The issue with a static budget is that it is out of date before the first month-end makes its appearance. When this happens, a tremendous of amount of energy is spent month after month “explaining the numbers” when they may not need to be explained or can be explained in much simpler terms. The solution is flex budgeting. A flex budget is a budget where costs are adjusted based on changes in activity levels of the business like sales volumes or production output.
Flex budgeting actually helps on two fronts. First, it will reduce the amount of time to prepare the budget once the model has been created. Second, once the new budget year starts, it will ensure that more meaningful discussions are the focus of variance analysis instead of arbitrary line-by-line comparisons to a static budget that bears no resemblance to reality.
Preparing a flex budget model does require some upfront work but the end result is well worth the extra effort. You will need to determine the nature of the various costs within your business. Are they fixed, variable or step costs? You will also need to determine what drives each of the variable and step costs. Is it sales, headcount, machine hours or some other driver? Once all of these determinations are made, the budget model can be built so it’s only necessary to update the assumptions about the values of the drivers and then many costs will be automatically calculated. An examination of historical trends will help in verifying the relationships between drivers and costs.
Once the fiscal year starts, actual results are compared against the flex budget which is calculated using the budgeted assumptions and the actual value of the activity level (usually sales volume). By doing this, there is no variance between actual and budget for sales, and the focus of any analysis work can center around costs. Yes, it is important to understand why sales differed from what we budgeted but with a flex budget that discussion can stand on its own. There is no cross-contamination between sales and costs to muddy the analysis waters. And without complicated analysis work, everyone can get to the root cause of cost issues and how to improve the bottom line much quicker.
A word of caution here — DO NOT take the easy way out and build your budget model so everything is calculated off of a single driver like sales volume. The predictive and analytical value of the flex budget goes into a nosedive when you do this. Take, for example, benefits which are directly related to the number of employees on staff. Yes, there may be an indirect correlation between the cost of benefits and sales volume since a certain number of people are needed to support sales. But since the number of people needed will probably stay constant over a certain range of sales, the cost of benefits is not a 1:1 ratio when compared to sales. Therefore, calculating benefits as a percentage of sales will not give you a meaningful number to compare against actual spend. You are far better off spending the time to have the model first determine the number of employees for the sales volume and then calculating the benefits cost based on the number of employees.
This is a simple introduction to the concept. A good flex budgeting model is very robust and requires everyone in the business to determine how revenues, costs and other drivers come together. This deeper understanding ensures that the focus of each person is on how to improve the bottom line.