Understanding a flexible budget (including an example)
By Indeed Editorial Team
Published 7 December 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
There are many different accounting methods and tools that companies can use to manage and adjust their budget. One such tool is a flexible budget, which allows a company to adjust their budget according to its volume of activity and changes in costs and revenue. This type of budget combines fixed costs, which do not change, with variable ones, which are adjusted depending on the company's performance. In this article, we define this type of budget, review the advantages and disadvantages of this approach and provide a step-by-step guide to creating one of your own.
What is a flexible budget?
A flexible budget is a type of budgeting that adjusts to a company's activity or profit margins. This type of budget also accounts for variable costs, continuously changes according to changes in costs or revenue. This approach means that businesses can anticipate any potential increases or decreases in monetary needs. On contrary, a static budget does not change from the figures established when the business creates the budget. This type of budget also includes these fixed figures for costs that are not variable, which may include overheads, such as rent.
When your budget is flexible, you may express costs as percentages and adjust according to actual revenue. For example, a company using a static budget may allot £100,000 to salary over a year. Instead of this, flexible approaches to budgeting may allot 25% of the company's revenue to salary instead of a fixed cost. This allows for changes in the number of staff the company employs, which may vary throughout the year depending on their needs.
What are the different ways to use a flexible budget
There are various levels of flexibility you can introduce to your business from basic to sophisticated, depending on the needs of your company. Here are the three basic levels of flexibility you could use:
At its most basic level, a flexible budget simply means allowing for variation in those costs that are directly related to income. This might mean that the budget model sets a percentage to be of actual revenues spent at a particular revenue level. Some companies may also use a cost-per-unit model if the number of products sold relates to spending in certain areas. This allows some flexibility according to the company's actual revenue, with most costs remaining static in the budget.
Intermediate budgets allow for variation in expenses that vary in ways that don't directly correspond with revenue. For example, a company may have lower telephone expenses at times when they have fewer expenses. In this case, express the cost allotted to telephones as a cost per employee rather than a fixed sum.
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This type of budget may take into account the variation and range of expenses for each category of a company's budget. It may also establish that costs may only vary within a certain range of revenue, staff numbers or other activity. In a sophisticated budget, you base targets on the proportions of various expenditures if the targets fall below or their expectations.
Advantages of this approach
Using a flexible budget instead of a static one can have many advantages for a company, that may include:
Suitability for variable cost environments: These budgets are particularly useful in situations where you can separate costs relating to business activity, which might include fixed costs such as rent or utilities, or variable costs such as merchandise and staffing.
Improved performance measurement: This type of budget automatically restructures itself in accordance with activity levels. This means that it is a good tool for evaluating managers by assessing whether the budget is closely aligned with expectations.
Budgeting efficiency: Accounting teams update a budget for which the figures for revenue or other activities have not yet been finalised for managers to approve, so the budgeting team can complete the budget without having the final figures.
Disadvantages of this approach
While this type of budget has many advantages, they don't work for every company and could have some drawbacks. If you're considering implementing a flexible budget for your business, it's worth considering the following disadvantages:
Complicated and time-consuming formulation**:** This involves formulating and administering a complicated budget for budgeting staff, particularly as many expenditures are not fully flexible and contain a fixed cost element. This means that the process can take time, so it may not be an efficient way of operating for some companies.
Delays in closing: While companies using static budgets can pre-load their budget into their accounting software and create financial reports immediately, this is not possible with a flexible budgeting system. Instead, the accountant can only input their revenue and other figures and produce financial statements once the accounting period is over.
Lack of revenue comparison: With flexible budgets, it is not possible to compare budgeted revenues with actual ones, since the two numbers are the same. This means that it's not easy to highlight whether actual revenues are higher or lower than predicted ones, which could be a disadvantage for some companies.
Not suitable for some companies: Some companies simply do not have enough variation in their costs to justify using this type of budget. For example, a company selling software online has no real cost-per-unit and the overheads they pay to run the store do not change according to revenue, so in this case, it would be pointless to construct a complex budget.
How to create a flexible budget for your business
If you're considering using this approach for your company, here are the steps you can take:
1. Identify your fixed and variable costs
The first step to creating your flexible budget is identifying fixed company costs and which ones vary according to revenue or activity. Usually, fixed costs include things like rent, marketing budgets and insurance. Variable costs could be anything that varies according to your sales, such as merchandise, or according to another factor, such as how many staff you're currently employing. Once you have decided which costs fit into each category, separate them on your budget sheet.
2. Divide the budget accordingly
When you have established your variable costs, divide the budget you plan on spending on them by your estimated production. This gives you a starting basis for a cost per unit sold approach to your budget. Alternatively, figure out the revenue you expect over the accounting period and what percentage of that revenue each cost represents. This allows you to express and adjust each cost as a percentage of your revenue if your estimation is higher or lower than your actual revenue over the period.
3. Create your budget
Create your budget with your set fixed costs and your variable costs expressed in whichever way is most appropriate for your company. For example, a cost-per-unit approach works in situations where the spending relates to how many units you sell, but may not be the best method in other cases. There are many accounting programs that can help you to input this information.
4. Update your budget and compare
Once the accounting period is over, update your budget with the actual revenue and/or activity measurements. This updates the variable costs based on accurate data for the accounting period. You can then input this final data into your accounting software and compare your expenditure to the expenses you initially predicted.
Flexible budgeting example
The following is an example of how a company might use this type of budgeting system:
Company A is a retail company that sells products to customers out of several large shops and online. They calculate an expected £5 million in revenue and £1 million in cost of the goods they will sell over an accounting period. They then determine that £400,000 of the £1 million is a fixed cost and cannot change, while £600,000 is variable depending on their revenue. This means that the amount of the budget that is variable accounts for 12% of the company's revenue.
At the end of the accounting period, Company A reviews their figures and finds that they have actually had sales amounting to £6 million, an increase in their predicted revenue of 20% on their predicted revenue. Because they used a variable budget model, they determine the variable cost of goods is £720,000 (12% of £6 million) to account for the extra products they sold.
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