June 20, 2011
In today’s business, a flexible budget helps plan for the future. This tool compiles expense, revenue, production, and cost data. The data produced from the flexible budget provides an organization with a tool for performance evaluation. This can assist management in determining the most profitable sales and production levels, in addition to determining fixed and variable costs. Examining how the flexible budget relates to fixed and variable costs as well as analyzing the correlation between the static and flexible budget leads to cost-volume-profit analysis.
Static and Flexible Budgets
Fixed cost, such as ...view middle of the document...
Because variable cost may vary, the company has the possibility to spend less than the planned amount which would cause a favorable affect on the flexible budget and allow money to be used elsewhere.
Fixed and Variable Costs in a Flexible Budget
Unlike the master budget, also called static budget because it remains unchanged disregarding any possible changes in the volume of activity, the flexible budget is a budget that adjusts accordingly to reflect changes in the volume of activity.
Fixed and variable costs are the two major components of the total overhead costs in a flexible budget. Fixed costs, or sunk costs are those that remain unchanged in production activity level or sales volume. Examples of facility sustaining costs include building rent or depreciation, personnel administrative and training costs, taxes, insurance, and advertising. On the other hand variable costs are those costs that have a direct relationship with changes in activity level. Variable costs include direct materials, direct labor, inspections, packaging, and shipping and handling while product level costs include quality inspection, engineering design, patents, and inventory holding costs.
Even though fixed costs are not affected by fluctuations in the production activity level, they may change with time as a result of discretionary costs incurred by the company - advertising is an example of a company’s discretionary cost. Fixed costs, or sunk costs, should not be taken into consideration by management while making a business decision because these are costs that the company will incur independently of the volume of sales or production. Some costs may have both fixed and variable elements.
It is critical for management to understand the relationship between fixed and variable costs and the increase in either production or sales activity levels. Fixed costs do not change in total, but they change on a per unit basis – as production increases the amount of fixed costs per unit decrease. Conversely, variable costs remain constant on a per unit basis, but they increase as production levels increase and decrease if production levels also decrease (Edmonds et al, 2007).
A cost-volume-profit (CVP) analysis reflects how changes in a company’s costs and volume will affect its operating income and net income. To be able to perform a CVP analysis, the company must have the amounts of variable and fixed costs, the sales price per unit, and the desired level of profit. CVP...