Flexible Budgets

Flexible budgets are financial planning tools that adjust budgeted figures based on actual activity levels. Unlike static budgets, which remain constant regardless of performance, flexible budgets allow managers to compare actual results against adjusted expectations. This adaptability is particularly useful in environments where costs and revenues can vary significantly, such as in manufacturing or service industries.

Flexible budgets are typically prepared for different levels of activity, enabling organizations to analyze variances more accurately. They help managers identify which costs are variable and how they behave under different operational scenarios. By accommodating fluctuations in sales or production, flexible budgets enhance financial control and provide deeper insights into the organization’s performance.

Implementing flexible budgets can improve decision-making by offering a clearer picture of financial health and operational efficiency. This approach encourages accountability, as it allows for performance evaluation based on relevant benchmarks. Organizations of various sizes and sectors can benefit from using flexible budgets to navigate the complexities of financial management effectively.

Published in: 2021

By: Joseph Dewey, PhD

Subject Terms

Flexible Budgets

Last reviewed: February 2017

Abstract

A flexible budget allows a company to measure its spending against actual expenditures at the end of the period. A flexible budget also allows accountants to measure the impact of variables that could not possibly be factored into the budget set at the beginning of the period. The budget can be adjusted or restructured entirely to account for actual events. As such, a flexible budget shows a much truer and more realistic picture of a company’s financial integrity for the period.

Overview

Traditionally, a budget gives a company a reliable metric to factor in its costs as they impact the actual operations of the company, whether that company provides a service (a dentist office or a movie theater, a department store or a hotel) or provides a product (microwaves or socks, cars or ice cream). Every business has expenses, from office supplies to utilities, from staff to raw materials. In fact, budgets have traditionally provided a variety of perspectives for a company to evaluate its operations, its personnel, and its field profile (Churchill, 1984).

A company understands that it needs to monitor expenses closely and to hold its employees and its management team responsible for spending practices that in turn cause spending spikes that might ultimately impact the overall revenue of the company. Budgets give upper echelon management the means to evaluate the company’s performance and to determine stronger and weaker employees and/or divisions. In many cases, decisions about promotions or terminations can stem from how well a division or department meets the budget. Thus, the accountant who prepares these annual (or fiscal quarterly) budgets must be completely in tune with the company operations in order to present an accurate summary of the relationship between expenses and revenue as that alone determines the success or financial peril of a company.

Static versus Flexible. Budgets that are defined at the beginning of the period and that simply generate numbers against the budget during the defined period are termed “static” budgets. According to this model, if a company stays under budget, it is considered solvent; if a department or division goes over budget, the problems become significant. A static budget more than anything else is a planning tool, a way for a company to control its expenses and improve revenue. By using the accumulated data covering probable expenses, an accountant at the start of a fiscal period can file a budget that works with reliable numbers in order to project a probable range of revenue.

A budget, however, must take into consideration two types of expenses: fixed and variable (Cole & Claiborne, 2015). Fixed expenditures include costs to maintain the physical facility of the company (most often rent); wages paid to the staff and management; insurance on facilities and/or personnel; and computer technology systems. These expenses are fairly predictable. Whatever boom or bust in revenue stream the company may cycle through, these expenditures are constant and as such are the foundational numbers for a budget. There are, however, in any fiscal period budget variable costs—that is, expenses that can be only estimated. Variable costs depend on future conditions that an accountant cannot possibly know with any certainty. A movie theater, for example, cannot reliably budget for concession snacks as that number depends entirely on the number of people buying tickets for shows that may or may not attract big numbers; a hotel cannot reliably budget for housekeeping as the required staffing for that depends entirely on bookings, which in turn may depend on weather or the price of gasoline; a clothing factory cannot reliably budget for raw materials such as flax and cotton, silk and wool. Every company, factory, or service, routinely sees entirely unpredictable events impacting expenses.

These industries cannot rely on the conceptual model of a static budget. To illustrate with an analogy, a family may prepare a budget based on regular income and predictable expenses to make sure they maintain reasonable spending parameters. A static budget works well until a breadwinner breaks a leg and cannot work for six weeks or the laundry room catches fire or the second car drops a transmission or the toilet springs a leak. Sudden changes in income or expenses will impact the financial status of the family, and the budget will no longer reflect their actual planning needs.

For a company, static budgets, prepared ahead of time and prepared without access to certain critical events (and numbers), can present a false or misleading financial profile for that company. Customer interest, for example, may prove broader than anticipated, or a gamble on an online store might create an unexpected spike in sales, resulting in higher than expected income. A ski lodge can experience a warmer than usual winter, or a global conglomerate’s massive computer network can crash, resulting in smaller than projected revenues. Then static budget becomes not merely unreliable but actually counterproductive and, in effect, useless as a way to accurately measure a company’s finances in real time. If these budgets are used, in turn, to shape the next year’s financial picture, misleading data can only produce misleading predictions.

Advantages. An accountant is professionally dedicated to the truthful measure of a company’s financial position. Because that truthful measure can be severely tested by conditions that occur during the period that the accounting department could not credibly anticipate, companies can adjust that static budget at the end of the period, factoring in those conditions as elements of defining the spending curve. Thus adjusted, this flexible budget can be used to evaluate that specific period with far more accuracy and in turn can be used to feed into the data that will be used to draw up the next cycle of budgets.

Although fixed expenses are constant in a flexible budget, those other expenses, ranging from staffing to raw materials, transportation to computer services, marketing to general supplies, can be far more reliably measured at the end of the period, giving accountants the tools to present a compelling and balanced financial picture adjusted to the appropriate changes in the volume of business activity experienced during the period. Actual revenue can be measured against actual expenses. Thus, managers or divisions that might be perceived as financial liabilities in a company because of operations that do not match budget projections can be, in the end, found to be far more in keeping with the efficient operations that any company desires (Alarcon & Caruso, 2013).

Applications

If expenses and revenue vary within a basically unstable and essentially unpredictable cost environment—after all, what accountant can entirely foretell weather, fuel prices, market spikes, demographic drops, staffing shifts, advertising efficiency, Internet buzz, a rise in competition, fluctuations in materials cost—a flexible budget becomes a valuable tool for an accountant, who in turn must present an assessment of a business’s operations at the close of a budget period.

For example, a small department store in a suburban strip mall sets a static operating budget for the third quarter, which includes the holiday season. The accountant, using data grounded in previous quarterly reports and projections, sets the budget at $160,000 for the three-month period. The number is divided between fixed costs (rental of the building, insurance on the property) and variable costs (staffing, utilities), much of which must be calculated using metrics that depend on the number of customers. Therefore, the accountant needs to set a probable customer number. Using data already generated from past quarterly budgets, the accountant sets the variables using as a base operating figure 400 customers, higher than other periods because of the holidays but because it reflects the mean of the previous four third quarter budgets, by any measure an appropriate and considered metric.

At the close of the holiday season, as the accountant is preparing the next quarterly budget, it is found that the store operating budget for that period turned out to be not $160,000 but rather $195,000, nearly 23 percent over budget. At first glance, the large rise in expenses appears to be disastrous, negatively impacting critical third quarter revenues, and is most easily explained as the result of financially irresponsible practices by store personnel, which must be addressed with draconian measures to ameliorate the numbers—staff reductions, curtailing store hours, and temporarily suspending benefits.

However, the accountant knows the broader picture and opts to prepare a flexible budget for the same holiday fiscal period. What the accountant noticed was that a long-term highway construction project along which the strip mall was located had finally ended in mid-October. With the renovations completed and the refurbished highway now open, the department store had in fact seen a significant increase in customer traffic, a return to volume the store had not seen in years, and a 68 percent increase over projections during the holiday quarter. With that increase in customer base, of course, more staffing was required, staff worked longer hours, and store maintenance costs increased.

The new flexible budget returns to the holiday quarter’s original numbers and this time factors in the increase in customer numbers. In turn, the budgetary picture shows that rather than operating with inflated overhead costs, the store actually operated at nearly peak efficiency, as costs across the revenue stream did not rise to the 68 percent increase in traffic—that is, with a flexible budget the store staff and its supervisors were shown to be operating at a remarkable level of efficiency, making the best use of the resources of a standard operating day given the dramatic rise in customer service.

A second example illustrates the opposite scenario. A first-run movie theater complex is located farther down the same highway. Its accountant works out the numbers for a static budget for the same holiday season, guesstimating based on previous quarterly averages that the four theaters would serve 17,500 moviegoers, a reasonable expectation given the 210-seating capacity in each of the four theaters and the standard rush in holiday theater attendance. Most static budgets would allow for a level of adjustment in the range of between 17,400 and 17,600 attendees.

Thus, the static budget—including variable costs such as staffing, concession stand snacks, utilities, maintenance—provides for $280,000 in operating expenses. At the end of the period, however, the theater staff has actually operated for $220,000, a savings of nearly 23 percent. This appears to be a result of high efficiency during peak season. Before the managers of the theater complex can celebrate their crack staff and its efficient operations, however, the accountant begs to differ. The highway construction project had moved down the road and now blocks the theater’s main entrance way, creating an annoyance that is driving many customers to other theaters. Attendance during the holiday quarter dropped to just under 14,000. Revisiting the same period with a flexible budget, the accountant showed that the store operations had in fact been more than 34 percent over budget—staff had been called in and had not worked, maintenance had cleaned and recleaned nearly empty theaters, snacks and concession drinks had gone unsold, and utilities had run all day without customers to service. The period had in fact been a revenue disaster, the truest dimensions of which could not be accurately gauged without a flexible budget report.

By first separating fixed expenditures for a fiscal period and then determining the exact dimensions of variable costs and how those costs had been impacted by conditions unknown at the beginning of the period, accountants can provide a measure of actual business operations and of actual customer interactivity. In the twenty-first century, with rapid and drastic fluctuations in the economy and changes to industry and consumer behavior, companies must be agile and able to account for a range of contingencies (Katz, 2016). Managerial expectations will be better adjusted once the period’s data is recalculated to include these impact-points.

Viewpoints

The advantages of a flexible budget are obvious—a business maintains a far more accurate measure of its operations and theoretically can base future budgets on adjusted figures that give a truer, clearer picture of the financial stability. Nevertheless, accountants can raise significant issues with the concept of such a budget largely because of its timing. A budget is an operating tool—it gives a reasonable range for managers to make day to day decisions about what to invest company monies into and what can be delayed or avoided entirely. A budget is really the only way to contain, control, and define expenses as a way to maximize revenue in real time. A static budget gives managers real-time parameters, real-time choices, real-time responsibilities—particularly when a business relies on annual rather than fiscal period budgets.

By comparison, a flexible budget necessarily invalidates the standing static budget. The actual numbers and the budget numbers are inevitably the same, but that information does not help define base operations because the numbers are not tabulated until after the period of operations; and almost by definition a flexible budget cannot be reasonably applied to the next fiscal period or really to any subsequent fiscal period because it takes into account conditions that are by definition period-bound. The value of such a budget then becomes entirely archival—a performance measure that really has little long-term operational relevance. Flexible budgets can even create financial chaos.

In a field committed to accuracy and to the process of defining company financial operations that are grounded in reality, however, flexible budgets provide the most reliable figures. The use of that data may be limited, but the usefulness is not. Companies can see exactly where their staff and their operations met challenges and where those critical elements of a company’s financial success failed. Flexible budgets recognize that a business must maintain financial integrity in a dynamic field of operations where conditions are constantly subject to change. Static budgets are tools to measure with rather than tools to decide with.

Flexible budgets, on the other hand, let businesses be businesses. Adjustments give businesses a far better perception of how well expenses are actually aligning with circumstances and, in turn, how they are impacting revenue streams. Either/or does not seem to work—companies have come more and more to use static budgets and flexible budgets both to match a challenging ever-changing business landscape. This hybrid model applies fixed budgets where uncertainty is not a large factor and flexible budgets where high uncertainty is inherent (Ekholm & Wallin, 2011).

Terms & Concepts

Dynamic Field of Operations: In contemporary accounting theory, the accurate template of a business world that is subject to change, to events and pressures that are, ultimately, not predictable, not controllable.

Fiscal: That which relates to revenue.

Fixed Expenditures: Those financial commitments that remain constant for a company during an entire fiscal year.

Impact-Point: In accounting, events that cannot be entirely foretold or factored into budget determinations.

Metric: A reliable method of measurement.

Static Budget: A budget prepared going into a fiscal period that projects using reliable numbers as the most probable metrics for expenses.

Variable Expenses: Those financial commitments that can change quarter to quarter during a company’s fiscal year.

Revenue Stream: Methods—product lines, services, data storage—through which a company secures its net income.

Bibliography

Alarcon, J., & Caruso, J. (2013). Put some flexibility into your planning. Pennsylvania CPA Journal, 84,(2), 36–39. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=88406981&site=ehost-live

Cole, E., & Claiborne, C. (2015). The Golden Cup: Identifying the inventory change variance. Journal of the International Academy for Case Studies, 21(3), 25–28. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=112427658&site=ehost-live

Churchill, N. (1984). Budget choice: planning vs. control. Harvard Business Review, 62(4), 150–164. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=4063123&site=ehost-live

Ekholm, B., & Wallin, J. (2011). The impact of uncertainty and strategy on the perceived usefulness of fixed and flexible budgets. Journal of Business Finance & Accounting, 38(1–2), 145–164. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=59268228&site=ehost-live

Jimenez, B. S. (2014). Raise taxes, cut services, or lay off staff: Citizens in the fiscal retrenchment process. Journal of Public Administration Research & Theory, 24(4), 923–953. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=98588262&site=ehost-live

Katz, D. (2016). Budgeting for the next big thing. CFO, 32(7), 41–43. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=117805177&site=ehost-live

Ketners, K. (2014). Budget process and fiscal rules: Analysis of past progress and future development. Proceedings of the International Scientific Conference Whither Our Economies, 46–54. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=108413854&site=ehost-live

Žubule, Ē., & Puzule, A. (2015). The conceptual content of state budget process in economic theory. Latgale National Economy Research, (1), 203–216. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=112570742&site=ehost-live

Flexible Budgets

On this Page

Subject Terms

Flexible Budgets

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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