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Flexible budgeting enables companies to adjust their expenditure and revenue expectations in real time so they can adapt to changing market conditions. Unlike traditional budgeting methods, a flexible budget changes with the business environment.
Flexible budgeting grew in popularity during the COVID-19 pandemic when many companies had to pivot and quickly adjust their business model. In an article from the Boston Consulting Group, Sebastian Strange and Alexander Roos said, “CFOs must do away with long budgeting cycles and rigid, overly detailed budgets”. Several years later, the global economy is still in the era of uncertainty.
This article will explore definitions, uses, advantages, disadvantages and steps to create a flexible budget so your business can stay agile.
A flexible budget adjusts with changes in volume or activity levels, making it ideal for businesses with fluctuating operations. It contrasts with static budgets, which remain fixed regardless of business performance.
A flexible budget contains four components that combine to create a financial model that adjusts to real-time performance data.
| Components | Description |
|---|---|
| Vertical Analysis | Looks at the proportional representation of each line item on financial statements by expressing them as a percentage of total sales. |
| Fixed Costs | These expenses remain constant regardless of the level of business activity. Examples include rent, salaries and insurance. Fixed costs provide a stable baseline, ensuring that certain essential expenses are covered irrespective of fluctuations in business activity. |
| Semi-variable Costs | These expenses have both fixed and variable components. Examples include sales commissions (a fixed base salary plus a variable commission) and utility bills with a base charge plus usage fees. Semi-variable costs add complexity but provide a more accurate picture of expenses that partially depend on activity levels. |
| Revenue Expectations | These are projected income figures based on different levels of business activity. Examples include sales revenue, service fees and subscription income. Estimating revenue accurately across various activity levels is crucial for aligning the budget with realistic financial expectations and performance targets. |
The benefits of flexible budgeting and the agility it can provide to organizations makes it a popular budgeting method for finance professionals to use. However, it’s important to be aware of the limitations of this method so that you can determine if it’s the right budgeting method to use at your organization.
| Pros | Cons |
|---|---|
| Adaptability to changes | Increased complexity |
| Enhanced performance analysis | Dependence on forecasting accuracy |
| Improved cost control | Potential for misuse |
| Strategic decision making | Data management challenges |
But what about the limitations of flexible budgeting?
After assessing if a flexible budget is right for your business, the next step involves creating one. Here’s a handy five-step process to create a flexible budget:
Review previous financial data to establish baseline figures and understand the behaviour of various costs.
Classify costs into three categories:
Define potential levels of business activity (e.g., low, medium and high) that the budget should account for, based on historical data and future projections. These levels will help in creating a dynamic budget that can adapt to varying business conditions.
Create mathematical formulas for each variable and semi-variable cost that reflect how they change with activity levels. Similarly, project your revenues for different activity scenarios. For instance, raw material costs might be calculated as a fixed rate per unit of production.
Set up your budget in a spreadsheet or accounting software, using columns for each activity level. Populate fixed costs across all levels and use formulas for variable and semi-variable costs. This setup will allow the budget to adjust automatically based on actual activity levels.
Once the budget is active, regularly compare actual revenues and expenses against it. Consider using a template, such as our free budget vs actuals excel worksheet.
Make adjustments to your forecasts and models as necessary, leveraging real-time data to refine budget accuracy. This ongoing process ensures that the budget remains relevant and reflective of current business conditions.
In the manufacturing industry, flexible budgeting can account for fluctuations in production levels, adjusting costs for materials and labor to maintain profitability. For example, a car manufacturer can adjust their budget to increase product, hire additional labour or procure more raw materials if there is an unexpected increase in demand for a particular car model.
Service businesses can adapt to varying client demands, ensuring efficient resource allocation during peak and off-peak seasons. For example, during peak tourist seasons, the budget for a hotel and lodging company could expand to cover additional staff, amenities and marketing efforts. During off-peak seasons, the budget would contract to reflect lower occupancy rates and reduced staffing needs.
Non-profits can manage funding variability by adjusting their budgets to reflect changes in donations and grants, ensuring operational sustainability. For example, if a major fundraising campaign exceeds its goals, the budget can be increased to fund more programs and services. If fundraising falls short, the budget can be adjusted to prioritize essential activities.
Once you've decided that flexible budgeting is suitable for your business, several key practices can be followed to ensure success and to maximize benefits.
Regularly update the flexible budget to reflect real-world conditions and changes in business activities. This ensures the budget remains accurate and relevant throughout the fiscal period. This means frequently comparing your budget vs actuals.
Ensure your financial team is well-trained in flexible budgeting techniques and software tools. Proper training equips them to manage and adapt the budget effectively.
Use advanced budgeting and forecasting software to automate and streamline the flexible budgeting process. This reduces manual errors and improves efficiency.
Read Customer Story
Flexible budgeting represents a significant improvement over traditional methods, offering businesses the agility to adapt to market conditions and operational realities. By adopting or refining flexible budgeting practices, companies can gain more control over their finances, make more strategic decisions and improve profitability.
