Just as a company can adjust its cost drivers in response to a variance, it can adjust its cost drivers under a flexible budget. A flexible budget assumes that costs are adjustable. This is compared to the traditional static budget, which assumes that all costs are fixed to the amount the company predicted at the beginning of the budget period. The flexible budget is multifaceted and allows the company to change its costs to reflect varying activity levels.
When the company converts the static budget to a flexible budget to adjust for varying activity levels, the new data helps owners and managers understand the effect of the changes on revenue and costs. However, identifying the cost driver behind the variance demonstrated by the flexible budget is not easy. Multiple cost drivers can cause a single variance. Also, adjusting cost drivers happens after the budget period. Companies use the flexible budget only to compare against the static budget; the flexible budget itself does not actually adjust costs during the budget period.
A flexible budget will likely reveal an activity variance. An activity variance is the difference between the company's revenues, costs, or both revenue and costs projected in its static budget and the actual revenues, costs, or both in the flexible budget.
Companies implement flexible budgets to understand activity variances, revenue variances, and spending. In response to these variances, a company will adjust its cost drivers due to changes in the level of activity, direct materials cost changes, and efficiency levels. Although adjusting cost drivers under a flexible budget may help the company increase its profitability, there are some cost drivers that are difficult to identify that will continue to cause a problem until they are identified. These include poor management and efficiency issues.