Question

Question #5: Explain the difference between static and flexible budgets. Provide a detailed example of how companies can use flexible budgets for decision making

Answer 1

Difference between Static and Flexible Budgets:

Criteria	Static Budget	Flexible Budget
NATURE	It does not change with the actual volume of the output achieved.	It is designed to change appropriately with the level of activity attained.
SCOPE	It cannot ascertain costs correctly in case of any change in circumstances.	It can easily ascertain the costs in different levels of activities.
DETERMINATION OF COSTS	It is prepared under the assumption that all conditions will remain unaltered.	It is prepared at different levels of activities considering the possible changes in the operational aspects of a business.
ASSUMPTIONS	It has a limited application and is ineffective as a tool for cost control.	It has a wide application and is an effective tool for cost control.
PRE-REQUISITES	It is prepared without classifying the costs according to their variable nature.	It is prepared by classifying the costs according to their variable nature.

Detailed Example:

Following is the static budget, flexible budget and actual results of X Co. Ltd for the month of October, 2018 :

Particulars	Actual	Static	Flexible
Units	40,000	30,000	40,000
Revenue	236,000	180,000	240,000
VARIABLE COSTS
Material	76,000	60,000	80,000
Labour	63,200	45,000	60,000
Factory Overhead	34,000	24,000	32,000
CONTRIBUTION	62,800	51,000	68,000
Fixed Costs
Factory Overhead	12,880	12,000	12,000
Office Expenses	22,000	20,000	20,000
OPERATING INCOME	27,920	19,000	36,000

The management is pleased with the income being higher than budgeted. However the significant increase in units sold renders the comparison of actual vs static unfair. Hence, we have to use a flexible budget.

The flexible budget on the other hand depicts an unfavourable variance of operating income of (36,000 - 27,920 = 8,080) which helps the company to identify the loop-holes and control costs to achieve the desired profits.