Budgeting Devices

Static budgets do not vary with volume. Each line item is a fixed amount. In contrast, a flexible budget is stated as a function of some volume measure. Flexible budgets and static budgets provide different incentives.

Static Budgets versus Flexible and Performance

Static budgets do not change as the level of services or volume levels increase or decrease. Thus, a deficiency with the static budget is the lack of flexibility to adjust to unexpected changes.

The static (or fixed) budget is suitable for a department whose workload does not have a direct relationship to sales, production, or other volume related to a department’s operations. The workload is determined primarily by management decision instead of sales volume. Some examples of departments in this category are administrative and marketing.

Fixed budgets may be used for projects involving fixed appropriations for specific programs, such as capital expenditures, advertising and promotion, and major repairs.

Emphasis on Flexible Budgets

A flexible budget is a tool that is extremely useful in cost control. In contrast to a static budget, the flexible budget

• Is geared toward a range of activity rather than a single level of activity
• Is dynamic in nature rather than static. By using the flexible budget formula, a series of budgets can be easily developed for various levels of activity.

A flexible budget is stated as a function of some volume measure. To prepare a flexible budget, the way costs respond to changes in volume must be known. Thus, four steps are involved in creating a flexible budget:

1. Estimate the range of expected activity for the period.
2. Analyze cost behavior trends, whether fixed, variable, or mixed.
3. Separate costs by behavior, that is, break up mixed costs into variable and fixed.
4. Determine what costs will be incurred at different levels of activity.

The static (or fixed) budget is geared for only one level of activity and has problems in cost control.

Flexible budgeting distinguishes between fixed and variable costs, thus allowing for a budget that can be adjusted automatically (via changes in variable cost totals) to the particular level of activity actually attained.

Thus, variances between actual costs and budgeted costs are adjusted for volume ups and downs before differences due to price and quantity factors are computed.

Note that a flexible budget is appropriate for marketing budgets as well as for manufacturing cost budgets.

Numerical Example I

To illustrate the difference between the static budget and the flexible budget, assume that the Assembly Department of Omnis Industries, Inc., was budgeted to produce 6,000 units during June.

Assume further that the company was able to produce only 5,800 units. The budget for direct labor and variable overhead costs is:

If a static budget approach is used, the performance report will appear in this way:

These cost variances are useless, in that they are comparing oranges with apples. The problem is that the budget costs are based on an activity level of 6,000 units, whereas the actual costs were incurred at an activity level below this (5,800 units).

From a control standpoint, it makes no sense to try to compare costs at one activity level with costs at a different activity level. Such comparisons would make a production manager look good as long as the actual production is less than the budgeted production.

Using the flexible budget formula and generating the budget based on the 5,800 actual units gives the next performance report.

Notice that all cost variances are unfavorable (U), as compared to the favorable cost variances on the performance report based on the static budget approach.