Steps to developing a flexible budget?

Answer 1

A traditional budget is often referred to as a "static budget." A static budget is not designed to change with changes in activity level. Once sales and expenses are estimated, they become the relevant benchmarks.

A flexible budget is an alternative that has some compelling advantages. It relates anticipated expenses to observed revenue. To illustrate, if a business greatly exceeded the sales goal, it is reasonable to expect costs to also exceed planned levels. After all, some items like cost of sales, sales commissions, and shipping costs are directly related to volume. How ridiculous would it be to fault the manager of the business for having cost overruns? Conversely,

failing to meet sales goals should be accompanied by a reduction in variable costs. Certainly it would make no sense to congratulate a manager for holding costs down in this case! A flexible budget

is one that reflects expected costs as a function of business volume; when sales rise so do certain budgeted costs, and vice versa.

The flexible budget responds to changes in activity, and may provide a better tool for performance evaluation. It is driven by the expected cost behavior. Fixed factory overhead is the same no matter the activity level, and variable costs are a direct function of observed activity. When performance evaluation is based on a static budget, there is little incentive to drive sales and production above anticipated levels because increases in volume tend to produce more costs and unfavorable variances. The flexible budget-based performance evaluation provides a remedy for this phenomenon.