A flexible budget is one that is allowed to adjust based on a change in the assumptions used to create the budget during management's planning process. A static budget, on the other hand, remains the same even if there are significant changes from the assumptions made during planning.
The greatest advantage that a flexible budget has over a static budget is its adaptability. In the real world, change is real and it is constant. A flexible budget can handle that reality and better position a company for the challenges of the marketplace.
Fixed versus variable expenses in a flexible and static budget.
Not all line items in a budget can be flexible. For example, a company's rent expense is likely fixed for the entire year. It's unrealistic to expect that to change every month or even every quarter. In either a flexible or static budget, the rent is what it is.
Other expenses though are not so simple. For example, a hiring plan may hinge on signing a large new customer to a long term contract. Or, if a sales and marketing plan works much more effectively than anticipated, then management should consider increasing the investment in those campaigns above what was originally budgeted.
In a static budget, the company would not have the ability to tweak the budget to manage the changes if that large client contract doesn't materialize or if sales grow faster than anticipated. Management could, and most likely would, adapt to those changes, but at year-end there would be large budget variances that do not provide any analytical value to better plan for the following year.
The flexible budget solves this problem, providing both senior executives and middle management with dynamic guidance on how much to spend based on the business' changing reality.
In this way, the flexible budget is able to account for both fixed and variable expenses in a better, more responsive way than the simpler static budget could.
How does the flexible budget actually work?
To construct a flexible budget, the first step is to identify and budget for fixed expenses. This part of the process is identical to creating a static budget; management should determine what those expenses will be and fill them into the budget as fixed items. Remember, these expenses are what they are, and they're unlikely to change. Rent expense is an easy example to understand the logic.
With the fixed expenses taken care of, next management should turn to the variable expenses. Variable expenses will be calculated based on other items that will be determined over time. For example, management may determine that marketing expenses should be equal to 15% of revenue each quarter. If the first quarter yields $500,000 in revenue, then the marketing budget will be 15% of that, or $75,000.
If revenue comes in lower than anticipated at just $400,000, then the marketing budget will automatically reduce based on that change in revenue. At $400,000, the marketing budget would reduce to $60,000.
Other expenses will be tied not to a given revenue figure, but to a cost-per-unit calculation based on production levels. This is particularly common in manufacturing operations.
For example, if a factory has a larger than typical order for next month, the expense budget for that month could be based on the anticipated number of units to be produced. Management could calculate that there are $3 in variable costs per unit produced, so an increase in production of 10,000 units will increase the budget by $30,000 for that month.
As complex or as simple as management needs
Every business will be unique in its budgeting needs. Each will have different considerations, different business models, and individual uses for the budget. The key for management is to consciously make decisions on how to budget based on sound logic. For a small, simple business a static budget may be appropriate. However, for larger and more complex businesses the use of a flexible budget is essential.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.