A more useful and usable budget is a flexible budget.
A flexible budget is one in which budgeted
variable revenues and costs have been adjusted to the total revenue or cost that would be anticipated for
the actual level of activity that has occurred, as opposed to the budgeted level of activity. Normally, fixed
costs in the flexible budget are the same as fixed costs in the static budget. Budgeted fixed costs in the
flexible budget are adjusted only if the actual activity level is outside the relevant range.
Flexible budget variances are a better indicator of operating performance than static budget variances
because they compare actual results to the budgeted results adjusted for the actual volume. If an
actual cost is higher than its flexible budget amount, then that variance may be cause for concern.
Flexible budget variances are Level 2 variances and are more useful for management decision-making.
The highest level of manufacturing variances, Level 3 variances, are variances calculated for a single
man-ufacturing input (for example, direct material, direct labor, or variable overhead). These are the
most detailed and provide the most specific information for management to work with.
Level 1 Variances: Static Budget Variances
Level 1 variances are the most global variances. Static budget variances are Level 1 variances; therefore,
static budget variances are the most global. They are based on the income statement and merely
compare the actual results with the static (master) budget. Since they are based on the income
statement, Level 1 variances report variances in revenue and cost of sales for sold units only. They do not
report detailed cost variances for all units produced.
While these variances indicate whether performance was better or worse than expected, they do not provide
any information as to why performance was better or worse than expected.
There are benefits and limitations to measuring performance by comparing actual results with the master
budget.
Benefits of Measuring Performance by Static Budget Variances
• Static budget variances provide a means for management to recognize unexpected variances, thus
pointing out which operating variances need to be investigated, one of the most important steps in
the budgeting process.
• Analysis of variances is part of the control loop, the process by which the activities of the company
are controlled.
Limitations of Measuring Performance by Static Budget Variances
• Variances caused by more or fewer sales than planned are not segregated from variances caused by
other factors.
• Comparison of actual results with the master budget focuses on short-term performance instead of
long-term success.
• Managers should be evaluated on performance measures other than just whether or not they have
met short-term financial targets. Meeting financial targets is only part of the measurement of perfor-
mance. Manager evaluation should include not only financial measures but also non-financial
measures.
Managers should be evaluated on their overall contributions to the achievement of the com-
pany’s goals. Managers’ financial contributions are part of their overall contributions, but they are not