Flexible budgeting
Definition, purpose, and time frame
The purpose of a flexible budget is to provide an adaptable financial plan that can accommodate fluctuations in activity, making it useful for performance evaluation and cost control. Flexible budgets can be prepared before the period for a range of anticipated activity levels, and applied after the period once actual activity is known, when performance evaluation is performed through variance analysis between the static budget, actual results, and the flexible budget.
Flexible budgeting is especially valuable in industries with variable production volumes, where costs and revenues shift based on demand, production levels, or other external factors. By adjusting for actual activity levels, flexible budgets offer a realistic basis for evaluating performance, helping managers control costs more effectively.
Components and interrelationships
The core components of a flexible budget are similar to those of a static budget: revenues, variable expenses, and fixed expenses. However, in a flexible budget, these components are recalculated at different activity levels, allowing costs to vary directly with production or sales volume changes.
- Variable costs: These costs fluctuate with changes in activity levels, such as direct materials, direct labor, and variable manufacturing overhead.
- Fixed costs: Fixed costs remain constant in both flexible and static budgets, though they may be periodically reviewed for adjustment, especially if the activity level is outside of the relevant range (see below).
Developing the flexible budget
The development of a flexible budget begins with identifying variable and fixed costs. Variable costs are determined per unit of activity, allowing the budget to adjust in response to different activity levels. These per-unit costs provide the basis for estimating expenses at various levels of production or sales. Fixed costs, on the other hand, remain consistent within a certain range of activity, known as the relevant range. Within this range, fixed costs do not change; for example, a company may be able to use the same warehouse space to store finished goods, incurring a stable level of rent. However, if production exceeds this range, additional storage might be required, causing fixed costs to increase. In the context of CMA exams, unless otherwise specified, it’s generally assumed that fixed costs remain within the relevant range.
For example, if a company expects production levels to vary between 1,000 and 1,500 units, it would set budget estimates for variable costs at each anticipated level of production. As actual production or sales levels become known, the flexible budget adjusts to reflect these activity levels, providing a more accurate benchmark for evaluating performance and cost management.
Comparison to static budget
While static budgets are useful for planning, they may not provide accurate benchmarks for performance evaluation if actual activity differs significantly from expectations.
A flexible budget, by contrast, recalculates costs based on actual performance, offering a more accurate comparison of budgeted to actual results.
Example: Actual results vs. static vs. flexible budget
In this example scenario, the company initially planned for production of 1,000 units, but actual production and sales reached 1,200 units. The budgeted sales price per unit is $100, with variable costs estimated at $40 per unit and fixed costs expected to be $10,000, assuming they remain within the relevant range.
However, actual results showed a higher variable cost per unit at $42 and increased fixed costs totaling $12,000. The increase in fixed cost is not related to the additional 200 units produced. These changes affect the overall cost structure and provide a basis for comparing static, flexible, and actual results.
Actual results
(actual units at
actual prices)Static budget
(budgeted units at
budgeted prices)Flexible budget
(actual units at
budgeted prices)Revenue (Rev) $120,000
(1,200 x $100)$100,000
(1,000 x $100)$120,000
(1,200 x $100)Variable costs (VC) $50,400
(1,200 x $42)$40,000
(1,000 x $40)$48,000
(1,200 x $40)Fixed costs (FC) $12,000 $10,000 $10,000 Total costs
(TC = VC+ FC)$62,400 $50,000 $58,000 Operating income
(Rev - TC)$57,600 $50,000 $62,000 In this example, the flexible budget applies the budgeted $100 price and $40 per-unit variable cost to the actual 1,200 units, producing revenue of $120,000, variable costs of $48,000, and fixed costs held at the budgeted $10,000 since volume stays within the relevant range. Actual results reached $120,000 in revenue but $50,400 in variable costs and $12,000 in fixed costs, producing operating income of $57,600 - $4,400 below the flexible budget’s $62,000, split between a $2,400 overrun in variable costs (the $2 per-unit cost increase x 1,200 units) and a $2,000 increase in fixed costs; this shortfall reflects spending and efficiency, not volume.
This chapter’s actual, static, and flexible figures set up the flexible-budget and sales-volume variance analysis covered in the flexible budget variance.
Benefits and limitations
Benefits
- Improved performance evaluation: Flexible budgets provide a realistic benchmark by adjusting for actual activity levels, helping managers evaluate efficiency accurately.
- Cost control: By recalculating budgeted costs as volumes change, flexible budgets allow for better tracking of expenses and identifying variances due to efficiency rather than volume differences.
- Adaptability: Flexible budgets are responsive to changes, providing an adaptable planning tool that reflects actual conditions more closely than static budgets.
Limitations
- Complexity and time requirements: Developing flexible budgets requires identifying and estimating variable costs per unit, which can be time-consuming and requires ongoing updates.
- Dependence on accurate data: Flexible budgeting relies on accurate cost behavior estimates for variable and fixed costs. Inaccurate data can impact the effectiveness of the budget.
- Not suitable for all organizations: Organizations with stable or predictable activity levels may not find flexible budgeting beneficial, as costs and revenues do not vary significantly.
Application in business situations
Flexible budgeting is valuable for companies facing high variability in production or sales, such as manufacturing and seasonal businesses. For instance, a company producing consumer goods with fluctuating demand can use a flexible budget as a benchmark restated at actual sales volume, isolating cost-control performance from the effect of volume swings. Service companies with variable workloads, like consulting firms, can apply the same approach, comparing actual costs to a budget restated at actual project hours rather than the original estimate.