To understand the flexible budget, you must first understand a static budget. A static budget is prepared by management before a given accounting period. This budget tells management what income and costs to expect during the upcoming accounting period. Unlike a static budget, a flexible budget is prepared at the end of the accounting period to show what the static budget should have looked like. Dennis Caplan, of Oregon State University's College of Business, defines the flexible budget as the one that would have been prepared “if I had known at the beginning of the period” what I know now. Although usually prepared after the fact, sometimes flexible budgets are prepared at the beginning of an accounting period to allow management to experiment with different numbers. When this happens, the flexible budget is often called a “pro forma budget.”
Budgets are an important tool for both small and large businesses, but can be especially helpful for small businesses where there is less room for financial missteps. Budgets are used to predict and control spending, but they can also be used to measure how well or poorly goals are being met. This last type of budgeting is known as flexible budgeting. It is crucial for small-business owners and managers to understand flexible budgeting and what it can tell them about business performance.
What is Flexible Budgeting?
Preparing a Flexible Budget
Preparing a flexible budget is simple and very much like preparing a static budget. To prepare a flexible budget, you must look back at the static budget to determine what per-unit fixed and variable costs were used to prepare it. Then find out how many units were actually manufactured during the period. Combine the fixed and variable costs used on the static budget with the actual number of units produced to create the flexible budget. Creating the flexible budget in a spreadsheet next to the original static budget will allow you to easily compare the two.
After the flexible budget is prepared, it is compared to the static budget to determine the amount of variance between the two. A positive variance means that the company did better than anticipated, either by generating more income than expected or incurring fewer costs. A negative variance, naturally, means the opposite and shows that the company did not do as well as anticipated. Variances are the part of the budget that managers use to analyze and improve company performance. Unless it is a pro forma budget, calculating these variances is the primary purpose of creating a flexible budget.
What it All Means
After the flexible budget determines budget variances, managers use the variances to evaluate performance. Favorable variances allow the company to know what they are doing well and help to keep them on track for meeting organizational goals. Negative variances, however, are often investigated to determine the cause. Were costs higher than expected because the price of raw materials went up or because there were several equipment breakdowns that slowed production? These types of questions allow management to focus on any areas where the company needs to be more effective or efficient. Without calculating budget variances, managers would have a much harder time determining where company practices excel and where they could be improved.
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