Business Degree Certification Practice Test

What happens to total costs when using a flexible budget and activity decreases within the relevant range?

1. Variable cost per unit decreases

2. Total costs decrease

3. Total fixed costs increase

4. Variable cost per unit increases

The correct answer is: Total costs decrease

When using a flexible budget and the level of activity decreases within the relevant range, total costs will decrease. This is because flexible budgets adjust total costs based on actual levels of activity. In a flexible budgeting system, variable costs change in direct proportion to activity levels; thus, when activity decreases, the variable costs decrease as well. Total costs are a sum of variable costs and fixed costs. Since fixed costs remain constant regardless of the level of activity within the relevant range, the only component that changes when activity decreases is the variable costs. As those variable costs drop with lower activity levels, the overall total costs consequently decrease as well. This understanding aligns with how businesses manage budgets and assess performance; if volume or activity decreases, flexible budgets will appropriately reflect lower total costs due to reduced variable expenses.