M5A1: Discussion—Working with Budgets

A flexible budget shows what the costs should be for various levels of activity. The flexible budget amount for a specific level of activity is determined differently depending on whether a cost is variable or fixed. If a cost is variable, the flexible budget amount is determined by multiplying the cost per unit of activity by the level of activity specified for the flexible budget. If a cost is fixed, the original budgeted fixed cost is used as the flexible budget amount. With a flexible budget, production is examined at various levels within the relevant range of production.

Flexible budgets are analyzed using budget variances. As covered previously, the two variances for variable overhead are variable overhead spending and variable overhead efficiency variances. In addition to these variances, when analyzing fixed overhead, two additional variances need to be examined. One is the budget variance, which is simply the difference between the actual total fixed overhead and budgeted fixed overhead. The other, more complex variance is volume variance, which is the difference between the amount of fixed overhead applied to inventory and the total amount of fixed overhead cost that was originally budgeted. The budget variance is a straightforward measure of the degree to which fixed overhead spending was under control. The volume variance is the consequence of treating a fixed cost as if it was variable, and its meaningful application is limited.