Relationship Between Fixed & Variable Costs Used in a Flexible Budget

Two overarching types of budget exist in the world of business, fixed and flexible. The flexible model of budgeting takes into account fluctuations in the certain costs on account of trends in markets and the economy. In addition to variable costs, flexible budgeting also takes into consideration fixed costs. The relationship formed between fixed and variable costs lies at the heart of flexible budgeting and impacts the ultimate framework of an actual budget created on the flexible model.

Flexible Budgets

Flexible budgets consider two types of costs common to companies, fixed and variable, or those that change and those that don’t. When creating the variable cost portion of the budget, companies create a variety of potential cost values based on various market conditions, such as ideal, expected, worst case and more. Flexible budgets exist in a state of constant flux, as the rise or fall in variable costs on a regular basis changes the apportioning of funds. Because of this, companies often set aside the absolute maximum assumed by a budget for variable costs, to avoid withdrawing funds from other aspects of the business to cover variable costs. For example, doctors’ offices require flexible budgeting due to the unpredictability of patient volume and thereby necessary supplies and manpower.

Fixed and Variable Costs

Variable costs constitute those business expenses with changing and often unpredictable price tags. These costs generally change in direct relationship to the demand for products or services. For instance, a rise in product demand precipitates a rise in labor and materials costs. For a concrete example, heavy snows mean more business for snow removal companies, though also higher costs for labor and gasoline. Fixed costs constitute all elements of a budget remaining the same indefinitely. These costs often constitute those over which a business exerts complete control. A business chooses, for instance, exactly how much to spend on marketing each year, but cannot always predict labor needs and, therefore, labor costs.

The Relationship

Variable and fixed cost budget elements maintain a close relationship. Every company maintains a budget ceiling, or maximum amount it may spend. Within budget limitations, a company must balance the needs for variable costs with fixed costs. A push and pull exists between these budget elements. For instance, assume a company wants to spend $100,000 on marketing in a month but needs at least $65,000 to cover monthly variable labor costs, and has only $150,000 for both. The business must decide whether to risk losing capital through inflated budget costs by reserving only $50,000 for labor and putting a full $100,000 towards marketing, or diminish the scope of its marketing campaign by fully funding labor costs. Some costs, such as loan repayments, remain absolutely fixed and must be subtracted from an overall budget before even considering variable costs.

Benefits of Flexible Budgets

Flexible budgets provide businesses with various advantages. First and foremost, these budget models allow changing budgets and re-apportioning funds on a daily basis, thus allowing companies to adjust to changes in markets and the economy in real time. Furthermore, flexible budgets lay out all of a business’ costs month-by-month, allowing accountants to see relationships between rising and falling costs. Identifying these relationships help businesses understand how to inject the operating capital into the company to optimize profits while controlling, or at least minimizing variance in, cost.