Problems with Static Budgets in Cost Accounting
When cost accounting, a static budget (also referred to as a master budget) is a summary of operating and financial plans. After the budget is created, it doesn’t change with the level of activity (sales, production) in your business.
A static budget is the starting point for determining a reasonable profit for your business. But a static budget assumes one level of output that never changes. This can create problems that are fixed by using flexible budgeting.
Here is a static budget for a toy manufacturer.
|Units sold||120 units|
|Indirect (overhead) costs||$6||$720|
Your static budget assumes only one level of production: 120 units. But direct material, labor, and indirect (overhead) costs are variable costs. They change as production changes. (Actually, you should keep in mind that indirect costs can be fixed or variable.) If you produce more or less than 120 units, you will have a variance that is caused just by volume (production). In fact, there are three major types of variances you might come across:
Volume variance: You produce more or less than planned. That may mean that you use more or less material than budgeted. You may also use more or less labor than planned.
Price or rate variance: The price you pay for materials, or that rate you pay for labor costs, is different than what you budgeted.
Sales variance: You sell more or less than planned.
Note an important difference: Volume variances are all about usage. Price or rate variances relate to the price you pay — regardless of how much you use.