Variable versus Fixed Budgets

One difficulty with budgets is that they are often inflexible. Thus, they could seem inappropriate for situations that change in ways beyond the control of the budget. For example an expense budget based on annual sales of $12 million may be completely off track if sales of $15 million are achieved. Since the expenses of manufacturing almost always increases when more items are produced to meet larger demand, it would be unreasonable to expect managers to keep to the original expenses budget under these circumstances.

To deal with this difficulty, many managers resort to a variable budget. This type of budget is also referred to as a flexible budget, sliding scale budget and step budget. Whereas fixed express what individual costs should be at one specified volume, variable budgets are cost schedules that show how each cost should vary as the level of activity or output varies. Variable budgets are therefore useful in identifying in a fair and realistic manner how costs are affected by the amount of work being done.

Three types of costs must be considered when developing variable budgets: fixed, variable, and semi-variable costs.

1. Fixed Costs: Fixed costs are those that are unaffected by the amount of work being done in the responsibility center. These costs accumulate only with the passage of time. For example, in many organizational units, monthly salaries, insurances payments, rent and research expenditures do not vary significantly across a wide range of activity.
2. Variable Cost: Variable costs are expenses that vary directly with the quantity of work being performed. An example is raw materials – the more goods produced, the greater the quantity (and cost) of raw materials required.
3. Semi-variable Costs: Semi-variable costs are those that vary with the volume of work performed but not in a directly proportional way. Semi-variables costs often represent a major part of an organization’s expenses. For example, short term labor costs are usually semi-variable – the number of personnel hired (or laid off) is rarely based directly on day-to-day changes in production. Similarly, the cost of the total sales effort often does not vary directly with the number of products sold.

In devising their budgets, managers must try to break down their total costs into fixed, variable, and semi-variable elements. The result will be more accurate and useful budgets, even though cost variability is often difficult to determine.

Variable budgets are used most appropriately where operations are repetitive, where there are a large number of different expenses, and here these expenses can be accurately estimated. The manufacturing facilities in the steel and toy industries are particularly well suited for the variable budget approach. The main disadvantage of variable budgets is that they are often quite expensive to prepare.