Flexible budgeting is an important tool for most small businesses. Learn how it can help your business respond to the ups and downs of the marketplace.
Definition and Examples of a Flexible Budget
A flexible budget is one that takes into account your actual production and revenue rather than what you originally projected. Most businesses begin the year with a static budget. This represents your best guess at what will be spent and what will be earned. Over time, though, your actual production, sales, and revenue will change. These changes can be due to variations such as changing inventory costs, supply chain concerns, and market conditions. You would then take your static, or master, budget and adjust the numbers based on your actual revenue. This is your flexible budget. It has been “flexed,” or adjusted, based on your real production levels. Flexible budgets usually try to maintain the same percentages allotted for each aspect of a business, no matter how much the budget changes. So if the initial static budget called for 25% to be spent on marketing, the flexible budget will maintain that same percentage for marketing whether the budget increases or decreases. For example, a widget company might start out the year with a static planning budget that assumes that the cost to produce 10 widgets is $100, and the company will produce 100 units per month. Each unit will bring in a net profit of $50, so the net profit per month will be 100 X 50, or $5,000. But two months into the fiscal year, a competitor closes its doors. Suddenly, there is only one company to meet demand for widgets, resulting in actual sales of 200 units per month. The actual revenue the widget company is taking in has doubled—but the production costs would also go up. The flexible budget for the quarter would reflect both these things.
How Flexible Budgets Work
A flexible budget starts with your fixed expenses. Fixed expenses such as rent, utilities, equipment costs, and salaries usually make up a significant portion of any business budget. While it’s possible that these costs will change slightly, most businesses simply budget for them upfront. The flexible budget will show different possibilities for variable expenses and revenue. Variable costs can include marketing and sales, and may also include the cost of materials, number of sales, and shipping costs. A flexible budget will include lines for different amounts. For example, if your production of widgets is 100 per month, your variable admin costs may be $200 per month. However, if your production of widgets is 200 per month, your variable admin costs would increase to $400. Your flexible budget would then look at revenue, based on both units sold and sales price. Changes in either of these can change your total revenue. For example, your flexible budget may have three columns that show the number of units sold, the sales price, and total revenue. A flexible budget will show the variance in both revenue and spending. Revenue variance is the difference between what revenue should have been for the actual production activity and what the actual revenue you take in is. It may be favorable (higher than it should have been for actual production activity) or unfavorable (lower than it should have been). Spending variance is the difference between what you should have spent at your actual production level and what you did spend. If it is favorable, you spent less than your actual production level should have required. If it is unfavorable, you spent more.
Pros and Cons of Flexible Budgets
Flexible budgets can be very useful, but they do have some downsides.
Pros Explained
Respond to real world changes: Flexible budgets allow businesses to respond quickly to events that impact variable costs and profits. Static budgets, by contrast, will always become outdated because they are, by definition, non-responsive.Adjust only variable costs: Because flexible budgeting requires a careful analysis of variable and constant costs, it’s easy to ensure that only variable costs are impacted by unexpected changes.Creates consistency: Because flexible budgeting is built around a consistent cost per unit, it’s possible to quickly adjust to changes without impacting the organization’s ability to produce on time and on budget.
Cons Explained
Complex to calculate: If you have a complex business, it can be difficult to calculate and manage a flexible budget.Requires managing a changing budget: Because your budget is always in flux, it can be hard to compare your actual and planned budgets.May not apply to your business: If your business has few variable costs, flexible budgeting may be an exercise in futility. For example, if you’re a consultant, your costs are almost entirely either fixed or, like travel, paid for by your clients.
