Preparation of Flexible Budgets

26/08/2021 1 By indiafreenotes

A flexible budget is one based on different volumes of sales. A flexible budget flexes the static budget for each anticipated level of production. This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales. Flexible budgets are prepared at each analysis period (usually monthly), rather than in advance, since the idea is to compare the operating income to the expenses deemed appropriate at the actual production level.

Types of flexible budgets

A company can produce several variations of a flexible budget that range from basic to sophisticated depending on the company’s needs. The following are the three types of flexible budgets most commonly used:

Basic flexible budget

This type of budget flexes with a company’s expenses that change directly in relation to its revenue. A basic budget may build in a percentage that varies based on revenue. This type of budget is typically used to denote cost per unit or percentage of sales.

Advanced flexible budget

This type of budget takes into account the variation and ranges of expenses based on each category of a company’s budget. An advanced flexible budget will also change based on the actual expenses for each category.

Intermediate flexible budget

An intermediate flexible budget takes into account expenses that go beyond a company’s revenue. Typically, this budget includes costs that are related to activity in addition to or rather than revenue. For example, a business’s insurance policy costs may vary based on how many employees the company has and may increase if the company hires new employees.

How to create a flexible budget

  1. Identify which costs are variable and which costs are fixed

Fixed costs typically include expenses such as rent and monthly marketing costs. Once you have determined which costs are fixed and which are variable, separate them on your budget sheet.

  1. Divide the budget

Divide the budget you plan on spending on variable costs by your estimated production. This will provide a starting budget for cost per unit.

  1. Create your budget with set fixed costs

Create your budget with set fixed costs that will not change and variable costs depicted as percentages that can be adjusted based on actual revenue.

  1. Update the budget

Once an accounting period is over, update your budget with the actual revenue and/or activity measurements. This will adjust the variable costs based on accurate data from the accounting period.

  1. Input and compare

Input the final flexible budget from an accounting period into your accounting software to compare it to the expenses you initially anticipated.

Preparation of Flexible Budgets:

There are three methods of preparing a flexible budget:

  1. Tabular Method or Multi-Activity Method.
  2. Charting Method.
  3. Formula Method or Ratio Method.

Charting Method:

Under this method, an estimate of expenses is made for different levels of activity by classifying the expenses into three categories, namely, variable, semi-variable, and fixed. The estimated expenses are plotted on a graph paper on Y-axis and level of activity is plotted on X-axis. The budgeted expenses corresponding to the level of activity attained can then be read out from the chart and the performance of departmental heads can be assessed.

Tabular Method:

According to this method, a flexible budget is prepared for different levels of activity showing different activity or capacity levels in horizontal columns and budgeted figures against different activity or capacity levels in the vertical columns.

The expenses are usually recorded under three groups, namely, variable, semi-variable and fixed. Budgeted figures for any level of activity not specifically covered in the flexible budget can be obtained by interpolation.

Formula Method or Ratio Method:

Under this method, a budget is prepared for the expected normal level of activity and variable cost per unit of activity is ascertained.

Expense budget allowed for a particular level of activity attained will be as follows:

Fixed cost + (Actual units of activity x variable cost per unit of activity)

For example, the overhead expenses budget for a normal level of 80% activity is Rs 90,000. Assuming that the expenses budget consists of fixed cost Rs 50,000 and variable expenses Rs 40,000, then variable cost per 1% activity is Rs 500 (i.e., Rs 40,000/ 80).

Suppose actual level of activity is 75%, the expense budget allowed will be:

50,000 (fixed) + 75 x Rs 500 (variable) = Rs 87,500.