What is a flexible budget?

A flexible budget is a budget that adjusts or flexes for changes in the volume of activity. The
flexible budget is more sophisticated and useful than a static budget, which remains at one
amount regardless of the volume of activity.

How flexible budget works

Assume that a manufacturer determines that its cost of electricity and supplies for
the factory are approximately $10 per machine hour (MH). It also knows that the
factory supervision, depreciation, and other fixed costs are approximately
$40,000 per month. Typically, the production equipment operates between 4,000
and 7,000 hours per month. Based on this information, the flexible budget for
each month would be $40,000 + $10 per MH.
Now let's illustrate the flexible budget by using some data. If the production
equipment is required to operate for 5,000 hours during January, the flexible
budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH).
If the plant manager is required to use more machine hours, it is logical to
increase the plant manager's budget for the additional cost of electricity and
supplies. The manager's budget should also decrease when the need to operate
the equipment is reduced. In short, the flexible budget provides a better
opportunity for planning and controlling than does a static budget.

The following steps are used to prepare a flexible

budget:
1.

2.
3.

Determine the budgeted variable cost per unit of output. Also determine
the budgeted sales price per unit of output, if the entity to which the
budget applies generates revenue (e.g., the retailer or the hospital).
Determine the budgeted level of fixed costs.
Determine the actual volume of output achieved (e.g., units produced
for a factory, units sold for a retailer, patient days for a hospital).

4.

Build the flexible budget based on the budgeted cost information from
steps 1 and 2, and the actual volume of output from step 3.

How activity based flexible budget differ

from conventional flexible budget:
1.Activity-based flexible budgets are an improvement on conventional flexible budgets.
2.While conventional flexible budgets center on one cost driver or the dominant variable
factor in the budget, this type of budget bases itself on budgeted costs for each activity
center and related cost driver.
3.The budget for each activity center within the budget depends on the appropriate cost
driver for the activity center.
4.The cost remains fixed relative to units and varies with such cost drivers. Such
budgets are appropriate when the basis of cost fluctuation comes from such cost drivers
rather than units of output.

Approach:--A flexible budget requires an estimate of the relationship between total cost
and activity volume. The form of that relationship depends on the structure of the
process for which costs are being estimated. Some criteria for choosing a measure of
volume include:
Causality -- an individual type of cost should be related whenever possible to that activity
which causes the cost to vary.
Independence of activity measure -- to the extent possible, the activity measure should
be independent of other influences. For example, labor or machine hours are
independent of changes in prices.
Ease of understanding -- Activity measure units should be easily understandable and
obtainable at reasonable expense. Complicated indices of activity volume are best
avoided.
Functionality - Activity measures should be functional and thus contribute to
organizational goals. For example, poor performance should not result in a more
generous budget for performance evaluation and control purposes.

Practice: the cost behavior assumption that underlies much of current accounting
practice is that cost is a simple linear function of volume. Specifically, it is assumed that

Total cost C = F + vQ, where F represents total fixed cost, v represents the variable
cost per unit of activity, and Q represents the level of activity for which the budget is to be
constructed. When there are multiple cost drivers for an activity, then the linear equation
is of the form

Total cost C = F + v1Q1 + v2Q2 + L + vnQn

(1)

In matrix form, we would write this as

Total cost C=F+ vQ

(2)

Flexible budgeting can be implemented whenever a reasonably strong relationship exists

between total cost and some measure of activity volume. The relationship can be
curvilinear or linear. The important concept is that the budget flexes, in a predetermined
manner, with changes in volume.
Measures of Activity:
1. Flexible budgets are sometimes based on measures of activity inputs (e.g., direct
labor hours) that indicate the budgeted costs necessary to acquire a given level of
resources at specified prices. These are acquisition budgets, such as might be used to
budget for the purchase of raw materials for a specified period.

2. Flexible budgets are sometimes based on measures of activity (e.g., hours a

production line is in operation) to forecast the cost of operating an activity, usually for a
given level of input or output (e.g., standard hours allowed for the output achieved). In
constructing such budgets, one must specify the rate at which resources will be
consumed to maintain the activity.

3. Flexible budgets are sometimes based on measures of activity output (e.g., number
of units produced during a period). In constructing such budgets, one must specify both
the rate at which resources will be consumed to maintain the activity and the rate at
which the activity will produce units of output. Thus, a flexible budget based on output
must be based on specified input/output ratios.