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A flexible budget is a type of budget that understands the relativity of fixed and variable costs to the output and or turnover and incorporates changes in line values such as expenses and net profit in accordance with the changes in turnover or output. Most flexible budgets are in a sense a combination of several static budgets, with different line values for different projected output or turnover, with the final budget being the one whose projected output or turnover matches the actual output or turnover attained during the budget period.
Image Credit: geograph.org.uk/Tim Hallam
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The primary use of a flexible budget is in performance evaluation, for a correct comparison between budgeted performance, and actual performance.
Static budget, the common type of budget is for a single level of activity and cause variance when actual output varies from the expected output in the budget. If the actual output is more than the budgeted output, or if the company produces and sells more products than expected, variable costs such as raw material costs, sales commissions, shipping costs, and others increase, and if actual output is less than the budgeted output variable costs decrease. Reliance on static budgets might actually lead to the conclusion of the company having improved its finances when the cause for such improvement might be the decline of sales. Similarly, a static budget showing an increase in expenses, oblivious to such increased expense coming from increased sales, might be interpreted as bad management. A flexible budget reflects expected costs as a function of business volume and removes this distortion in performance evaluation.
For instance, comparison of an actual output of 10,000 units with a static budget that estimates an output of 9,000 unit leads to distortions, for the total budgeted costs for 9,000 units being less than the actual cost for 10,000 units might indicate improved financial control when the opposite might be the case. For a real comparison, the budget should also cater to 10,000 units. Flexible budgets have projections for several output-levels, and if the actual output is 10,000, choosing the budget prepared for an output of 10,000 units for comparison with the actual line values remove all distortions.
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The advantages a flexible budget brings to the business is that it allows management to have a greater level of control over business operations. Adoption of flexible budgets allows real time monitoring and control of actual results against budgeted results.
Computerized flexible budgets adjusted on a real time basis to reflect the changed customer demands helps to schedule production, manage raw material inventory, schedule distribution, and undertake other supply chain tasks more efficiently.
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Flexible budgets prepared at the start of the budget period incorporating different line values for different sales projections also become useful planning tools, and help react to changes in an external environment more efficiently. For instance, an ice cream company preparing a flexible budget based on anticipated sales for every possible variation in temperature, helps ti plan daily staffing, purchases of milk and cream, production, and distribution levels in advance.
Many large corporations of the world are no longer asking why use a flexible budget and have adopted flexible budgeting for a variety of purposes, and this stands as a testimony to its effectiveness.
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- Caplan, Dennis. Management Accounting: Concepts and Techniques. Oregon State University College of Business. http://classes.bus.oregonstate.edu/spring-06/ba422/Management%20Accounting%20Chapter%205.htm.
- CliffsNotes.com. Flexible Budget. http://www.cliffsnotes.com/study_guide/Flexible-Budgets.topicArticleId-21248,articleId-21241.html
- PrinciplesofAccounting.com. Tools for Enterprise Evaluation. http://www.principlesofaccounting.com/chapter%2022.htm