Definition
A flexible budget is a financial plan that adjusts or flexes for changes in the volume of activity. It is a budgeting tool that increases or decreases in correlation with a company’s productivity levels or revenue. Thus, unlike a static budget, a flexible budget accounts for changes in revenue and expenses, and is often considered more practical as it allows for adaptations to unexpected circumstances.
Key Takeaways
- A flexible budget is a financial plan that adjusts, or flexes, with changes in volume or activity. It provides a more accurate picture of a company’s performance and efficiency as compared to a static budget.
- This type of budget is particularly useful in accurately reflecting changes in revenues and costs, as it allows for modifications based on variations in actual business operations or changes in the business environment.
- By helping to isolate the effects of changes in volume or efficiency on revenues, costs, and net income, a flexible budget is a significant tool in variance analysis – the process of identifying and explaining the reasons for different outcomes between planned and actual operations.
Importance
The finance term “Flexible Budget” is important as it provides a more dynamic and realistic financial perspective to an organization.
Unlike static budgets, flexible budgets adjust based on changes in revenue or other factors, making it more adaptable to unforeseen events or unpredictable market conditions.
This means that it can provide more accurate performance evaluations and make appropriate cost allocations.
It also allows a company to be proactive, enabling them to adjust resources in response to these changes to optimize profit.
In this way, flexible budgets are crucial for effective strategic planning, decision making, and overall financial management.
Explanation
The purpose of a flexible budget is to allow a business to adapt to changing circumstances. This type of budget is designed to change in relation to variations in activity levels, such as production volume or sales volume. A flexible budget accommodates changes in business activities and eliminates the limitations of static budgets, particularly the rigidity to adjust with business realities.
Therefore, it serves as a more realistic, performance-enhancing and decision-facilitating tool, especially when a company operates in a fluctuating business environment. The flexible budget influences planned operations, guides managerial decisions by providing comprehensive information about costs, revenues, and profits associated with different operational scales. The flexible budget is used for performance evaluation and control.
Managers can use it to draw comparisons between actual results and expected results based on actual output levels, rather than making comparisons with the original budgeted figures. This helps to determine if the variances were due to increased activity or due to inefficient use of resources, and thereby rigorously assess the efficiency of management. Additionally, flexible budgets are used in cost control.
They allow the budgeted costs to reflect the expected cost of output, making it easier to discern whether cost overruns are due to inefficiency or simply higher output levels. Thus, the information derived from flexible budgets is effective in pinpointing managerial responsibility for any discrepancies from planned to actual performance.
Examples of Flexible Budget
Manufacturing Company: A manufacturing company might use a flexible budget to manage costs across different departments. For example, suppose a business produces 10,000 units annually and estimates $5 per unit in direct labor cost. If production increases to 12,000 units the following year, the company can adjust its budget according to the increase by multiplying the estimated cost per unit ($5) by the new production volume (12,000). This gives them a more accurate prediction of their labor costs.
Restaurant Business: A restaurant might use a flexible budget to account for fluctuations in food costs and customer numbers, which can vary seasonally. For instance, during holidays or local events, customer traffic might increase. As a result, the restaurant expects to spend more on food and labor. On the other hand, during off-seasons, if customer traffic is lower than expected, they can adjust or decrease the budget to avoid waste and overspending.
Educational Institution: A school or university might use a flexible budget for their annual academic activities. For instance, they could allocate a certain budget for the estimated number of students that will participate in sports activities. If more students decide to take part as the year progresses, they could adjust the budget based on the actual number participants. Conversely, if fewer students participate, the budget can be scaled down. In all of these examples, a flexible budget allows for better planning, control, performance analysis, and cost management in line with actual output or activity levels.
FAQs on Flexible Budget
1. What is a flexible budget?
A flexible budget, also known as a variable budget, adjusts to changes in actual revenue levels. Instead of being a static budget, it’s designed to flex with the actual business conditions.
2. What is the purpose of a flexible budget?
The purpose of a flexible budget is to allow for adjustments as changes occur over a budget period. This flexibility makes it a useful tool for managing budgets because it can adjust for variations in revenue or costs.
3. How do you prepare a flexible budget?
A flexible budget is prepared by identifying the fixed and variable costs of a business. Variable costs are then adjusted based on the changes in the business’s level of activity, while fixed costs remain constant.
4. What is the difference between a fixed budget and a flexible budget?
A fixed budget is a static budget that does not change with the volume of output. On the other hand, a flexible budget changes in response to variations in output.
5. What are the advantages of a flexible budget?
One advantage of the flexible budget is its adaptability to changes. This type of budget can easily adjust according to a company’s actual performance throughout a period. It is regarded as more realistic and useful in controlling costs compared to a fixed budget.
Related Entrepreneurship Terms
- Variable Costs
- Fixed Costs
- Operating Income
- Overhead Cost Control
- Business Forecasting
Sources for More Information
- Investopedia: A respected online resource for a variety of finance and investment terms and concepts, including flexible budgeting.
- AccountingTools: Provides a wealth of information on financial topics, including accounting standards and practices like flexible budgeting.
- Coursera: Offers a variety of courses from universities and businesses around the world, some of which include classes on financial planning and budgeting.
- Business Standard: This site offers in-depth articles and news on various business topics, including finance and budgeting techniques.
