VLSM (Variable Length Subnet Mask) allows efficient allocation of IP addresses by using subnets of different sizes based on network needs. This example shows how VLSM can fulfill the address requirements of different departments within a company using a single Class C IP address, whereas FLSM (Fixed Length Subnet Mask) would waste many addresses. The tutorial outlines the steps to perform VLSM subnetting to allocate specific subnet sizes and addresses to each department and network based on their requirements in a way that minimizes wasted addresses.