Also, temporary staff or additional employees needed for overtime during busy times are best budgeted using a flexible budget versus a static one. A great deal of time can be spent developing step costs, which is more time than the typical accounting staff has available, especially when in the midst of creating the more traditional static budget. Consequently, the flex budget tends to include only a small number of step costs, as well as variable costs whose fixed cost components are not fully recognized. A flexible budget is a budget that changes based on your actual production or revenue.
While preparing any budget at all is always better than not having one, a static budget does not prepare you for revenue and expense changes in real time. The flexible budget at first appears to be an excellent way to resolve many of the difficulties inherent in a static budget. However, there are also a number of serious issues with it, which we address below. They allow managers to predict the effect that changes will have on their company’s income statement and balance sheet while still being able to reflect actual figures. It helps to provide accurate forecasts without using theoretical data since they are based on what occurred.
It may be favorable (higher than it should have been for actual production activity) or unfavorable (lower than it should have been). The flexible budget for income before income taxes is $20,625, and 40% of that balance is $8,250. Actual expenses are lower because the income before income taxes was lower. A static budget based on planned outputs and inputs for each of a company’s divisions can help management track revenue, expenses, and cash flow needs. A flexible budget is best used in a manufacturing environment where the budget is able to be based on production volume. You should assume that the fixed expenses remain constant for all levels of production.
- In a static budget situation, this would result in large variances in many accounts due to the static budget being set based on sales that included the potential large client.
- Unlike a static budget, a flexible budget includes both fixed and variable costs that can be adjusted based on revenue percentage or production cost incurred throughout the course of the budget period.
- Any unexpected market shifts may find a material essential to your production line suddenly costing more than three times the original budgeted amount.
Everything starts with the estimated sales, but what happens if the sales are more or less than expected? What adjustments does a company have to make in order to compare the actual numbers to budgeted numbers when evaluating results? 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.
Expenses such as rent, management salaries, and marketing costs remain static and do not change based on production. Changing costs in the manufacturing process can severely impact your profit margin. Any unexpected market shifts may find a material essential to your production line suddenly costing more than three times the original budgeted amount. Creating a business budget, particularly a flexible budget, requires some familiarity with the accounting process and is best left to experienced accountants and bookkeepers with knowledge of cost accounting. An alternative is to run a high-level flex budget as a pilot test to see how useful the concept is, and then expand the model as necessary. Many costs are not fully variable, instead having a fixed cost component that must be derived and then included in the flex budget formula.
The expenses that do not change are the fixed expenses, as shown in Figure 7.23. This approach varies from the more common static budget, which contains nothing but fixed amounts that do not vary with actual revenue levels. This means that the variances will likely be smaller than under a static budget, and will also be highly actionable.
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Total net income changes as the amount for each line on the income statement changes. Instead, Steve should flex the budget to determine how much overhead he should have, assuming that the company makes 130,000 units. Using a flexible budget will immediately alert you to any changes that are likely to impact your bottom line, allowing you to make changes proactively instead of reactively. These points make the flexible budget an appealing model for the advanced budget user. However, before deciding to switch to the flexible budget, consider the following countervailing issues. A factory is currently working at 50% capacity and produces 10,000 units.
In contrast, a flexible budget might base its marketing expenses on a percentage of overall sales for the period. That would mean the budget would fluctuate along with the company’s performance and real costs. For example, let’s say a company had a static budget for sales commissions whereby the company’s management allocated $50,000 to pay the sales staff a commission. levered free cash Regardless of the total sales volume–whether it was $100,000 or $1,000,000–the commissions per employee would be divided by the $50,000 static-budget amount. However, a flexible budget allows managers to assign a percentage of sales in calculating the sales commissions. The management might assign a 7% commission for the total sales volume generated.
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Now let’s illustrate the flexible budget by using different levels of volume. 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). If the machine hours in February are 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH).
How to Implement a Flexible Budget
Mark P. Holtzman, PhD, CPA, is Chair of the Department of Accounting and Taxation at Seton Hall University. He has taught accounting at the college level for 17 years and runs the Accountinator website at , which gives practical accounting advice to entrepreneurs. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.
Step Cost Development is Time-Consuming
If Skate increased production from 100,000 units to 125,000 units, these variable costs should also increase. A flexible budget can be created that ranges in level of sophistication. In short, a flexible budget gives a company a tool for comparing actual to budgeted performance at many levels of activity. Let’s assume a company determines that its cost of electricity and supplies will vary by approximately $10 for each machine hour (MH) used. It also knows that other costs are fixed costs of approximately $40,000 per month. Typically, the machine hours are between 4,000 and 7,000 hours per month.
Unlike a static budget, it adjusts your original budget projection in using your actual sales or revenue. Flexible budgets calculate, for example, different levels of expenditure for variable costs. Subsequently, the budget varies, depending on activity levels that the company experiences.
Let’s imagine that a manufacturer has determined what its electricity and supplies costs are for the factory. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
They work well for evaluating performance when the planned level of activity is the same as the actual level of activity, or when the budget report is prepared for fixed costs. However, if actual performance in a given month or quarter is different from the planned amount, it is difficult to determine whether costs were controlled. Within an organization, static budgets are often used by accountants and chief financial officers (CFOs)–providing them with financial control. The static budget serves as a mechanism to prevent overspending and match expenses–or outgoing payments–with incoming revenue from sales. In short, a well-managed static budget is a cash flow planning tool for companies. Proper cash flow management helps ensure companies have the cash available in the event a situation arises where cash is needed, such as a breakdown in equipment or additional employees needed for overtime.