Fixed, Flexible and Revised Budgets

Methods to Deal with Changes in Volume in Business

May 26, 2009

Companies have choices when preparing projections for future periods. A flexible budget can provide better results than a simple fixed budget.

For businesses, budgets provide the ability to track revenues and expenses for better analysis and decision-making. Fixed and flexible budgets offer a trade-off between ease of use and improved information.

Fixed Budgets

A company will establish a fixed budget with the intention of keeping that forecast unchanged for the entire year. The business will create expectations of volume, revenue, expense and profit for the year, and will not adjust them despite changes in conditions.

This method is easier, and works well if there is an expectation that business is stable. Variances can be explained by changes in operations. If there major differences in outside influences, the budget becomes unusable.

Revised Budgets

If there is a major change in operating conditions, it does make sense to revise the entire budget. If an expected shift in sales happens, or salary conditions vary rapidly, the company is better served by revising the budget in total.

Flexible Budgeting

In contrast, a flexible budget is designed to vary based on volume. A business may reasonably expect that expenses will be constant at a particularly volume. But if sales grow or fall by a large amount, the fixed budget may not be useful.

A flexible budget allows projected expenses to change when volume changes. This enables management to continue to hold employees responsible to budget even if volume falls, and allows for increased expense when it volume spikes.

An Example of Fixed and Flexible Budgets

Consider a simple business, such as an ice cream cone stand. This particular stand only offers one product; ice cream cones, and only has four different types of expenses: wages, ice cream, cones and rent.

The company expects to sell 1,000 ice cream cones. The fixed budget calls for the following expenses

As long as company sells around 1,000 cones, variances from the budget can be explained by other reasons. An unexpected rent increase or a decrease in the price of cones would be understandable. But, what happens when a competitor opens across the street, and volume is cut in half? How does the company know what is an acceptable variance?

If the cones sales are 1,000, the flexible budget will still equal the fixed. If sales are cut in half, the budgeted amounts become:

If the actual expense equals the budget, then the volume explains the variance. If the expenses differ from the flexible budget, then other reasons must be found to explain the variance.

Flexible budgets help businesses identify variances better, but in a complicated situation, may not add enough value to justify the increased time involved in set-up.

The copyright of the article Fixed, Flexible and Revised Budgets in Accounting is owned by James Hutchinson. Permission to republish Fixed, Flexible and Revised Budgets in print or online must be granted by the author in writing.