Flexible budget definition
/What is a Flexible Budget?
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.
In its simplest form, the flex budget uses percentages of revenue for certain expenses, rather than the usual fixed numbers. This allows for an infinite series of changes in budgeted expenses that are directly tied to actual revenue incurred. However, this approach ignores changes to other costs that do not change in accordance with small revenue variations. Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs. By incorporating these changes into the budget, a company will have a tool for comparing actual to budgeted performance at many levels of activity.
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Advantages of Flexible Budgeting
Since the flexible budget restructures itself based on activity levels, it is a good tool for evaluating the performance of managers - the budget should closely align to expectations at any number of activity levels. It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.
Disadvantages of Flexible Budgeting
Though the flex budget is a good tool, it can be difficult to formulate and administer. Several issues are noted below.
Not All Costs Are Variable
Many costs are not fully variable, instead having a fixed cost component that must be derived and then included in the flex budget formula.
Step Cost Development is Time-Consuming
A great deal of time can be spent developing step costs, which is more time than the typical accounting staff has available, especially when in the midst of creating the more traditional static budget. Consequently, the flex budget tends to include only a small number of step costs, as well as variable costs whose fixed cost components are not fully recognized.
Limited Applicable Range
The flexible budget model usually only works within a relatively limited revenue range; the budget analyst is unlikely to spend the time developing a more wide-ranging model if it is considered unlikely that outlier revenue amounts will be encountered.
Time Delay Issues
There may also be a time delay between when there is a change in revenue and when a supposedly variable cost changes. Here are several examples:
Sales increase, but factory overhead costs do not increase at a similar rate, since the sales are from inventory that was produced in a prior period.
Sales increase, but commissions do not increase at a similar rate, since the commissions are based on cash received, which has a 30-day time lag.
Sales decline, but direct labor costs do not decline at the same rate, because management elected to retain the production staff.
When to Use Forecasting Instead of a Budget
Given the considerable amount of time required to maintain a flexible budget, some organizations may instead opt to eliminate their budgets entirely, in favor of using short-range forecasting without the use of any types of standards (flexible or otherwise). 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.
Example of a Flexible Budget
Quest Adventure Gear has always budgeted for sales of its polycarbonate climbing helmets using a static budget, but sales have differed markedly from expectations, resulting in large variances in its production budget. For the new budget year, Quest is experimenting with a flexible budget. This budget is divided into variable cost and fixed cost components, with the variable costs being tied to the number of unit sales of the helmet. The resulting budget is shown in the following table, which notes both budgeted and actual results for the first month of the budget period.
The budget model multiplies the $21.50 budgeted unit cost of the helmet components by the 1,500 actual units sold to arrive at budgeted variable costs for the month of $32,250. All other costs shown in the budget are fixed.
Terms Similar to Flexible Budget
A flexible budget is also known as a flex budget.