For costs that vary with volume or activity, the flexible budget will flex because the budget will include a variable rate per unit of activity instead of one fixed total amount. In short, the flexible budget is a more useful tool when measuring a manager’s efficiency. These variances Navigating Financial Growth: Leveraging Bookkeeping and Accounting Services for Startups are used to assess whether the differences were favorable (increased profits) or unfavorable (decreased profits). If an organization’s actual costs were below the static budget and revenue exceeded expectations, the resulting lift in profit would be a favorable result.
Accounts for unforeseen expenses
By incorporating these changes into the budget, a company will have a tool for comparing actual to budgeted performance at many levels of activity. 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. Instead of estimating production levels, use the actuals from the previous month to create your flexible budget. For instance, if your company produced 50,000 units in January, and you want to budget for 75,000 units in February, you have to look at your variable costs.
Advantages of Flexible Budgeting
ABC Company has a budget of $10 million in revenues and a $4 million cost of goods sold. Of the $4 million in budgeted cost of goods sold, $1 million is fixed, and $3 million varies directly with revenue. Once the budget period has been completed, ABC finds that sales were actually $9 million. If it used a flexible budget, the fixed portion of the cost of goods sold would still be $1 million, but the variable portion would drop to $2.7 million, since it is always 30% of revenues.
What Is a Static Budget?
- The changes made in the flexible budget would then be compared to what actually occurs to result in more realistic and representative variance.
- Although with the flexible budget, costs would rise as sales commissions increased, so too would revenue from the additional sales generated.
- Instead, the hope is that patterns will be observed making future cost planning easier and more accurate.
- A flexible budget is a budget that changes based on your actual production or revenue.
If production is higher than planned and has been increased to meet the increased sales, expenses will be over budget. To account for actual sales and expenses differing from budgeted sales and expenses, companies will often create flexible budgets to allow budgets to fluctuate with future demand. A static budget is a type of budget that incorporates anticipated values about inputs and outputs that are conceived before the period in question begins. A static budget–which is a forecast of revenue and expenses over a specific period–remains unchanged even with increases or decreases in sales and production volumes. However, when compared to the actual results that are received after the fact, the numbers from static budgets can be quite different from the actual results. Static budgets are used by accountants, finance professionals, and the management teams of companies looking to gauge the financial performance of a company over time.
- The reporting of the energy per unit of output has sometimes been in error and can mislead management into making changes that may or may not help the company.
- If the factory has to use more machine hours one month, its budget should logically increase.
- However, there are also a number of serious issues with it, which we address below.
- If 5,000 machine hours were necessary for the month of January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH).
Conversely, if revenue didn’t at least meet the targets set in the static budget, or if actual costs exceeded the pre-established limits, the result would lead to lower profits. A static budget helps to monitor expenses, sales, and revenue, which helps organizations achieve optimal financial performance. By keeping each department or division within budget, companies can remain on track with their long-term financial goals. A static budget serves as a guide or map for the overall direction of the company. The table below shows that Lobster Instant Noodles sold 7000 less units and instead of making a budgeted $42,500 of profit, instead made just $900. Of course, if you sell 18,000 less units, you would expect profit to be less – this is where the flexible budget comes in.
What is a Flexible Budget?
If a SaaS company is forecasting its cost of benefits, it might tie the budget line item to its headcount forecast. So as headcount increases, the cost of benefits also increases according to the per-employee assumption. For SaaS companies, flexible budgeting relates more to the cost of revenue — the actual costs for creating and delivering a product/service to customers. The cost of revenue involves hosting fees, service and cloud fees, and website development. Companies with variable costs require flexible budgets because this kind of budget allows them to course correct or account for that variation with minimal disruption to their operations.
Why do companies use flexible budgets?
A flexible budget adjusts for changes in activity levels for all costs, including both fixed and variable costs. This type of flexible budget takes into account how changes in activity levels affect all costs and provides the most accurate picture of expected costs at different levels of activity. Flexible budgets are especially helpful in environments where costs are closely aligned with the level of business activity. SaaS businesses typically work with costs like hosting fees and site development, so when website traffic starts to increase, so do those hosting costs. In its simplest form, the flex budget uses percentages of revenue for certain expenses, rather than the usual fixed numbers.
Use the variable cost ratio to create a budget model
The master budget, and all the budgets included in the master budget, are examples of static budgets. Actual results are compared to the static budget numbers as one means to evaluate company performance. However, this comparison may be like comparing apples to oranges because variable costs should follow production, which should follow sales. Thus, if sales differ from what is budgeted, then comparing actual costs to budgeted costs may not provide a clear indicator of how well the company is meeting its targets.
A sophisticated flexible budget will change the proportions for these expenditures if the measurements they are based on exceed their target ranges. For example, Figure 10.26 shows a static quarterly budget for 1,500 trainers sold by https://businesstribuneonline.com/navigating-financial-growth-leveraging-bookkeeping-and-accounting-services-for-startups/ Big Bad Bikes. 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.
A flexible budget is a budget that can be adjusted for changes in business activity like sales or production volume. Typically, these adjustments are predetermined so as to avoid scalability challenges, like taking on more clients than the company can reasonably handle. In a flexible budget, there is no comparison of budgeted to actual revenues, since the two numbers are the same. The model is designed to match actual expenses to expected expenses, not to compare revenue levels.
More than 3,000 active customers across the globe rely on Prophix to achieve organizational success. Finally, you want to compare your actual expenses to your budget and evaluate how effective and accurate your flexible budget was. You should model scenarios based on the cost variance that is likely to occur, with some leeway for unexpected scenarios. For example, costs like rent, debt repayments, or PP&E are likely to remain fixed and consistent. Companies around the globe experienced this in March 2020 when the COVID-19 pandemic required lockdowns that grounded much of the economy to a halt.
