Question

Compare planning budgets vs flexible budgets.

Be thorough in describing what each is, and the differences between them. Conclude with what the best use is for each.

Answer 1

Answer:

Definition of a Plan Budget (static budget)

A budget is a financial plan for a defined period, often one year. It may also include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows . Therefore, Creating this spending plan allows you to determine in advance whether you will have enough money to do the things you need to do or would like to do. If you don't have enough money to do everything you would like to do, then you can use this planning process to prioritize your spending and focus your money on the things that are most important to you

Since Planning budgeting allows you to create a spending plan for your money, it ensures that you will always have enough money for the things you need and the things that are important to you. Following a budget or spending plan will also keep you out of debt or help you work your way out of debt if you are currently in debt.

A static budget is a budget that does not change as volume changes. If a company's annual master budget is a static budget, the budget for sales commissions expense will be one amount such as $200,000 for the year. In other words, in a static budget the budgeted amount for sales commissions expense will remain at $200,000 even if the actual sales during the year are $3 million, $4 million or $5 million.

In contrast to a company's static master budget, the company's sales department might have a flexible budget. In the flexible budget, the sales commissions expense budget might be expressed as 5% of sales. In that instance, the department's budget for sales commissions expense will be $200,000 when actual sales are $4 million, but it will decrease to $150,000 when actual sales are $3 million, and the budget will increase to $300,000 when actual sales are $6 million, and so on.

Definition of a Flexible Budget
A flexible budget is a budget that adjusts or flexes with changes in volume or activity. The flexible budget is more sophisticated and useful than a static budget. (The static budget amounts do not change. They remain unchanged from the amounts established at the time that the static budget was prepared and approved.)

For costs that vary with volume or activity, the flexible budget will flex because the budget will include a variable rate per unit of activity instead of one fixed total amount. In short, the flexible budget is a more useful tool when measuring a manager's efficiency.

Example of a Flexible Budget
Let's assume a company determines that its cost of electricity and supplies will vary by approximately $10 for each machine hour (MH) used. It also knows that other costs are fixed costs of approximately $40,000 per month. Typically, the machine hours are between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be $40,000 + $10 per MH.

Now let's illustrate the flexible budget by using different levels of volume. If 5,000 machine hours were necessary for the month of January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH). If the machine hours in February are 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH). If March has 4,100 machine hours, the flexible budget for March will be $81,000 ($40,000 fixed + $10 x 4,100 MH).

Difference between Plan Budget and Flexible Budget:

Following are the main differences :

1. Nature
A static budget does not change with the actual volume of the output achieved. A flexible budget is designed to change appropriately with the level of activity attained.

2. Scope
A static budget cannot ascertain costs correctly in case of any change in circumstances. Flexible budget can easily ascertain costs in different levels of activities.

3. Determination Of Cost
Static budget is prepared under the assumption that all conditions will remain unaltered. Flexible budget is prepared at different levels of activities considering the possible changes in the operational aspect of a business.

4. Assumptions
Static budget has a limited application and is ineffective as a tool for cost control. Flexible budget has a wide application as an effective tool for cost control.

5. Pre-requistes
Static budget is prepared without classifying the costs according to their variable nature. Flexible budget is prepared by classifying the costs according to their variable nature

Conclusion:

A flexible budget is one that is allowed to adjust based on a change in the assumptions used to create the budget during management's planning process. A static budget, on the other hand, remains the same even if there are significant changes from the assumptions made during planning.

The greatest advantage that a flexible budget has over a static budget is its adaptability. In the real world, change is real and it is constant. A flexible budget can handle that reality and better position a company for the challenges of the marketplace

Not all line items in a budget can be flexible. For example, a company's rent expense is likely fixed for the entire year. It's unrealistic to expect that to change every month or even every quarter. In either a flexible or static budget, the rent is what it is.

Other expenses though are not so simple. For example, a hiring plan may hinge on signing a large new customer to a long term contract. Or, if a sales and marketing plan works much more effectively than anticipated, then management should consider increasing the investment in those campaigns above what was originally budgeted.

In a static budget, the company would not have the ability to tweak the budget to manage the changes if that large client contract doesn't materialize or if sales grow faster than anticipated. Management could, and most likely would, adapt to those changes, but at year-end there would be large budget variances that do not provide any analytical value to better plan for the following year

The flexible budget solves this problem, providing both senior executives and middle management with dynamic guidance on how much to spend based on the business' changing reality.

In this way, the flexible budget is able to account for both fixed and variable expenses in a better, more responsive way than the simpler static budget could.

Therefore, Every business will be unique in its budgeting needs. Each will have different considerations, different business models, and individual uses for the budget. The key for management is to consciously make decisions on how to budget based on sound logic. For a small, simple business a static budget may be appropriate. However, for larger and more complex businesses the use of a flexible budget is essential