To obtain an in-depth understanding of capacity budgeting, its pros and cons, and how to implement it.
- Budgeting has various classifications, forms, and models, but in all variations, the idea is to at least have some understanding of an organization's potential earnings and expenses.
- The term "capacity budgeting" or capacity planning dictates that an increase in revenue targets or sales should also be backed up by a proportionate increase in production capacity. That is, if a company is planning to increase revenue by 20%, it should also plan to increase sales expenses by the same 20%.
- However, a budget that is prepared at the beginning of the year and not changed until it's time to make a new one at the start of the next cycle is called a "static budget." Here, the proposed figures or individual budgets do not change throughout the entire year, regardless of anything that happens in the business environment — which seems closer to what was described in the notes.
- The opposite of a static budget is known as the "flexible budget." Here, a series of budgets are prepared to account for various levels of activities, revenues, and expenses. According to Investopedia, a static budget evaluates the effectiveness of the original budgeting process, while a flexible budget provides deeper insight into current business operations.
Implementation (Flexible Budget)
- When implementing a flexible budget, considerations must be made for a number of potential scenarios and the firm's responses to them. In flexible budgeting, all expenses are defined as a percentage of sales rather tied to a fixed figure.
- For example, if sales were to increase dramatically or in a manner that was not previously accounted for, flexible budgets would get adjusted to increase spending on marketing to take even more advantage of unexpected increases in revenues. If this scenario were to play out with a static budget, sales expenses would be limited as directed by the budget, and additional sales personnel or machinery would not be deployed to exploit the sudden increase in sales.
- So based on the above, if sales were to increase suddenly by 20%, then sales expenses are expected to increase by an additional 20% to cater for the sudden increase in sales.
Pros and Cons of Flexible Budgeting.
- With flexible budgeting, companies can take advantage of sudden increase in the market as illustrated above without having to result to the next budgeting cycle. It also helps the management of a company to determine the production level in different market and business conditions.
- On the other hand, the budget is more expensive to prepare compared to the static budget as skilled workers are required due to the complex nature of the budget. Also, a flexible budget runs the risk of forgoing fiscal discipline in its attempt to capture potential markets.
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