Before we explain what a flexible budget is we need to step back and have a look at what a static or fixed budget is. The budget made during the planning for the coming calendar year or any other period is usually fixed. Here, the budget is set in stone for a given period, and the company should stick to it regardless of changes in circumstances as time goes by. It is based on what the management thinks will happen based on the previous years and other data.
The fixed budget can possibly work well for short-term planning and/or for businesses that incur expenses and have income that can be accurately predicted. It is clear that it is silly to assume that the direct cost of producing 1000 units of products will be equal to the direct costs of materials for the production of 500 units of products in any company. A flexible budget is designed to accommodate changes in the level of activity, such as production.
The flexible budget allows a company to set the expected spendings as percentages of revenue. For that period, items of fixed costs, such as rent, do not change when the volume of production changes. Other costs will vary in proportion to the level of output or sales. This way, management can control spendings to some extent based on more recent information instead of doing guesswork and hoping that circumstances do not change significantly from what we expected.
Purpose and Usage
The flexible budget clearly identifies the link between a static budget and what actually happened. It links alternative options for the volume of sales of products/services with the total costs of the enterprise. Therefore, the main task in developing a flexible budget is to find an equation that links costs and volume of production – a flexible budget formula, which can be used to correctly determine budget costs for any level of business activity of an enterprise.
This budget is prepared by establishing all the fixed costs and then building a budget where spendings that vary with production levels are represented as a percentage or a per-unit cost while fixed costs stay as is since they are not affected by the business activity level. Afterward, the actual results can be compared to the budget set for that activity level.
In practice, using flexible budgets consists of preparing a set of budgets defining profits and costs for different levels of activity, such as manufacturing. As an alternative to multiple budgets, you can simply revise the budget figures at the end of the benchmark period when the production level is known.
One of the main advantages of a flexible budget is that it can be used to obtain predictive data for different levels of business activity. It also allows to quickly and efficiently make management decisions depending on the current level of business activity and goals because it is possible to look at the actual costs and the amount of funds allocated by the budget for the same level of production.