Managerial Accounting

418 Chapter 10

In the last chapter we explored how budgets are developed before a period

begins. Budgeting involves a lot of time and effort and the results of the budgeting

process should not be shoved into a fi ling cabinet and forgotten. To be useful, budgets

should provide guidance in conducting actual operations and should be part of the performance

evaluation process. However, managers need to be very careful about how budgets

are used. In government, budgets often establish how much will be spent and indeed, spending

more than was budgeted may be a criminal offense. That is not true in other organizations.

In for-profi t organizations, actual spending will rarely be the same as the spending that

was budgeted at the beginning of the period. The reason is that the actual level of activity

(such as unit sales) will rarely be the same as the budgeted activity; therefore, many actual

costs and revenues will naturally differ from what was budgeted. Should a manager be penalized

for spending 10% more than budgeted for a variable cost like direct materials if unit

sales are 10% higher than budgeted? Of course not. In this chapter we will explore how budgets

can be adjusted so that meaningful comparisons to actual costs can be made.

Characteristics of a Flexible Budget

The budgets that we explored in the last chapter were planning budgets. A planning

budget is prepared before the period begins and is valid for only the planned level of activity.

A static planning budget is suitable for planning but is inappropriate for evaluating

how well costs are controlled. If the actual level of activity differs from what was planned,

it would be misleading to compare actual costs to the static, unchanged planning budget.

If activity is higher than expected, variable costs should be higher than expected; and if

activity is lower than expected, variable costs should be lower than expected.

Flexible budgets take into account how changes in activity affect...