The result is a varying budget, depending on the actual activity levels experienced. The flexible budget is more sophisticated and useful than a static budget, which remains fixed in an amount, regardless of the volume of activity reached.
The underlying definition of flexible budgeting is that a budget is of little use unless costs and income are related to the actual volume of production. Therefore, a budget could be prepared for various levels of activity; for example, 80%, 90%, and 100% capacity utilization.
So whatever the output level actually achieved, it can be compared to an appropriate level. A flexible budget gives the business a tool to compare actual versus budgeted performance at many levels of activity.
Characteristics
In flexible budgeting, actual income or other activity measures are entered once an accounting period has been completed, generating a specific budget for those values.
This approach varies from the common static budget, which only contains fixed amounts that do not vary with actual income levels.
The “budgeted versus actual” reports under a flexible budget tend to show much more relevant variations than those generated under a static budget, since both the budgeted and the actual expenses are based on the same activity measure.
Advantage
Use in a variable cost environment.
It is especially useful in businesses where costs are closely aligned with the level of business activity, such as a retail environment, where overheads can be segregated and treated as a fixed cost, while the cost of merchandise is directly related to income.
Performance measurement
Since flexible budgeting adjusts based on activity level, it is a good tool for evaluating managers' performance - the budget should be closely aligned with expectations at any number of activity levels.
Disadvantages
Formulation
Flexible budgeting can be difficult to formulate and manage. One problem with its formulation is that many costs are not completely variable; instead, they have a fixed cost component that must be calculated and included in the budget formula.
Also, a great deal of time can be spent developing cost formulas. This is more time than staff in the middle of the budget process have available.
Closing delay
A flexible budget cannot be preloaded in accounting software to compare with financial statements.
Instead, the accountant must wait until the financial reporting period is complete. Then you enter the income and other activity measures in the budget template. Finally, it extracts the results from the model and loads them into the accounting software.
Only then is it possible to issue financial statements that contain budget versus actual information, with the variations between the two.
Income comparison
In a flexible budget, the budgeted income is not compared with the actual income, since the two numbers are the same. The model is designed to compare actual expenses with expected expenses, not to compare income levels.
Applicability
Some companies have so few variable costs that building a flexible budget doesn't make sense. Instead, they have a large amount of fixed overhead that does not vary as a result of activity level.
In this situation there is no point in building a flexible budget, as the result will not vary from a static budget.
How to do it?
Since fixed costs do not vary with fluctuations in short-term activity, it can be seen that the flexible budget will actually consist of two parts.
The first is a fixed budget, made up of fixed costs and the fixed component of semi-variable costs. The second part is a truly flexible budget consisting solely of variable costs. The steps required to build a flexible budget are:
- All fixed costs are identified and segregated in the budget model.
- It is necessary to determine to what extent all variable costs change as the level of activity changes.
- The budget model is created, where fixed costs are “embedded” in the model and variable costs are expressed as a percentage of the activity level or as a unit cost of the activity level.
- An actual level of activity is entered into the model after the accounting period has been completed. This updates the variable costs in the flexible budget.
- For the completed period, the resulting flexible budget is entered into the accounting system to compare it with actual expenses.
Example
Suppose a manufacturer determines that its variable cost of electricity and other supplies for the factory is approximately $ 10 per machine use per hour (HM-Machine Hour). Factory supervision, depreciation, and other fixed costs are also known to total $ 40,000 per month.
Commonly, production equipment operates between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be $ 40,000 + $ 10 per HM.
Now we are going to illustrate flexible budgeting by using some data. If the production team is required to operate a total of 5,000 hours in January, the flex budget for January will be $ 90,000 ($ 40,000 fixed + $ 10 x 5,000 HM).
Since the equipment must operate in February for 6,300 hours, the flexible budget for February will be $ 103,000 ($ 40,000 fixed + $ 10 x 6,300 HM).
If March requires only 4100 machine hours, the flexible budget for March will be $ 81,000 ($ 40,000 fixed + $ 10 x 4100 HM).
Conclution
If the plant manager is required to use more machine hours, it makes sense to increase the plant manager's budget to cover the additional cost of electricity and supplies.
The manager's budget should also decrease when the need to operate the equipment is reduced. In short, flexible budgeting provides a better opportunity to plan and control than a static budget.
