adopts a flexible budget approach, the fixed costs of goods sold will remain at $3 million. Still, the variable cost of goods sold would reduce to $4.8 million since they budgeted 40% of revenue for their variable costs.
Firm A is looking to determine the supplies and electricity costs, with a $20 cost per machine hour plus a fixed cost of $45000.
Fixed cost for insurance premiums, rent, etc., remains stable monthly. The equipment in the factory operates for 3000 to 5000 hours on an average monthly.
Judging from the above information, the monthly intermediate flexible budget=$45000+$20 per machine hour.
Assuming in June, the factory utilizes 4000 machine hours:
The monthly flexible budget for June can be calculated as =$45000+(20×4000) = $125,000.
On the other hand, if the factory utilizes 3500 machine hours in July:
The flexible budget in July will be calculated as = $45000+(20×3000)=$105,000
Therefore, one can conclude that a flexible budget is susceptible to change depending on the machine hour consumed by the factory.
How to prepare a flexible budget
Here are some steps you can follow to create a flexible budget for a company
Recognize fixed cost
The first step to creating a flexible budget is recognizing your fixed costs. These are costs that remain stable, notwithstanding a company's performance. Some examples of fixed expenses are:
- Mortgage, loan payments, and rent: The amounts established for these monthly costs are usually consistent.
- Salaries: The yearly cost for workforce salary falls under the fixed cost because an equivalent amount goes into every paycheck
- Insurance: This can also fall under fixed cost if you are consistently charged the same amount.
Recognize variable costs
Once you have identified your fixed costs, you can recognize the variable costs that fluctuate depending on the service or production volume. Here are some examples of variable costs:
- Utility bills: Your company's utility bills may decrease or increase depending on how the energy you consume.
- Part-time wages: The wages you pay part-time workers may vary based on the number of hours they work
- Supplies: The cost of office supplies like printer ink, stationery, paper, or coffee may not be the same for every purchase.
Determine the way your variable costs change
After recognizing your variable and fixed cost, you should determine the rate at which the variable costs change each month.
One ongoing cost is the cost per unit of production. Divide your variable costs by the total number of units to determine the variable cost per unit. Then, repeat the same calculation with your fixed costs. For instance, if it costs you $4,000 to produce 100 units, you should divide $4,000 by 100 to get the cost per unit( $40 in this case). So it costs your company $40 to produce one unit.
With the above information, you can determine your total variable cost. To do this, you must multiply your total production output by the variable cost of a unit produced. For example, if your total production output is 2,000 products, and the variable cost per unit is $25, the total variable cost will be $50,000.
In addition, you can calculate the average variable costs that aren't related to production. For instance, if your company's utilities cost $350, $250, and $300, you should sum the costs, then divide them by the total number of months. In this case, $900 divided by three gives you $300; hence, your average variable cost for utilities is $390 every month.
Determine the total overhead costs
Overhead costs are ongoing company expenses that do not directly relate to the cost of producing goods. To ascertain the total overhead costs, first, recognize the costs that are not directly related to production.
Next, differentiate between the variable and fixed costs. In the concluding flexible budget calculations, the variable overhead costs will fluctuate as the output changes. However, the fixed overhead costs will be consistent.
Below are some samples of overhead costs:
- Shipping: This variable overhead cost is not related directly to production.
- Marketing: Marketing and sales do not create a product directly, so they are samples of overhead costs. Depending on their relationship to an organization and its products, marketing may be variable or fixed.
- Administrative costs: The costs associated with record-keeping are samples of overhead costs. Administrative costs will likely be fixed overhead costs.
Prepare the budget
You can sum the fixed costs, variable costs, and the amount which varies into your budget.
There are several ways you can utilize to create your budget. You can incorporate variable and fixed costs into the budget as set numbers, creating a different column for variance. On the other hand, you could use percentages to stand in for the amount of the budgeted variable costs. Another way is to have columns indicating the variable costs for separate benchmarks, such as the total amount of income. Then, list totals for variable, fixed, and overhead costs to ascertain the budget.
Whatever medium you adopt for representing your numbers, ensure an outsider can easily understand your budget if you need the budget for auditing or accounting purposes.
Regularly visit and update the budget
Once you are already using your budget, ensure to periodically update it with any modifications to the variable cost percentages to make it more accurate. It is advisable to revisit a flexible budget at least once in three months or when the organization undergoes significant budgetary changes. This will be helpful to the organization, as it aids you to continue making informed expense decisions for your organization.
Input and compare
Input the conclusive flexible budget from the accounting period into the accounting software. Then, compare it to the actual expenses you previously anticipated.
Types of flexible budget
There are three types of flexible budgets. They are:
Basic flexible budget
With this budget, the expenses that vary with revenue are usually expressed as percentages of sales or per unit cost. A basic flexible budget is susceptible to adjust as the level of output changes.
Intermediate flexible budget
With this budget, expenses don't vary with revenue; instead, they vary depending on other measures, such as the electricity cost based on the consumed number of units. An intermediate flexible budget takes into account expenses changes based on other activity levels.
Advanced flexible budget
With an advanced flexible budget, the expenses remain stable at a particular activity level but eventually fluctuate beyond such a level. An advanced flexible budget considers expenditures based on changes in such levels.
Cases where a flexible budget is necessary
- In a labor-intensive company, where labor is a vital factor of production. For instance, staff performs a major portion of work in the handloom industries, jute industry, etc. Here, flexible budgets come in handy for the management to ascertain labor productivity.
- From the onset, a new business venture can not predict product demand accurately. Thus, a flexible budget helps in this situation. The business can prepare a flexible budget based on several variations of output levels derived from a similar product demand analysis.
- An organization creating seasonal products can adopt a flexible budget approach. This is because the activity level differs from time to time. It could be due to demand variation or its nature.
- In the fashion market, fashion trends frequently change. A flexible budget that is accommodative to the changes in the different cost components to accommodate the changing trends is usually advisable.
- For some businesses, the production factor is not always available. In this case, the activity level varies depending on their availability. Here, a flexible budget serves as actual activity measures for production levels.
Importance of a flexible budget
Tool for allocating expenditures
The estimates of expenses derived through a flexible budget aid in comparing the actual cost for the activity level. A flexible budget serves as a benchmark by setting the expenditures for different activity levels. Thus, any identified changes help to plan and control better.
Aids in the ascertainment of the variability of cost factors
A flexible budget helps ascertain the variability of cost factors at different activity levels. It reveals the relevant range between the variances. Hence, cost variance analysis becomes easy.
Easy detection and correction of errors
A flexible budget helps to recognize operational errors and inefficiencies. Therefore, a flexible budget is a great tool for correction and control.
Aids in quotation and price determination
A flexible budget aids in setting quotations and prices for a business contract. Therefore, it comes in handy during project acquisition.
Instrument for the assessment of organizational performance
It aids in assessing the management's and critical production personnel's performance. Thus, a flexible budget boosts the employees' efficiency.
Easy profit attainment
The better cost control that a flexible budget enhances leads to better profit planning.
Aids in the analysis of variables
A flexible budget aids in variance analysis after comparing the company's actual results.
Disadvantages of flexible budgeting
Although a flexible budget has greater importance, however, there are some disadvantages to it. They are:
Necessity for expertise
An organization requires the services of experts to prepare a flexible budget. Thus, the availability of these experts is a vital factor in designing a flexible budget.
Heavy dependency on proper accounting
A flexible budget is heavily dependent on proper accounting disclosure. Therefore, any books of account error can mislead the budget preparation, and chances of variance for a flexible budget may increase. This is because the project's root is the organization's past performance.
The management's prediction can be volatile since it depends highly on production factors beyond the management's control.
Analyzing the cost variances may be tricky as the nature of the total expenditures may not be similar.
Unpredictability of concerning factors
Variable and fixed cost determination occurs on an arbitrary basis. Thus, flexible costs are less relatable to the actual budget cost of the activity level.
A flexible budget is often challenging to formulate. Since some costs are fixed, and others are variable costs. The process of ascertaining each cost's categories and the sort of cost it falls under can be challenging and take time.
Critical differences between flexible and fixed budget
- A flexible budget is a financial plan that varies based on activity level or production units. A fixed or static budget is a financial plan that does not change due to activity or output level.
- Flexible budgets can be adjusted depending on the business necessity. A fixed budget is rigid, notwithstanding the activity level, and isn't susceptible to change.
- A flexible budget is semi-variable; some parts are fixed, while others change depending on the activity level. A fixed budget is always static; this means it is constant for any activity level.
- Flexible budgets appear complicated. A fixed budget seems simple.
- It takes a long time to prepare flexible budgets. It takes a little time to prepare a fixed budget
- A flexible budget is ascertained based on the realistic situations of an organization. A fixed budget is established from past data and the management's anticipation of future events.
- A flexible budget is advantageous to all business sizes – from small to macro. A fixed budget is not suitable for large and medium organizations, only small organizations.
When we compare fixed and flexible budgets, we will discover the more applicable and useful ones. Even if a static or fixed budget is easy to prepare, ideally, it isn't an excellent budgeting approach because fixed budgeting does not leave room for modifications.
However, a flexible budget adjusts easily to an organization's actual performance. As a result, an organization does not have to incur losses. That is, it is safe and prudent to utilize flexible budgeting notwithstanding the scale of your business.
A flexible budget is a budget or financial plan that is primarily helpful to manufacturing industries, where the costs change depending on activity level. It is important to note that for organizations to create accurate budgets, they have to involve the services of skilled workers so that the scope of error is lessened and the variance analysis of the organization is improved.