A flexible budget is a budget that is created using a specific cost or formula. Unlike a static budget, a flexible budget includes both fixed and variable costs that can be adjusted based on revenue percentage or production cost incurred throughout the course of the budget period.
Overview: What is a flexible budget?
A flexible budget is designed to change based on revenue or production levels. Unlike a static budget, which can be prepared in anticipation of performance, a flexible budget allows you to adjust the original master budget using actual sales and/or production volume.
For instance, if you prepare a static budget for a small manufacturing company, the budget will remain the same whether the factory produces 500 or 5,000 products, leaving your business with an inaccurate budget as production increases or decreases.
A flexible budget is best used in a manufacturing environment where the budget is able to be based on production volume.
Creating a business budget, particularly a flexible budget, requires some familiarity with the accounting process and is best left to experienced accountants and bookkeepers with knowledge of cost accounting.
Static budget vs. flexible budget: What’s the difference?
Both static and flexible budgets are designed to estimate future revenues and expenses.
However, a static budget remains at the original budgeted amount, regardless of any changes in revenue activity, production, or volume, while a flexible budget is designed to adjust budget totals based on any changes in revenue or production.
In other words, if your restaurant budgets for serving 1,000 meals in a month, but you actually serve 2,000 meals, your budgeted expenditures in a static budget remain the same, while the budget totals adjust to reflect the changes in both revenue and production.
Benefits of having a flexible budget for your small business
If you manage a high-level production environment, creating a flexible budget can help mitigate the typical variances found on static budgets.
While completed after the fact, when production levels for the entire month are available, creating a flexible budget can help you better forecast both revenue and expenses that can be directly tied to production. Here are a few other ways in which a flexible budget can be useful for your business:
1. Reflects changing costs
Changing costs in the manufacturing process can severely impact your profit margin. Any unexpected market shifts may find a material essential to your production line suddenly costing more than three times the original budgeted amount.
Using a flexible budget will immediately alert you to any changes that are likely to impact your bottom line, allowing you to make changes proactively instead of reactively.
2. Includes real-time data
While preparing any budget at all is always better than not having one, a static budget does not prepare you for revenue and expense changes in real time.
While variances are noted in static budgets, a flexible budget allows you to enter the revenues and expenses relevant to that particular budget period, adapting flexible costs using real-time data.
3. Allows for market variances
If you own an ice cream shop, you know that the height of your business will be in the warm summer months. Using a flexible budget allows you to account for increased revenues, higher labor costs, and higher inventory costs during the busier months without having to adjust for months when business is slower.
How to create and implement a flexible budget for your business
Creating a flexible budget can be a time-consuming process, but once you create the initial budget, you can simply build off of your original numbers to create a real-time flexible budget that accounts for increases and decreases in revenue.
To get the most mileage out of your budget, you should be familiar with the following accounting terms:
- Accounting period: The period of time covered by a company’s financial statements. An accounting period can be a calendar month, a quarter, or a year.
- Fixed costs: Fixed costs are costs that remain consistent whether production or services increase or decrease.
- Variable costs: Variable costs are costs that change based on production or service levels.
If you’re ready to create a flexible budget for your business, here are a few steps to guide you:
Step 1: Create a static overhead budget
The first step in creating a flexible budget is to create a static overhead budget. This allows you to assume standard production levels and all associated expenses. The static budget also serves as a base for adjusting budget variances on the flexible budget.
Step 2: Identify fixed and variable costs for the period
In order to create an accurate business budget, you’ll need to separate fixed costs from variable costs since a flexible budget is only concerned with variable expenses, such as production levels, materials and labor.
Expenses such as rent, management salaries, and marketing costs remain static and do not change based on production.
Step 3: Enter production levels based on actuals
Instead of estimating production levels, use the actuals from the previous month to create your flexible budget. For instance, if your company produced 50,000 units in January, and you want to budget for 75,000 units in February, you have to look at your variable costs.
Let’s say your indirect materials cost to produce 50,000 units was $22,000 while your indirect labor cost was $19,000. In order to build your flexible budget, divide the total cost for each category by the number of units. For instance:
$22,000 ÷ 50,000 = $0.44
That means that your indirect material cost per unit is $0.44.
Your indirect labor cost is:
$19,000 ÷ 50,000 = $0.38
Both of these totals would be included in your flexible budget based on production. In other words, if you’re budgeting to produce 75,000 units for February, your budgeted totals would be reflected in your flexible budget, making your indirect material cost $0.44 x 75,000 = $33,000.
The same calculation would apply for indirect labor costs, which would be $0.38 x 75,000 = $28,500.
You can also add in the utility cost for a more complete picture. For instance, if your electricity for the factory was $750 to produce 50,000 units, your calculation to determine utility cost would be $750 ÷ 50,000 = $0.015.
The flexible budget example below displays both the original static budget amount as well as a flexible budget based on increased production levels.
Step 4: Compare to actual results
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.
Flexible budgets create an accurate picture of production costs
While even a static budget is better than no budget at all, creating a flexible budget provides a much clearer picture of revenues and production costs.
Keep in mind that if you or your bookkeeper are unfamiliar with cost accounting, the process of creating a flexible budget is best left in the hands of an accounting professional or CPA.
While accounting software is an important part of tracking all of your financial transactions, many software applications simply don’t have the capability of preparing a flexible budget.
If you do find yourself in the market for accounting software for your small business, be sure to check out The Blueprint’s accounting software reviews and find an application that is a good fit for your business needs.
View more information: https://www.fool.com/the-blueprint/flexible-budget/