The variable budget is based upon an analysis of expense items to determine how individual costs should vary with volume of output. All costs are categorised into fixed and variable costs.
Some costs do not vary with volume, particularly in a very short span. Examples of these costs are taxes, rental payments, depreciation, insurance, maintenance, and costs of keeping a minimum staff and other key personnel on a readiness to serve basis.
Costs that vary with volume of output range from those which are fully variable to those which are only slightly variable.
Before each category of cost can be related to volume, variable budget process must first determine a unit of measure (for example, percentage of occupancy) that reflects volume, to study the various categories of costs. Department heads are then asked to estimate the volume forecasts for the immediate future, from which is calculated the monetary amount of variable costs that make up the budget.
The sine qua non of variable budgeting is analysing the cost behaviour. The basic difference between variable and other budgets is that whereas other budgets are prepared at a given level of demand, variable budget permits management to evaluate the variance costs and demand, on an ongoing basis.
The cost behaviour is analysed through:
i. Segregating the cost charged to various expenses into appropriate cost classification (i.e. fixed, or variable, and sometimes also semi variable).
ii. Statistical analysis of past data to determine how costs varied with volume in different categories of output.