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A budget is a plan comprising of many line values such as production costs, net profit, production volume, and the like. Comparison of the budget to actual results provides valuable information about performance. The most common type of budget is the static budget that projects a fixed level of output, costs of production, and net income before the start of the budgeting period.
What is a flexible budget? Flexible budgets, also known as variable or dynamic budgets, on the other hand change in accordance with the level of activity during the budget period. It recognizes the relativity of fixed and variable costs to fluctuations in output or turnover and make provisions to change line values depending on changes in output or turnover.
Image Credit: flickr.com/Jeff Keen
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What is the purpose of a flexible budget?
Flexible budgets help plan for potential changes in production costs or sales volumes, allowing businesses to respond quickly to changes and, thereby maximize profits by seizing the opportunity.
Flexible budgets are a performance evaluation tool aimed at allowing for a correct comparison between budgeted performance and actual performance. For instance, comparison becomes distorted if actual production is 10,000 units and the static budget estimates 9,000 units. Revising the original budget to 10,000 units makes possible a precise comparison between budgeted costs and actual costs, for the various line values reflect the values relative to the same output.
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There are two approaches to preparing a flexible budget:
- At the end of the period, by adjusting the static budget for the actual level of output. This is a budget prepared with the benefit of hindsight, based on the actual output volume instead of the expected output volume.
- Before the start of the period, by featuring alternative estimates for various line items such as output level, production costs, and net income to anticipate costs and revenues for any projected level of output. In this sense, flexible budgets are several static budgets with the one that matches the final output selected for analysis at the end of the period.
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Static budgets assign a fixed limit or value to each line item. Flexible budgets also assign such values to each line item, but also incorporates the provision to amend the line items if some unforeseen complication arises. For instance, delayed shipments of raw materials lead to slowdown in operations, and flexible budgets already have the revised values of the various line items that reflect this delay. Such a contingency approach minimizes the impact of unforeseen events.
Creation of a flexible budget at the start of a budget period is through a pro forma analysis that includes the following steps:
- Estimating the volume of output
- Estimating the variable cost per unit of output, sales price per unit of output and fixed costs
- Building the budget based on information obtained from steps 1 and 2
- Repeating steps 1 to 3 for each estimated volume of output
- Identification of actual volume of output
- Selecting the budget where estimated volume of output matches actual volume of output
The steps to create a flexible budget at the end of the budget period include:
- Deriving the variable cost per unit of output, sales price per unit of output, and fixed costs from the static budget.
- Determining the actual volume of output achieved
- Determining the flexible budget variance or the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results
- Building the flexible budget by reconciling static budget cost information to the actual volume of output.
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Why use a flexible budget? The popularity of flexible budgeting is attested by the fact that most of the major corporations of the world prepare this type of budget for attaining effective managerial control over their business operations.
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- Caplan, Dennis. Management Accounting: Concepts and Techniques. Oregon State University College of Business. http://classes.bus.oregonstate.edu/spring-06/ba422/Management%20Accounting%20Chapter%205.htm.
- CliffsNotes.com. Flexible Budget. http://www.cliffsnotes.com/study_guide/Flexible-Budgets.topicArticleId-21248,articleId-21241.html