Definition: A flexible budget allows a business to make changes based on the level of activity. In this respect, it is superior to a static or fixed budget. However, preparing a flexible budget could require a great deal of effort as the components of the budget need to be altered after taking the increase or decrease in output into account.
What does Flexible Budget mean?
The process of preparing a flexible budget involves altering those expenses that change with revenues. This is normally done on a percentage basis. For example, a certain expense, say, raw material costs, may always be a certain percentage of the total cost of production. If this is true, then the flexible budgeting exercise will require that the figure for raw material cost be adjusted accordingly. However, all the entries in a flexible budget may not be so easy to compute. Certain expenses may not vary in direct proportion to the level of activity. Employee costs may remain the same at different levels of production. But they may rise by a large amount if additional staff is recruited. Similarly, certain other costs like maintenance costs may not rise in direct proportion to the level of output. A detailed exercise would need to be conducted to ensure that the flexible budget is prepared accurately. But why should a company go to the trouble of preparing a flexible budget? Despite the difficulties involved in making this type of budget, the exercise can prove to be extremely useful. Some of the advantages that it offers are: ⇨ A company’s performance can be predicted with a greater degree of accuracy. ⇨ It is easier to assess the output of individual departments more accurately. ⇨ The budget for individual departments and for specific activities can be altered to reflect changing conditions.
Example of Flexible Budget
King’s Apparel, a garment manufacturer, has a practice of preparing a fixed budget at the beginning of every year. However, its actual performance varies very widely when compared to its budgeted figures. That’s because the number of garments that King’s Apparel produces fluctuates based on the orders that it is able to get. The company switches over to a flexible budget. It finds this change very useful as it can alter its budgeted expenses to take its new orders into account. Instead of preparing a budget on a yearly basis, King’s Apparel switches over to a monthly budget. It also classifies each expense into “fixed,” “variable,” and “semi-variable.” This allows it to make accurate adjustments based on the level of activity. The company finds that it is in a far better position to predict its financial performance.
A flexible budget allows a firm to see how costs change with output. It is especially useful for companies that experience widely varying levels of production.