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Flexible Budgets and Performance Analysis

Flexible Budgets and Performance Analysis

Abstract

Primarily the paper focuses on flexible budgeting in enterprises. In order to understand the approach to budgeting, the paper defines the budgeting process; explores flexible budgeting alongside its characteristics and highlights the role of budgeting. In addition to evaluating the advantages and disadvantages of the flexible budgeting approach, the paper compares and contrasts flexible and static budget. Based on the comparison, the paper finds that the former’s focus on fixed estimates and the latter’s allowance for variations form the basis of their differences.

Based on the exploration which parties can adopt flexible budgeting, it emerges that, entities operating in cyclical market conditions are likely to benefit from the method. Thus, the nature of a business cycle determines the usage of a static or flexible budget. In addition, the competency of an accounting department influences the choice of a budget method to use. Overall, the paper concludes that given the strengths and weaknesses of the flexible and static budgets, it is ideal to use the two concurrent to enhance the performance of an organization.

Introduction

Budget preparation is an essential exercise in business. Among various approaches to budgeting entities select the type that is deemed to be beneficial. Each method has its strengths and weaknesses. Factors such as the nature of business and variance between cost and profit projections influence the choice of a budgeting approach. Thus, one budgeting method might be useful to one organization but not to another. It is also evident that a flexible budget is more suitable for businesses that face uncertainty in their areas of operation. Given the pros and cons of the static and dynamic budgeting approaches, the paper holds that organizations would benefit from using both methods by developing yearly static budgets and supplementary monthly/ quarterly flexible budgets.

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Definitions

Budgeting

Defining the term budgeting is helpful in understanding its role in an entity. According to Derfuss (2016), budgeting is described as a quantitative reflection of a business or an individual plan on the use of resources for a specified period of time, in many instances per year. In simpler terms, budgeting is the generation of a document that brings together approximations of income and expenditure for an upcoming period. Given the small duration that is covered, budgeting is also viewed as short-term financial arrangement or plan (Garrison, Noreen & Brewer, 2008). In addition, budgets are taken as representations of action plans that help managers pursue business objectives. Thus, it is summed that budgeting is a comprehensive and coordinated plan, based on financial figures, pertaining to operations and resources used in an organization for a specified duration in the future. The overall objective of the budgetary process is to improve the performance of the organization.

Flexible Budgeting

Comprehending a flexible budget is essential towards understanding of its role in enhancing business operations. Also known as a sliding scale budget, flexible budget is one that recognizes the variations in constant and variable costs as they relate to the variance in turnover, output, and other factors such as labor (Heinle, Ross & Saouma, 2014). As a result, a flexible budget is designed to allow for changes based on fluctuations in variable business costs. Often businesses face two types of costs, namely, fixed and variable. According to Heinle, Ross and Saouma (2014), a flexible budget generates dissimilar budget costs across different levels of production. In practice, flexible budgets are prepared upon making an intelligent taxonomy of all anticipated expenses between variable, semi-variable and fixed costs since the importance of the forecast depends on the approximation accuracy at different output levels.

Characteristics of Flexible Budgeting

A number of characteristics distinguish flexible budgeting from other budgeting methods. Basically, a flexible budget is characterized by comprehensiveness and coordination (Mikesell, 2013). As an entire business plan, the budget involves many activities across an organization. Van Roestel (2016) stated that although budgets are prepared for each unit in a business, such plans must be in harmony at the collective level. In other words, the budget of one section must supplement those of other departments. Alternatively, the budget of a department is viewed as a component of the master business budget (Mikesell, 2013). In practice, for harmony to be realized, budgets of different units must be coordinated. In the event that these budgets are not prepared jointly, the main budget is likely to suffer and lose its significance. Thus, the feature of being comprehensive and coordinated is essential in the preparation of flexible budgets.

A flexible budget, just like any other budget, is prepared with the help of financial terms. Budgetary analyses are quantitative (Garrison, Noreen & Brewer, 2008). Although in the initial stages, budgets are prepared using qualitative terms such as varieties, in the end, they are expressed in monetary figures. As an example, budgets on production and purchases involve descriptions of finished goods and raw materials, while the labor budget entails workers and hours worked. However, a coordinated and exhaustive budget is developed when the budgets of all departments are amalgamated using a common denominator which is money.

Another feature of the flexible budget is based on its highlighting business resources and operations. As a planning mechanism, budgets present all operations that a firm aims to execute, alongside the resources it intends to deploy (Derfuss, 2016). Key aspects of operations in firms are revenues and expenditure. Budgets give details about revenues and related expenses pertaining to each activity (Derfuss, 2016). In addition, another feature of the flexible budget is that it is a plan of future operations. Hence, it is a forecasting tool.

Flexibility is one of the distinguishing features of the flexible budget. In general, budget approximations are focused on some targets. All functional budgets are premised on the expected level of activity (Garrison, Noreen & Brewer, 2008). In the case of a flexible budget, recognition is paid to the difference in how fixed and variable costs behave in reference to the output level. Thus, the budget design allows to make changes based on the variations in the above relationships.

Role of Budgeting

The significance of a flexible budget cannot be overemphasized. For instance, such budgets give a sensible comparison of budgeted costs and variance allowances (Garrison, Noreen & Brewer, 2008). Through such comparisons, an organization becomes ready to handle differences in the market decisively. It is also evident that flexible budgets play the role of streamlining operational realities by harmonizing the aspects of control and profit (Daumoser, Sohn & Hirsch, 2016). The flexible budget provides a balanced view based on different cost and output variations. In practice, during the preparation of a flexible budget, actual activity costs are compared to budgeted costs thus the approach is useful in illuminating the decision-making process.

In business, tracking expenditures is essential. Budgeting facilitates such exercise by providing business owners with a detailed account of how the resources are used (Garrison, Noreen & Brewer, 2008). A big percentage of businesses complete their budgeting processes annually. However, it is possible to track the variances in the budget on a monthly basis. Through monthly analyses of variances, businesses are able to understand where money is spent in comparison to the generated revenue (Garrison, Noreen & Brewer, 2008). The implication is that it is possible to identify wide variances between estimates and actual financial outcomes. The findings can inform about the need to review the budget.

Often, budgets are useful in generating performance reports.  On this basis, Daumoser, Sohn and Hirsch (2016) asserted that budgeting is thus critical in stating and evaluating the performance of an organization. The evaluation process targets both financial and non-financial matters that contribute to budget variances which go beyond the accepted variation. Cost of resources or additional expenses largely contribute to increases in budget statistics (Daumoser, Sohn & Hirsch, 2016). On the other hand, financial overruns are linked to sub-standard resources that require replacement, or a need for more workers to carry out the production. Therefore, budgeting is also important for performance monitoring.

Reference to the flexible budget also shows some usefulness of budgeting. The flexible budget works on the concept of variability thus, it plays a facilitative role in logical comparisons between approximate and actual expenditure (Van Roestel, 2016). Therefore, it is a means of budget control. 

The static type of budgeting is vital as well. Static budgets are significant because they play the role of helping in the identification of costs or expenses that are necessary, and those that are unnecessary (Van Roestel, 2016). In addition, the calculation and payment of fixed costs first ensures that important bills are settled before funds run out. After the settlement, remaining resources are used for variable costs.

Static budgets propose a spending limit. Although it is easier to calculate the amount of fixed costs such as land, mortgage and loans expenses, it is difficult to determine the value of variable costs such as gas and groceries (United States Government Accountability, 2015). Limits are set based on months, weeks or other durations to help organizations operate within their resources.

Preparation of Flexible Budget

Usually, the preparation of a flexible budget is based on three approaches namely: the multi-activity/ tabular method, ratio/ formula method or charting method. The tabular approach to the preparation of a flexible budget takes cognizance with the idea that different levels of activity exist in budgeted figures and horizontal columns against dissimilar activity levels across the vertical columns (Mikesell, 2013). In practice, the expenses are divided into three categories: fixed, semi-variable and variable cost. For any activity or level, the budgeted figures are obtainable through interpolation. The charting method makes estimates of expenses for different activity levels based on the classification of expenses into three groups, namely: fixed, semi-variable and fixed costs (Mikesell, 2013). A graphical representation is then used with the approximated expenses being plotted on the Y-axis, and the activity level on the X-axis. In this regard, the corresponding budgeted expenses with the activity level can be read and assessed.

The third method differs from the above two. Under the formula/ ratio method, the preparation of the budget takes into account the standard level of activity against the variable costs for each unit of activity (Mikesell, 2013). Drawing an expense budget for a given level of activity takes the following perspective: Fixed Cost+ (Actual activity units × Variable Cost for each unit) (Mikesell, 2013). As an illustration, if the overhead expenses of a budget for a standard-level activity of 80% activity is 90 000 dollars, and assuming that the expenses budget comprises $50 000 Fixed Costs, and $40 000 Variable Costs, then Variable Cost per one percent activity is $ 500 ($ 40 000/ 80).

Assuming that the actual level is 75%, the budget expense allowable is as shown below. (Fixed Cost = 50,000) + 75 x $ 500 (Variable Cost) = $ 87,500.

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Advantages and Disadvantages

A flexible budget comes with a number of advantages as well as disadvantages. Regarding benefits, Van Roestel (2016) noted that a flexible budget is advantageous for purposes of comparison. Such a budget allows a business to compare actual costs/ sales against targeted or expected sales and costs. For instance, a flexible budget for a hotel might comprise performance figures based on 100, 200, or 300 revelers served in a week. Hence, the figures provide an overview of organization’s overall performance level. Hence, the budget helps the business to assess if it is achieving its goals, or underachieving.

Hindsight is essential in business. In practice, enterprises prepare flexible budgets after the lapse of the 1st financial quarter (Derfuss, 2016). Consequently, a flexible budget depends on hindsight because such knowledge is necessary to make adjustments deemed necessary. The reliance on previous records to adjust budgets is useful although such dependence might not capture the future accurately. Regardless, the ability to forecast based on previous performance is advantageous because such information, if harnessed well, can give an approximation of future behavior.

One of the obvious advantages of the flexible budgeting method is its capacity to generate real-time data for use. The budget offers instantaneous data on forecast versus expected outcomes pertaining to output and costs, as well as the efficiency in the management of the production process (Derfuss, 2016). As a result, flexible budgets provide greater cost control compared to static budgets. This leads to the observation that flexible budgeting is critical in organizations where performance is falling.

One of the disadvantages of the flexible budgeting approach is its dynamic nature. As already observed, the method allows for variation of costs based on changes in the environment. Although a plausible allowance, in case changes are needed, the approach eliminates certainty (Derfuss, 2016). Businesses do not have clear budgetary allocations because they are dependent on circumstances. Thus, the uncertainty created by the approach might undermine planning which is the essence of budgeting.

One of the concerns related to the flexible budgeting method is its dependence on some results in the process of creation. Mikesell (2013) noted that, initially, flexible budgets rely on historical data retrieved from static budgets. The implication is that using a flexible budget might raise concerns about the right level of resources necessary to satisfy prevailing needs, albeit in the first time. Consequently, rapid growing units or organizational departments might be underfinanced while at the same time, others are overfunded. Flexible budgets become more accurate only after accumulation of sufficient data

Flexible Budgeting and Static Budgeting Comparison

The two budgets show similarities and differences. According to Mikesell (2013), a flexible budget is believed to be more accurate than the static budget in highlighting requirements for additional cash allocations to inputs and projections on sales. Regardless, static budgets are less complex, easier to design and to use (Garrison, Noreen & Brewer, 2008). Given that a flexible budget is focused on adapting resource inventory and deployment, it is deemed capable of providing a precise degree of control over organizational processes in comparison to the static budget. It is also held that variable budgets are better in attempts to predict the future, and facilitating adjustments based on unexpected external factors which influence productivity.

The preparation of the budgets also exhibits differences. A static budget is a typical budget that incorporates values and inputs as well as outputs before the production process begins in the preparation of estimates (Daumoser, Sohn & Hirsch, 2016). One of the key features of static budgets is its fixed nature. By helping in the computation of fixed expenses and placing spending caps on variable costs, static budgets also play in controlling costs.

A static budget does not allow for changes as time moves. This is unlike the flexible budget that incorporates alterations based on periodic business performance (Derfuss, 2016). For instance, in static budget, if the sales commission is set at 1 000 dollars, the estimate remains regardless of whether the salesperson breaks the record or fails to meet the goal. However, in the case of a flexible budget, the performance influences the budget figures, thus, adjustments will be made either to 1 200 or 800 dollars, depending on the performance. Based on the above account, capping estimates are useful in controlling business costs and providing a degree of certainty pertaining to organizational finances. In other words, when using the static budget, an entity is on the way to maximize its savings.

Budget mobility is an essential attribute in business. Unlike the flexible budget, the static budget lacks mobility (Derfuss, 2016). The absence of mobility implies that an entity lacks the ability to redistribute resources based on emerging needs or changing business circumstances. Thus, enterprises using static budgeting approach feel disadvantages when it comes to taking advantage of opportunities in markets or address unfavorable occurrences such as breakdown of machinery. In such circumstances, a possibility exists that organizations suffer a drag on its revenue streams which might lead to losses. Such concerns are not experienced if flexible budgeting is applied.

The manner in which the budgets resolve the issue of variance shows a departure. In a bid to control for variance, static budgets allocate excess resources to cater for unexpected changes (Mikesell, 2013). Therefore, inventory is likely to be affected by the approach. On the contrary, a flexible budget is designed after the actual volume of sales is determined (Dess et al., 2012). Hence, the aspect of variance is greatly reduced.

Who Uses Flexible Budgeting

Given the ease to vary the budget, the flexible type of estimates are ideal for some companies only. To begin with, new businesses find flexible budgeting ideal because it is not easy to forecast the demand for their products (Daumoser, Sohn & Hirsch, 2016). In addition, the budget is useful to organizations that work in a cyclical way, meaning that the demand for their output varies across periods. Moreover, business entities that operate in an environment characterized by shortages of production factors might use the budgeting method. Hence, if the level of productivity depends on the availability of products, then the business must adopt flexible budgeting. Another entity that would benefit from flexible budget is one that deals in fashion products. Given the unexpected variations in the demand for fashion products, it is necessary to use flexible budgeting in order to allow for unforeseen market changes.

Publicly-traded companies show a tendency of using both static and flexible methods of budgeting. The entities produce yearly static budgets in order to guide investors and analysts a predictable perspective of business (Daumoser, Sohn & Hirsch, 2016). On the other hand, such businesses develop short-term budgets that are flexible in nature to cater for the uncertainty in the business environment. 

Conclusion

 

The flexible budget seems appropriate for businesses operating in uncertain conditions. However, the choice between static and flexible budgeting depends on many factors. For instance, the type of business plays a n important role. In addition, the variance or discrepancy on contraction or expansion of profits also influences the choice of the budgeting approach. The variance is affected by business expenses (whether fixed or variable). Given the pros and cons of the static and dynamic budgeting, organizations would benefit from using both methods to develop a yearly static budget and supplementary monthly/ quarterly flexible budgets. It may be concluded that the budgeting process influences the performance of the business since it influences the use of resources. The differences in static and flexible budgeting support the adoption of both methods in a supplementary manner.

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