This responsive approach allows for more accurate financial forecasting and better resource allocation, aligning expenses closely with operational activity. The Finmark Blog is here to educate founders on key financial metrics, startup best practices, and everything else to give you the confidence to drive your business forward. Imagine your product goes viral on social media and gains unexpected popularity overnight, now there is a demand for 20 units next month, which would cost $20 to make. Now, let’s assume that it costs one dollar to make each unit of product, so you budget $5 a month for this. For example, if your business predicts that five units will sell per month at $5 each, you can expect a revenue of $25 a month.
Any item that is not in cash, such as depreciation, is ignored by the cash budget.
By incorporating a dynamic and responsive approach to budgeting, companies can better align their financial plans with the ever-evolving landscape where they operate. Static budgeting is constrained by the ability of an organization to accurately forecast its needed expenses, how much to allocate to those costs and its operating revenue for the upcoming period. Flexible budgets come with advantages like their usability in variable cost environments, their detailed picture of performance, and their overall efficiency for budgeting teams. A Flexible Budget is a budget or financial plan that varies according to the company’s needs. They made it flexible because the specific company’s or department’s needs do not remain static. For example, a widget company might start out the year with a static planning budget that assumes that the cost to produce 10 widgets is $100, and the company will produce 100 units per month.
By comparison, the sales-volume variance compares the flexible budget to the static budget to determine the effect that a company’s level of sales activity had on its operations. Firstly, a flexible budget allows for accurate performance evaluation by adjusting projected expenses and revenues based on varying activity levels. It enables a more precise assessment of actual performance, enhancing cost control and facilitating improvement. Additionally, flexibility supports better cost management, promoting efficiency and resource optimization within the organization. By incorporating varying production levels, sales, or other key variables, a flexible budget enables companies to anticipate how revenues and costs will fluctuate under different scenarios.
Step Cost Development is Time-Consuming
This also targets more accurately where performance levels are falling below or meeting expectations. An approach that larger companies take to dealing with such variables is to have a static budget for the overall organization, and a flexible budget for each individual department. Big Bad Bikes is planning to use a flexible budget when they begin making trainers. The company knows its variable costs per unit and knows it is introducing its new product to the marketplace.
When using a static budget, some managers use it as a target for expenses, costs, and revenue while others use a static budget to forecast the company’s numbers. Flexible budgeting puts more pressure on you to have rock-solid financial assumptions as you tie various line items together in the model. And the reality is that the effort you put into tying certain line items together may not be worth the time. Not every line item or set of line items has a strong enough correlation to others for flexible budgeting to work.
What Is a Flexible Budget for Small Business?
While creating and maintaining real-time adjustments can be somewhat time-consuming, there’s tangible value in terms of more efficient budget allocations and more agile decision-making. After each month (or accounting period) closes, a flexible budget assumes you’ll compare projected revenue to actual results and adjust the next month’s expenses accordingly. The difference between your projected and actual figures gives you the flexible budget variance, an essential metric to understand flexible budget meaning how well your predictions align with your actual performance. In an unpredictable financial world, flexible budgets are helpful in manufacturing industries where costs change with a change in activity level. Companies must involve experts to make accurate budgets, ensuring there is less scope for error and improving variance analysis. It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.
- If a SaaS company is forecasting its cost of benefits, it might tie the budget line item to its headcount forecast.
- And because flexible budgets expand and contract in real time, they allow businesses to exist as the organic, growing entities that they are.
- Under this approach, managers give their approval for all fixed expenses, as well as variable expenses as a proportion of revenues or other activity measures.
- Companies develop a budget based on their expectations for their most likely level of sales and expenses.
- Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs.