3 Words for a COVID-19 World: Flexible Budget Variance

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 https://business-accounting.net/ to budgeted performance at many levels of activity. This budget can be prepared even if the activity level is not decided since fixed costs are already known to every department and variable costs can be approved as a percentage of sales per unit. Let us consider the following information regarding the costs that are expected to be incurred by a company in the upcoming accounting period.

Likewise, such budgets are used to evaluate successful and unsuccessful areas of the previous accounting period. In this case, management can compare budgeted numbers and actual numbers to see where improvements are needed going forward. The biggest advantage to a flexible budget is that it more accurately reflects the state of your finances. The alternative, static budgeting, can’t account for unexpected expenses or changing income.

Advantages of flexible budgeting

Variances can be calculated based on the revised budget and the actual performance. Static budgets are projection tools designed to estimate business expenses for an accounting period. There will be discrepancies between the budgeted amount and the actual spending amount, especially if you deal with fluctuating costs of raw materials or the cost of goods sold. These discrepancies are known as a static budget variance.

Therefore, we can conclude that with the change in the machine hours of the factory, the flexible budgets also change. And it helps in better financial planning and controlling. There are many companies like service industries where variable costs don’t have a major role to play and such companies do not require a flexible budget. It also helps in the reclassification of various levels of budgeted costs along with sales so that managers can easily identify the profit areas and thus may act accordingly. Thus, if the actual expenses exceed $8,880 by $X in the month with an 80% activity level, it would mean that the company has not saved any money but has overspent $X more than the budgeted amount. A flexible budget is much more realistic than fixed budgets since it gives emphasis on cost behavior at different levels of activity. If sales declined to $150,000 per month, then labor cost should be reduced to $37,500 (25 percent of $150,000).

Usage in Variable Cost Environment

A flexible budget can be created that ranges in level of sophistication. In short, a flexible budget gives a company a tool for comparing actual to budgeted performance at many levels of activity.

Flexible budgeting can also go a long way in updating a budget for which revenue and other figures are yet to be factored in. Managers can use this opportunity to verify all fixed costs and variable expenses before any production operation commences. 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. Some expenditures vary with other activity measures than revenue. For example, telephone expenses may vary with changes in headcount. If so, one can integrate these other activity measures into the flexible budget model.

Better Cost Controls

Do executives have the stomach to say no, even when there is funding to undertake an unbudgeted project? If not, flexible budgeting may not be right for your company. Though powerful anytime, you can imagine how useful this capability would be now, with so much disruption to normal course of business activity. And it’s a safe bet that advantages of a flexible budget business planning and budgeting overall will be subject to rapid and ongoing course correction for months to come. As we’ve already seen, most costs are not exclusively fixed or variable. The procedure for drawing up a flexible budget is quite straight forward. The flexed budget is only accurate, if costs behave in a predicted manner.

• Fixed cost is constant in all activity levels, therefore it must appear in all columns.
• Advantages of a flexible budget include the ability to cut or increase spending, depending on marketplace and business conditions.
• Finally, you can’t compare budget to revenue, since your budget intentionally tracks your revenue.
• In some industries, a flexible budget can be enough for an entire company’s budget, but it’s best used as part of the larger overall budget.
• The rest of this article will focus on the personal finance of flexible budgeting because… well, that’s a lot more relevant to the rest of us.

Firms can prepare in response to the changes in the activity resulting from new government policies. The accuracy of the budget largely depends upon the efficient classification of the costs.

Disadvantages

As it helps in the forecasting of different output levels. The main reason for preparing a flexible budget is that every business is dynamic and ever changing. Hence, a flexible budget is prepared according to the relevant range of production. A reliable basis is available from flexible budget for comparisons.

Business owners may find it difficult to get relevant information even if they have access to databases and electronic processes. Thus, authenticity of a flexible budget will always be at risk. At times, getting information for analyses can be extremely costly which, in turn, increases the overall cost of the organization’s operations. For example, determining the exact competition level in a sector requires effort and money. While controlling costs is one of the objectives of budgets, a flexible budget becomes a headache if you find it too costly. A flexible budget, or “flex” budget, incorporates different expense levels into the budget, depending upon changes in the amount of actual revenue generated. This approach varies from the more common static budget, which contains nothing but fixed expense amounts that do not vary with actual revenue levels.

Definition of Flexible Budget

The flexible budget offers the most customizable experience, allowing it to be easily adopted by many different businesses. Note that fixed expenses and variable cost ratios didn’t change, because they don’t vary based on activity.

Flexible budgets offer close monitoring of expenses versus revenue, and they allow for the opportunity to test things out and see what might work and what won’t without rigid financial constraints. Flexible budgets are best used for startups that have a number of variables such as manufacturing, and others that have revenue based on seasonality, as costs are directly impacted by demand. Imagine your product goes viral on social media and gains unexpected popularity overnight, now there is a demand for 20 units next month, which would cost $20 to make. Flexible budgets are dynamic systems which allow for expansion and contraction in real time. They take into account that a business is an organic, growing system and that life is not predictable.

Sales Volume as a Measure of Activity of a Flexible Budget

Suppose material costs for a product suddenly increase during the year, making this item unprofitable. A flexible budget would spot this variance, and management could take corrective actions. It might be a price increase or an effort to find cost savings in manufacturing expenses. All of the different budget models have their benefits and drawbacks – even flexible budgets…as amazing as they sound. This is where a flexible budget comes into play justifying the cost increase based on the actual earned revenue. We’ve previously covered the five different types of budget models that businesses can choose from.