How To Create a Flexible Budget (With Types and Example)

Updated March 11, 2023

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Businesses can use several accounting tools to plan for and track their monetary activity. One tool that's
helpful for companies that experience frequent variations in cost-related activities throughout the year
is a flexible budget. You can learn how to create a flexible budget to help you make accurate budgets
with enhanced variance analysis.

In this article, we explore what a flexible budget is, its types, its advantages and disadvantages, how to
create a flexible budget and an example to reference when creating your own.

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What is a flexible budget?

A flexible budget is a budget that adjusts to a company's activity or volume levels. Unlike a static budget,
which doesn't change from the amounts established when the company creates the budget, a flexible
budget continuously changes with a business' cost variations. This type of budgeting often includes
variable rates per unit rather than a fixed amount, which allows you to anticipate potential increases or
decreases in monetary needs. It's usually based on changes in a company's actual revenue and uses
percentages of revenue rather than static numbers.
For instance, when using a flexible budget, you may allocate 25% of a company's revenue to salary
instead of allocating $100,000 to salary in a given year. This allocation accounts for any changes in the
company's revenue and staff that may occur throughout the year.

Related: Forecast Budget: Definition, Benefits and Tips To Create One

3 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:

1. Basic flexible budget

This type of budget shows a company's expenses directly related to its revenue. You may build a
percentage into the basic flexible model, which you multiply by actual revenues to determine the
expenses at a specified revenue level. You can use cost per unit rather than a percentage of sales if it's
the cost of goods sold (COGS).

Related: Q&A: What Is Forecasting? Definition, Methods and Examples

2. Intermediate flexible budget

A flexible intermediate budget accounts for expenses that go beyond a company's revenue. Typically,
this budget includes costs that vary based on other activity measures. For example, a business's
insurance policy costs may vary based on the company's number of employees and may increase if the
company hires new employees.

Related: Your Guide to Careers in Finance

3. Advanced flexible budget

This type of budget considers the variation and ranges of expenses in certain categories of a company's
budget. An advanced flexible budget also changes based on the actual costs for each category. The
expenses in your advanced flexible budget may only vary within a certain revenue or activity level range
and change beyond if it goes to such a level.

Related: 22 Accounting Jobs That Pay Well

Advantages of a flexible budget

The following are a few of the benefits you may experience when using a flexible budget:

Adjustments based on profit margins and costs: A flexible budget gives you a realistic idea of your
budgets based on changing costs and profit margins. It can help you make adjustments and compensate
for decreases or increases in costs, unlike a static budget, which remains the same when you create the
budget at the onset of a new year.

Potential to maximize revenue: Static budgets don't change to reflect an increase in sales, but flexible
budgets do. Using a flexible budget, a company can better determine where to increase marketing or
other efforts when it experiences increased revenue.

Increased cost controls: A flexible budget helps you know when to change certain costs. For example,
you may have projected sales that are less than expected, and a flexible budget may show updated
percentages of each category, enabling you to make adjustments to spending to compensate for
decreased sales.

Budget efficiency: You can use a flexible budget even when you don't yet know the activity because you
can easily figure out the fixed costs and managers can approve variables. This type of budgeting helps in
forecasting and can allow you to determine budgeted sales, cash flow and expenses at different activity
levels.

Related: Variance Analysis: Definition, Types, Formulas and Examples

Disadvantages of a flexible budget

A flexible budget also has some potential disadvantages. Understanding the disadvantages of this type
of budgeting can help you determine if using a flexible budget is suitable for the company. The following
are a few drawbacks that may result from a flexible budget:

Lack of revenue comparison: A flexible budget regularly adjusts to compare a company's actual expenses
to expected expenses. This budget design doesn't compare actual revenue to expected revenue, making
it challenging to determine if a company's revenue is above or below expectations.

Delays: You may experience delays in issuing financial statements since you wait for the completion of
actual activities to create financial reports that contain a comparison between budgeted and actual
information. These delays can affect financial planning and other processes in a company.

Complicated formula: A flexible budget can be challenging to formulate because some variable costs
aren't fully variable and have a fixed cost element that requires calculation. Calculating each category
and determining the required cost type can take time.

Applicability: A flexible budget may not benefit certain companies, especially those with a majority of
fixed overhead costs, such as companies in the service industry. For example, a company with little to no
COGS and a set overhead cost each month may not benefit from a flexible budget plan.
How to create a flexible budget

Here are steps you can take to create a flexible budget:

1. Identify variable and fixed costs

The first step in creating a flexible budget is determining fixed costs and variable costs. Fixed costs don't
change during business operations and typically include rent and monthly marketing costs. Once you
determine fixed costs and variable ones, separate them on your budget sheet.

2. Divide the budget

Once you identify the variable costs you may incur, determine the variable cost as a percentage of the
activity level or per-unit basis. You can do this by dividing the budget you plan on spending on variable
costs by your estimated production. The results provide a starting budget for cost per unit.

3. Create your budget

Create your budget with set fixed costs that don't change. Depict the variable costs as percentages that
you can adjust based on actual revenue. Plotting these costs for the budgeted activity level gives you a
flexible budget.

4. Update the budget

Once an accounting period is over, update your budget with the actual revenue and activity
measurements. You calculate variances based on the revised budget and actual performance. It adjusts
the variable costs to reflect accurate data of the budgeted costs from the accounting period.

Read more: Flexible Budget Variance: Definition and Example

5. 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. You can analyze the data and identify areas that need
improvement. A flexible budget can also help in future budget forecasting.
Related: Operations Management: Everything You Need To Know

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Example of a flexible budget

The following is an example of how a business may use flexible budgeting:

A company budgets for $5 million in revenue and $1 million in COGS. The company determines that
$400,000 of the $1 million of the COGS comprise fixed costs and $600,000 of the COGS may vary based
on revenue. This means that the variable or flexible amount of COGS is 12% of the company's revenue.
Here are the company's calculations:

($600,000 / $5,000,000) x 100 = 12%

At the end of the accounting period, the company determines that its actual sales equaled $6 million,
which is $1 million more than it anticipated. Using the flexible budget, the fixed cost of goods remains at
$400,000, while the variable portion of the cost of goods adjusts to $720,000 to reflect the 12%
designated for this portion of the cost of goods. The following are the company's calculations:

(12 / 100) x $6,000,000 = $720,000

The company incorporates an additional $120,000 into its variable cost of goods budget to account for
increased sales.