Flexible Budgets

Overview

• What you’ll learn: The difference between static and flexible budgets, how to construct a flexible budget, the flexible-budget variance vs. the sales-volume variance, and why static budgets lie about efficiency.
• Prerequisites: Lessons 1-3
• Estimated reading time: 16 minutes

Introduction

The Grand Historian records: A static budget is a portrait painted before the battle — it shows what we expected. A flexible budget is the battle report written after — it shows what we should have spent given what actually happened. Only by comparing the two can we separate the sins of poor planning from the sins of poor execution.

Horngren (Chapter 7) introduces the flexible budget as the bridge between the static (master) budget and actual results. It answers: “Given the actual level of output, what should costs have been?” This eliminates the volume effect and isolates the efficiency effect.

Static Budget vs. Flexible Budget

The Problem with Static Budget Variances

Consider: A factory budgets $500,000 for materials to produce 10,000 units ($50/unit). Actual production is 12,000 units at a cost of $570,000 ($47.50/unit). The static budget variance is $70,000 unfavorable. But the manager actually improved per-unit efficiency! The static budget condemns the efficient manager because it confuses volume growth with cost overrun.

Constructing the Flexible Budget

The flexible budget recalculates variable costs at the actual output level while holding fixed costs constant:

Flexible Budget Amount = (Variable cost per unit × Actual units) + Budgeted fixed costs

For the example above: Flexible budget = ($50 × 12,000) + Fixed costs = $600,000 + Fixed. Actual = $570,000 + Fixed. The flexible-budget variance is $30,000 favorable — the truth the static budget concealed.

Variance Decomposition

The total static-budget variance decomposes into two components:

Total Variance = Flexible-Budget Variance + Sales-Volume Variance

• Flexible-budget variance: Actual results − Flexible budget. Measures efficiency — how well did we perform at the actual volume?
• Sales-volume variance: Flexible budget − Static budget. Measures the effect of producing/selling more or fewer units than planned.

Multiple Cost Drivers

Sophisticated flexible budgets use multiple cost drivers rather than a single output measure. Machine hours may drive power costs, number of setups may drive setup costs, and number of shipments may drive distribution costs. Activity-Based Costing (ABC) principles enhance the accuracy of flexible budgets by matching each cost pool to its appropriate driver.

Key Takeaways

• Static budgets compare actual results to planned output — conflating volume and efficiency effects.
• Flexible budgets adjust variable costs to actual output, isolating true efficiency variances.
• Total variance = Flexible-budget variance + Sales-volume variance.
• Multiple cost drivers improve flexible budget accuracy for complex operations.
• Flexible budgets are essential for fair performance evaluation.

What’s Next

In Lesson 5, we drill deeper into variances — specifically direct-cost variances for materials and labor (price and efficiency).