A budget doesn't just determine how a company should spend its money. The budget also helps a company evaluate its performance over time. All budgets have flexibility, as unpredictable changes can affect how a company should allocate its funds. A flexible budget, also called a flex budget, is extremely useful due to the dynamic changes that most firms encounter throughout an accounting period.
Companies prepare flexible budgets at the end of an accounting period to compare how they actually spent their money with how they had planned to spend their money. The flexible budgets show how they truly spent their funds. The original budgets, the static budgets, show how they had expected to spend their funds.
For instance, if a business's static budget predicted $2.48 million in sales during one quarter, and the company sold $2.52 million, the flexible budget would record the latter. This shows a favorable variance of $40,000. If the company had planned to spend $8,300 on equipment but actually spent $10,200 because of breakdowns, the flex budget would show the latter.
Flexible budgets also allow companies to model how they might allocate their funds in lieu of particular changes. A company can prepare an array of flexible budgets that each reflect a different scenario. This is termed pro forma analysis.
For example, a hotel might create a budget showing what its profits and expenses would be if it had 10,800 bookings that year. The hotel might also create a budget showing profits and expenses for booking 8,000 rooms and 5,000 rooms that year. Each version would adjust various items in the budget, not just earnings. For example, if business booms the hotel might need to hire new employees or pay overtime, and to buy new linens.
Each budget would estimate how much these items would cost in the scenario it depicts. To create these budgets, the company first must identify fixed costs, such as mortgage payments, and variable costs, such as supplies and advertising.
A company can create a flexible budget to show what it spent and earned, and its total equity (profits returned to the company and stockholders), over a long period. For instance, the company might create a flexible budget reflecting its performance over the past five years, or since its creation. This shows stakeholders how well the company has performed overall. Adding all the static budgets together would show how much the company had expected to earn, showing stakeholders whether the company has met its own standards.
A store might create a flexible budget to reflect its short-term achievements or shortcomings, such as the previous week's sales. For instance, if a store earned $52,000 in a week when the static budget predicted $45,000, the manager might prepare a flexible budget to determine what factors played a role. The flexible budget might show that the company paid employees $15,000 in wages instead of $13,000, reflecting extra hours that they worked. This would suggest that the extra hours were a good investment. By comparing short-term budgets each day or week over time, a manager can track factors that make a difference in the company's success.
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