It’s a core tenet of business to maximize profits by minimizing costs. This is typically upheld by businesses creating forecasts to predict business activity, and then setting budgets with maximum spend levels so not a single dollar goes through unchecked.
As time goes on, the budget gets updated with actuals: the real world financial figures. They may spot areas where they’re over or underspending and adjust.
But what about if their sales activity is different than expected? What does that mean for all of their expenses that they planned for based on their projected sales?
When financial pros want a budget that has the ability to shift based on real world sales outcomes, they turn to flexible budgets. And if you want to maximize profits no matter the sales number, you should read on to get familiar with them.
What is a flexible budget?
A flexible budget is a method of budgeting that allows for changes based on the activity and output of the business.
Budgets set strict controls on how much a business can spend on specific expense categories. The purpose is to keep expenses in check to maximize the business’s profit in a specific period of time.
But budgets are also built off of assumptions of how the future is going to play out. What happens if these assumptions don’t hold? What if sales activity is higher or lower than expected?
A flexible budget enables the business to make changes on the fly based on how things play out in the real world. It incorporates variable factors, like costs changing or volume of sales.
Static budget vs flexible budget
If a budget isn’t flexible, it’s static. So what exactly is a static budget?
Static budgets don’t adjust based on sales activity. All expense levels hold steady regardless of what the real world outcomes are.
Most businesses create a static budget based off of a certain expected volume, typically taken from a financial forecast. It’s a useful starting point for setting budgets, but will not take into consideration whether the actual activity is in line with expectations.
This doesn’t mean that a static budget is valueless. It’s still an important starting point in creating a flexible budget and is commonly used in businesses.
Three types of flexible budgets
Flexible budgets have three levels, varying in complexity.
1. Basic flexible budget
Basic flexible budgets will only adapt expenses that are directly tied to revenue, like cost of goods sold or labor costs that apply to service fulfillment. Any other are static and will not change with business activity.
The simplest form of a basic flexible budget will account for expenses as a percentage of sales revenue. So if the business expects cost of goods sold to be 20% of sales revenue, the budget adapts based on the actual sales number.
2. Intermediate flexible budget
Intermediate flexible budgets includes additional expenses that may vary with activity, but are not directly tied to revenue. An example of this would be the salaries and wages of customer support workers whose workload would increase with sales, but not drive sales.
A good way to think about intermediate flexible budgeting is to identify what are the costs that you would spend more or less on based on the business activity. If you could split one dollar proportionally across those costs, how would you do so? It’s possible to bake this distribution into your flexible budget.
3. Advanced flexible budget
With an advanced flexible budget, all costs (including fixed and variable costs) are tied to changes in activity.
This is the most complex level of flexible budgeting. It requires identifying the connection between sales revenue and each expense category and incorporating that information into a fully dynamic budget.
The payoff is a budget that flexes completely based on sales activity, but it requires the most amount of work to set up.
Benefits of using a flexible budget
If you start using flexible budgets, you’ll start to see some of the following positive effects on your financial planning.
Adapting to real world results
Budgets are typically made in conjunction with a forecast which is built off of assumptions. These assumptions may or may not turn out to be true.
Using a static budget means that you’re holding costs constant no matter what’s happening in the real world results. This could result in underspending and failing to capture sales activity or overspending and missing hurting your bottom line.
A flexible budget offers the wiggle room to adjust and adapt based on actual activity so the business is always doing what’s best in the moment.
Decisions driven by data
Flexible budgets are always tied to sales activity. Because the expense levels adjust based on that activity, they will always be driven by real world data.
Sometimes, you may know that a budget needs to be adjusted, but you may not know how to change the budget. A flexible budget answers that question given that expense levels are dynamic.
Compare a flexible budget against an alternative like scenario planning, a practice that involves building out budgets for different assumptions (e.g. individual budgets for a 5% increase, 10% increase, and 15% increase in sales each.
Keeps costs in check
When things are going well, you want to spend to capitalize on that activity. But when things aren’t going well, businesses need to make tough decisions on what to cut.
Using a flexible budget helps you identify where you need to reduce spending to protect your bottom line. You’ll always have an idea of what you need to do based on the amount of sales activity.
And if things are going better than expected, you’ll know just how much extra cash you have to work with so you don’t overspend.
Important components of a flexible budget
A flexible budget can be broken up into four components.
Sales activity
Sales activity can be measured in sales revenue, units sold, projects completed, or anything else that’s an indicator of sales volume.
This is the component that the rest of the flexible budget is contingent on. The measurement you use should reflect how your business operates and what your costs are tied to.
An e-commerce shop that sells socks could look at units sold while a lawncare company could look at completed projects. Either could also use sales revenue.
What’s important is that there’s an established logic behind what you’re using to measure sales activity and the costs that will “flex” based on it.
Variable costs
Variable costs are costs that change based on sales activity. These are the costs that you’ll first look to as adjusting based on your measurement of sales activity.
Examples of variable costs include raw materials used in production, shipping costs, and packaging.
Fixed costs
Fixed costs are constants regardless of the level of sales activity. In advanced flexible budgets, they are treated as something that can change, but in most cases, businesses will not flex the expense level associated with them.
A prime example of a fixed cost is rent, especially if it’s on a long-term lease. Not only does the cost not change, but it’s hard to get out of a lease or negotiate the rent price.
Semi-variable costs
Semi-variable costs are treated as a fixed cost up until a certain point, at which point they become a variable cost.
For example, you may have employees who work in manufacturing. Their total capacity may be 1,000 units so you treat their salary and wage as a fixed cost if manufacturing is 1,000 units or less. But if demand surges to 1,500, you may need to hire additional employees.
These costs can be treated as tiered expenses. If sales activity hits a certain point, you add an additional amount of budget (e.g. for each 500 units sold, increase budgeted wages by $1,000).
How to create a flexible budget
Creating a flexible budget can be done alone, but it’s worthwhile to consult with members of other teams to figure out some of the following steps.
- Decide on your sales activity measurement: It’s easiest to start with sales revenue, but you may want to use a different measurement of sales activity that better reflects your operations.
- Estimate baseline costs: Start with creating a loose outline of a budget based on a forecast or past financial data.
- Define your variable and semi-variable costs: These are the costs that will change with sales activity.
- Create the flexible budget adjustment factors: For each of the defined variable costs, choose the adjustment factor based on your sales activity measurement (e.g. for every additional unit sold, increase the cost of goods sold budget by $5).
- Track actual performance: As the sales activity rolls in, incorporate this data into your flexible budget and adjust the expense levels as needed.
- Revise and adjust: Connecting expense levels to sales activity is tricky and you may not get it perfectly first try. Make sure the flexible budget is having its intended results and adjust your assumptions.
Example of flexible budget
A business is expecting to sell 10,000 units in a quarter and builds budgets based on this assumption.
However, the business is experimenting with a new marketing push which may push demand past the initial projections. To account for this, they decide to work with a flexible budget.
There are two parts of their budget that they treat as variable costs that are adjusted based on sales activity: cost of goods sold and salaries and wages.
Initially, they budget for $50,000 at $5 per unit sold. For each unit sold above 10,000 units, they will add an extra $5 to the budget.
They also know that one employee can approximately fulfill 1,000 units over the course of the quarter. Once they sell a unit above an increment of 1,000, they will account for an extra employee and budget for their wages (estimated at $10,000 for the quarter).
This is broken down into a table with different possible outcomes.
By using a flexible budget, the business can plan for the different possible sales outcomes and understand how it impacts their bottom line.
Simplify budgets with automated financial tools
Switching to flexible budgets helps you keep your costs proportional to revenue. But the positive effect only happens if you manage to stick to that budget.
Enter Bill Spend and Expense, an expense management platform and corporate cards with cost controls that give you complete control over spending. Spend less time approving expenses knowing that each purchase is checked against spending rules before being approved.
Reach out to schedule a demo and learn how this platform will help you forecast, budget, and hit your financial goals in the time ahead.
