Its production equipment operates, on average, between 3,500 and 6,500 hours per month. Let’s imagine that a manufacturer has determined what its electricity and supplies costs are for the factory. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.
The master budget, and all the budgets included in the master budget, are examples of static budgets. Actual results are compared to the static budget numbers as one means to evaluate company performance. However, this comparison may be like comparing apples to oranges because variable costs should follow production, which should follow sales. Thus, if sales differ from what is budgeted, then comparing actual costs to budgeted costs may not provide a clear indicator of how well the company is meeting its targets. A flexible budget created each period allows for a comparison of apples to apples because it will calculate budgeted costs based on the actual sales activity.
How Does a Flexible Budget Work?
Once you have created your flexible budget, at the end of the accounting period you will want to compare the flexible budget totals against actuals. This comparison allows you to make any future adjustments based on the flexible budget variance indicated in the comparison. If, however, the cost was identified as a fixed cost, no changes are made in the budgeted amount when the flexible budget is prepared. Differences may occur in fixed expenses, but they are not related to changes in activity within the relevant range. They work well for evaluating performance when the planned level of activity is the same as the actual level of activity, or when the budget report is prepared for fixed costs.
- For example, this article shows some large U.S. cities are faced with complicated budgets because of high fixed costs.
- This comparison allows you to make any future adjustments based on the flexible budget variance indicated in the comparison.
- However, when compared to the actual results that are received after the fact, the numbers from static budgets can be quite different from the actual results.
- The flexible budget shows an even higher unfavorable variance than the static budget.
- If it used a flexible budget, the fixed portion of the cost of goods sold would still be $1 million, but the variable portion would drop to $2.7 million, since it is always 30% of revenues.
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, 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. Big Bad Bikes used the flexible budget concept to develop a budget based on its expectation that production levels will vary by quarter.
Flexible budgets create an accurate picture of production costs
A static budget is one that is prepared based on a single level of output for a given period. A flexible budget starts with fixed expenses, then layers a flexible budgeting system on top that allows for any fluctuation in costs. Most flexible budgets use a percentage of projected revenue to account for variable costs.
Even if a cost is assigned a numerical value, a monthly review of costs compared to revenue allows that number to be changed for future periods. We’ve previously covered the five different types of budget models that businesses can choose from. The flexible budget offers the most customizable experience, allowing it to be easily adopted by many different businesses. An alternative is to run a high-level flex budget as a pilot test to see how useful the concept is, and then expand the model as necessary. Flexible budgets are usually prepared at each business analysis period (either monthly or quarterly), rather than in advance. For example, under a static budget, a company would set an anticipated expense, say $30,000 for a marketing campaign, for the duration of the period.
How to Create a Flexible Budget?
A static budget based on planned outputs and inputs for each of a company’s divisions can help management track revenue, expenses, and cash flow needs. Flexible Budget Variance is the disparity between the actual and budgeted output, costs and standards. Flexible budgets come with advantages like their usability in variable cost environments, their detailed picture of performance, and their overall efficiency for budgeting teams.
What Are Flexible Budgets? 4 Best Practices
The more sophisticated relative of the static budget model, a flexible budget allows for change, and as we’ve said – business can be unpredictable. The flexible budget example below displays both the original static budget amount as well as a flexible budget based on increased production levels. In short, a flexible budget requires extra time to construct, delays the issuance of financial statements, does not measure revenue variances, and may not be applicable under certain budget models.
Budgeting Efficiency
Layered on top of that is a flexible budget system allowing for variable costs to fluctuate based on sales performance. A flexible budget adjusts based on changes in actual revenue or other activities. The result is a budget that is fairly closely aligned with actual results. This approach varies from the more common static budget, which contains nothing but fixed expense amounts that do not vary with actual revenue levels. Suddenly, there is only one company to meet demand for widgets, resulting in actual sales of 200 units per month.
Step Cost Development is Time-Consuming
Within an organization, static budgets are often used by accountants and chief financial officers (CFOs)–providing them with financial control. The static budget serves as a mechanism to prevent overspending and match expenses–or outgoing payments–with incoming revenue from sales. In short, a well-managed static budget is a cash flow planning tool for companies.
