Flexible budget: everything you need to know

What is a flexible budget? A budget is a budget, right?

A flexible budget is a unique kind of budget that accounts for variances in business activity and provides a plan forward for them.

In other words, it helps businesses stay nimble.

But how do you create a flexible budget? And why else might you want to use one? And isn't too much flexibility a waste of time?

We'll get into all that and more in this article.

What is a flexible budget?

A flexible budget is a budget that can be adjusted for changes in business activity like sales or production volume. Typically, these adjustments are predetermined so as to avoid scalability challenges, like taking on more clients than the company can reasonably handle.

It's often mentioned in the same breath as the static budget, which is based on a fixed level of activity or output.

Why do companies use flexible budgets?

Because flexible budgets allow companies to adjust how much they spend on different business activities, it helps them more effectively manage their cash flow. Flexible budgets, to state the obvious, help companies be more flexible with their spending.

Flexible budget example

Here's a quick example to illustrate the benefit of a flexible budget.

Say a company's paid advertising channel is performing well and generating more revenue than was expected. A flexible budget gives the company the green light to reinvest more of that revenue back into the channel.

This should lead to even more profit.

However, it can also lead to scalability challenges if the sales and customer success teams aren't able to handle more accounts than were "budgeted" for. A robust flexible budget will have a plan for these scenarios and allocate funds accordingly.

Let's say there's an unexpected expense. With a flexible budget, assuming you've created a scenario where there's an unforeseen expense, you have a plan to follow.

Flexible budget vs. static budget

A flexible budget provides guidelines for a company to change their operations—to invest or divest in business practices—based on some external factor, typically revenue from those activities.

A static budget provides no guidance or allowance for change. It's more rigid and its outcomes are more clearly defined.

Flexible budget variance formula

Flexible budget variance is any difference between the results generated by a flexible budget and actual results from following that budget.

The flexible budget variance formula is pretty simple:

Flexible budget variance = (Actual amount - Flexible budget amount)

A positive (or favorable) flexible budget variance number means you came in "above plan," while a negative (or unfavorable) number means you weren't as profitable or you spent more than you expected.

Basic vs. intermediate vs. advanced flexible budgets

We can categorize flexible budgets into three types based on their influences and complexity.

Basic flexible budget: This kind of flexible budget only allows for changes based on revenue numbers.

Intermediate flexible budget: This considers other activities which might cause a change in revenue or business activities, such as headcount changes or number and complexity of clients.

Advanced flexible budget: This type of flexible budget considers various expenses across the company, like product launches, ratios like the SaaS magic number or the debt-equity ratio, and dividends from investments.

Most companies that build flexibility into their budget will use a basic flexible budget.

Benefits of a flexible budget

Why would a company want to use a flexible budget? As it turns out, the ability to respond to the actual performance of your company can be useful for maintaining the status quo and for growing faster than expected. Uncertain market conditions make the case for the flexible budget, as it's more certain that a single plan won't be followed.

Good for companies with variable costs

Companies with variable costs require flexible budgets because this kind of budget allows them to course correct or account for that variation with minimal disruption to their operations.

For example, a company with a large seasonal variation should have a flexible budget to account for the increase and drop in supply and demand according to the seasonality.

Performance measurement

Nothing's better than telling the company that you're on plan. And with a flexible budget, you have multiple contingencies to stay on plan. 

Because you've planned for variances in the budget, you know exactly which path to follow to maintain the trajectory that'll keep the company on plan.

More efficient budgeting process

Flexible budgets are efficient because they do all the work while you're making the budget. While this results in a longer initial budget time, it makes for a much faster overall budgeting process, since you (ideally) don't need to re-forecast scenarios or calculate new projections.

Better cost controls

Predicting your costs ahead of time is a great way of controlling them. Since a flexible budget empowers the finance team to think ahead and rein in spending under certain scenarios, it gives the finance team much more robust cost controls. This helps keep the over budget variance down, which is a good thing.

Accounts for unforeseen expenses

A flexible budget, by its nature, will account for unforeseen expenses to some degree. While the magnitude of the unforeseen expense(s) might not align with what you've created in the budget, the path you've laid out for the business will in many cases be applicable, with some adjustments to the raw numbers.

More accurately reflects how finances are used

A company is a living entity, and a budget should be, too. While it's great to have an ideal, static budget, the flexible budget is more true to how companies and budget owners actually assess their finances.

Limitations of a flexible budget

Of course, flexible budgets aren't unilaterally good things. Like anything else, they have their drawbacks.

More time-consuming to create, develop, monitor, and maintain

Because they're necessarily more complex than static budgets, and because they're by definition not "set it and forget it," flexible budgets require a lot more brainpower to create, and they also necessitate a close monitoring to follow. This can lead to some strain on an already thin-stretched FP&A team.

Too much flexibility can limit FP&A's ability to plan

It's possible to have too many plans, inasmuch as a company's ability to plan is limited by the number of hours its team(s) can use to create plans. Budget leaders should be careful not to let the flexible budget—especially advanced flexible budgets—become a runaway train of complexity.

Predictions have a shorter lifespan and become outdated quickly

While flexibility is great, sometimes something unexpected happens that invalidates all the work you did before.

Companies around the globe experienced this in March 2020 when the COVID-19 pandemic required lockdowns that grounded much of the economy to a halt. Models and projections were scrapped, and companies that had spent a lot of time and resources on creating a flexible budget saw huge amounts of their time and effort invalidated.

Less accountability or incentive for budget owners to adhere to the original budget

The knowledge that the budget can be adjusted can be a green light for some budget owners to play with their spending. Be careful to set expectations with them that deviations from the budget come from the FP&A team.

Closing delays can cause friction with the accounting team

While the ability to adjust the budget is nice, it can create a lot of headaches for the accounting team, especially when they have to redo much of their work for closing the books, turning a process that's frequently delayed due to unforeseen circumstances into something even later.

Lack of revenue comparisons

One of the biggest advantages of the consistency inherent in a static budget is the clean comparisons that it allows for. But a flexible budget introduces much more variance, which makes it difficult—if not outright impossible—for a team to perform an accurate revenue comparison or variance analysis based on an ideal or former scenario.

What is flexible budget variance?

Flexible budget variance is the difference in spending or revenue between the base or original budget and the budget that was flexed into.

Flexible budget variance example

For example, say a company budgets the COGS of a $100 product at $20. But after running the numbers they find the COGS is $25. They increase the cost of the product to account for this variance and make 50 of their 100 product sales during this reporting period at this new price. Their flexible budget variance for this product, therefore, is -$250 (50 units sold with $5 more COGS than budgeted, or -$5).

5 steps to successfully implementing a flexible budget

If you've decided that a flexible budget is the right path for your organization, here's how to successfully implement one.

1. Identify fixed and variable costs

It's essential that you identify where variances can exist. For example, costs like rent, debt repayments, or PP&E are likely to remain fixed and consistent. But costs like sales and marketing spend can vary wildly.

Separate out the variable costs. This will vastly reduce the amount of scenarios you need to create.

2. Use the variable cost ratio to create a budget model

The variable cost ratio compares the costs of increasing production to the resulting revenue. In this step, you want to identify your variable cost ratio for each product, good, or service you sell, and create a model that you can use for your scenario analysis in the next step.

The formula for the variable cost ratio is as follows:

Variable Cost Ratio = Variable Costs / Net Sales

Alternatively:

Variable Cost Ratio = 1 – Contribution Margin

3. Model different scenarios with the budget model

Now that you have a budget model, it's time to model scenarios. You should model scenarios based on the cost variance that is likely to occur, with some leeway for unexpected scenarios.

An FP&A tool like Prophix is great for this step.

4. Decide on your budget

Now that you've mapped your numerous scenarios, it's time to assign some budget numbers and parameters. This is more of an art than a science, but you should begin by prioritizing via a conservative budget and then layering on more convenient or superfluous expenses.

Any budgeting method works here—you can use incremental budgeting for a basic flexible budget, or zero-based budgeting to completely rework the budget.

5. Compare your budget model with actual expenses with variance analysis

Finally, you want to compare your actual expenses to your budget and evaluate how effective and accurate your flexible budget was.

Budget variance analysis is an essential final step of any budgeting process and a necessary prerequisite to the next budgeting cycle.

Understanding and evaluating your previous budgets will help you create a more accurate future budget, which makes everybody's job easier and stabilizes the company's finances.

Conclusion: Flexible budgeting with Prophix

Now you know all about how to create and use a flexible budget.

And if you'd like to create a flexible budget for your organization, Prophix can help. With Prophix, you can quickly and easily create scenarios and calculate your budget analysis, minimizing the two biggest time sucks of the budgeting process.

Sound intriguing? Click the link to get a demo.