Flexible Budget

A flexible budget is a budget that is recalculated for the actual level of activity a business achieves, such as units produced, hours worked or customers served. Instead of a single set of figures fixed in advance, it uses cost formulas that show how each cost should behave as volume changes. At the end of a period, managers plug in the actual volume to find out what costs and revenues should have been, then compare that with what actually happened.

The flexible budget is contrasted with a static budget, which is prepared for one planned level of activity and does not change. Static budgets are useful for planning, but they make performance reviews misleading when actual volume differs from plan, because costs naturally rise or fall with output. Flexible budgets fix that problem and are a standard tool in management accounting and budget variance analysis.

A flexible budget depends on separating costs by their cost behavior. Variable costs are expressed as an amount per unit of activity, while fixed costs are expressed as a total for the period. Mixed costs are split into their fixed and variable parts. The resulting cost formula is:

Here $\text{Fixed costs}$ are the budgeted period costs that do not change with volume, $\text{Variable cost per unit}$ is the budgeted cost for each unit of activity and $\text{Actual units}$ is the activity level actually achieved. The same idea applies to revenue: the flexible budget revenue is the budgeted price multiplied by the actual quantity sold.

A furniture workshop prepares a static budget for 1,000 chairs at a price of $120 each. Budgeted variable costs are $70 per chair and fixed costs are $30,000 for the month, so planned operating income is $120,000 minus $70,000 minus $30,000, or $20,000. The workshop actually sells 1,200 chairs for $142,000, with actual variable costs of $87,000 and fixed costs of $31,000, giving operating income of $24,000.

• The flexible budget for 1,200 chairs shows revenue of $144,000, variable costs of $84,000 and fixed costs of $30,000, for operating income of $30,000.
• Compared with the flexible budget, revenue is $2,000 unfavorable because the average price was slightly lower than planned.
• Variable costs are $3,000 unfavorable and fixed costs $1,000 unfavorable, so actual income is $6,000 below the flexible budget.
• The $10,000 difference between the static budget and the flexible budget is the sales volume variance, which is favorable because more chairs were sold.

A static comparison would have shown income $4,000 above budget and suggested costs were well controlled. The flexible budget reveals that the higher volume should have produced $10,000 more profit, and that weaker pricing and spending gave back $6,000 of it.

Flexible budgets separate two different questions: did the business sell as much as planned, and did it control prices and costs for the volume it actually achieved? This split lets companies hold sales managers responsible for volume and production or department managers responsible for spending at each cost center. The same framework underlies standard costing systems, in which variable cost variances are divided further into price and efficiency parts. A flexible budget also supports cost-volume-profit analysis by showing how the contribution margin and operating income change at different volumes, and it can be prepared in advance for several activity levels to support planning.

A flexible budget is only as good as its cost formulas. Many costs are not neatly fixed or variable, and the relationship may hold only within a limited range of activity. Choosing the wrong activity measure, such as labor hours in a highly automated plant, can make the adjusted figures misleading. Flexible budgets also do not tell managers whether the original volume target was sensible, and they cannot correct for budgetary slack built into the per-unit rates.