Budgets are important tools for helping companies analyze their costs and pinpoint ways to maximize their profits. Some companies follow static budgets, which remain constant regardless of sales volume or revenue. Others, however, use flexible budgets.
A flexible budget is one that adjusts for changes in sales volume and revenue. Rather than use fixed numbers that remain constant regardless of volume, flexible budgets are designed to allocate additional financial resources as necessary to accommodate an increase in business activity.
Let's say a company wants to create a budget to cover a one-year period and assumes that it will sell 10,000 units of a given product during that time. With a static budget, the company might allocate $50,000 to labor costs and leave that number as-is regardless of volume. But what happens when the company is able to sell 15,000 units instead? The problem with this approach is that it might require additional resources to facilitate the production and shipping of those 5,000 extra units, yet under a static budget, there's no wiggle room to increase the amount allocated to labor costs. A flexible budget, by contrast, is designed to accommodate changes in volume, for better or worse. In our example, the company has the option to increase that $50,000 it originally allocated to labor costs to $75,000 to keep up with its increase in sales.
Even though flexible budgets are adjustable in nature, there are certain costs within those budgets that always remain the same. Other costs, however, can fluctuate based on activity. Both fixed and variable costs must be accounted for when establishing and maintaining a flexible budget.
Fixed costs are those that do not change with an increase or decrease in business activity. Rather, they are set at a specific amount and have to be paid regardless of sales volume. One example of a fixed cost is a lease on a building. If a company has to pay $8,000 a month under its lease agreement, it must do so regardless of how many product units it manufactures or sells.
Variable costs are those that change with an increase or decrease in business activity. Direct materials -- those that go into a product -- are a good example of a variable cost. If production increases for a company, it will require more direct materials to produce additional units, which means it will need to spend more money to acquire those materials. Hourly employee wages are another example of a variable cost. If a company's output increases, it may need to pay for additional manpower.
Costs that are both fixed and variable
Some fixed costs have a variable element, and vice versa. For example, a company might pay a certain base amount each month for utilities, but its month to month bills might fluctuate depending on exact water and electricity usage. Along these lines, certain variable costs have fixed elements. For example, a company might have a salesforce whose members work on commission but also receive a small base salary regardless of how much they sell. When creating a flexible budget, a company will typically identify its fixed costs and enter them as set figures into the budget model. From there, it will enter its variable costs as percentages of the activities to which they are relevant.
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@example.com. Thanks -- and Fool on!