Both fixed and flexible budgeting are ways to prepare a budget for your business or division. While one is rigid, the other is adjustable to your business’s output level (be it sales, units produced, or some other activity).
What is a fixed budget?
A fixed budget is one that is created using a standard or fixed level of activity. It does not vary as the level of activity in your business rises or falls.
Imagine your company is making an annual departmental budget for its manufacturing division. The departmental budget is prepared based on the assumption that 65,000 items will be produced during the budget year. A summary of the department’s budget based on the output level of 65,000 items is:
Fixed expenses (salaries, maintenance of machinery, etc.) of $460,000 + Variable expenses (materials, wages, etc.) of $260,000 (65,000 items X $4 each) = Total fixed budget of $720,000.
Now, suppose your company produces 69,000 items as opposed to 65,000 assumed at the time of making the budget. If we use a fixed budget, it is going to remain the same at $720,000 and will not be changed when more or less than 65,000 items are produced.
It is only in rare circumstances that the level of output actually attained conforms to the one assumed for budgeting purposes. The actual activity is usually less or more than the one assumed for making a budget. But since a fixed budget is prepared at a standard level of activity and cannot be moulded to make it comparable with the actual level of activity, it will not serve any purpose. Thus, it will be meaningless to adopt the budgeted cost of $720,000 at 65,000 level of output to compare it with actual costs at 69,000 output level.
Because of these flaws in fixed budgeting, it has become a normal practice in businesses where sales and production cannot be precisely forecasted to abandon the concept of fixed budgeting, as it does not allow for automatic volume adjustments.
Meaning of flexible budget
By identifying the distinction between fixed, semi-fixed, and variable cost, a flexible budget is designed to change in relation to the activity attained. It is a budget prepared in such a way that it provides the budgeted cost for any level of activity.
The key feature of a flexible budget is that it depicts expenditure appropriate to various levels of output. If production volume changes, the expenditure appropriate to it can be easily established from a flexible budget. Unlike fixed budgets, when a flexible budget is used, the actual cost of actual volume is compared with the budgeted cost of actual volume, i.e., two things to the same base. This facilitates in logical comparison of budget allowances with actual costs as a means of control. (source)
Continuing our discussion with the above example, a flexible budget will increase or decrease according to the actual number of items produced, i.e., 69,000. It will adjust the elements of costs in proportion to the output generated. Therefore, the department’s budget will be re-drawn based on the output level of 69,000 items in the following way:
Fixed expenses (salaries, maintenance of machinery, etc.) of $460,000 + Variable expenses (materials, wages, etc.) of $276,000 (69,000 items X $4 each) = Total flexible budget of $736,000.
With this computation, the management can now logically compare its actual costs at 69,000 level of output with budgeted cost ($736,000) at the same level of output (i.e., 69,000). Such budgeted costs will act as a benchmark to exercise control over actual costs. If actual costs are going beyond $736,000, your company may take measures to control them.
Had the company been using a fixed budget of $720,000 which stays stagnant with a 65,000 level, it would have given misleading results. The company would have gone after $720,000 rather than $736,000 to set its budget benchmark for 69,000 units.
Let us take another example. Suppose you set your sales commission budget at $350,000. Now if you use a static budget, sales commission expense will be budgeted at $350,000 only whether the actual sales for the budget year are $4 million or $6 million.
However, if you use a flexible budget, it might express the sales commission expense as a specific percentage of sales (say 5%). Now when sales are actually $4 million or $6 million, the flexible budget for sales commission expense will be set at $200,000 or $300,000 respectively.
Some of the important characteristics of a flexible budget can be summarized as follows:
- Flexible budgets are the opposite of static budgets. Instead of preparing for a standard level of activity, they are prepared for a range of activities. This enables a company to arrive at the budgeted cost, whatever be the level of activity attained.
- Because they are automatically adapted to variations in volume, they provide a highly dynamic basis for comparison with actual costs.
- They create a custom budget for any given level of volume.
- These are based on a thorough understanding of cost behavior patterns.
When is a fixed budget suitable?
Below is a list of essential conditions for the suitability of fixed budgets:
- The nature of business is not seasonal.
- Business activities are not impacted by external factors.
- The demand for a product is certain and stable.
- Supply orders are received and issued regularly.
- The production of products does not create a need for special labour or material.
- There is a trend of price stability.
From the above conditions, it can be inferred that a fixed budget is not much suitable for business concerns because all the above conditions are not found in general practice.
We know that once a fixed budget is prepared, it is not changed even if the level of production changes. Therefore, fixed budgets are mostly useful only for fixed expenses since such expenses remain constant at all levels of output. Moreover, fixed budgets may also be used by some service companies or for some administrative functions such as engineering, accounting, and purchasing.
When is a flexible budget desirable?
Flexible budgets are desirable to use in the following circumstances:
- Flexible budgets are helpful when the volume of activity varies throughout the year, either because of the seasonal nature of an industry or because of fluctuations in demand. For example, the volume of sales in festive seasons is usually more for businesses engaged in assorted cookies. In such cases, a flexible budget might be essential to see how budgeted costs vary from one season to another.
- Flexible budgets prove to be helpful when the business is new and it is difficult to predict the demand of a product accurately.
- Also, where a company is suffering from the shortage of some factors of production like materials, labor, or plant capacity, a flexible budget can furnish the details of targeted costs at different points in time.
- Flexible budgeting may also be resorted to in the case of labor-intensive industries where the quantum of production is dependent upon the availability of labor.
- Flexible budgets are very much needed in circumstances where an entity keeps on bringing in new products into the market or frequently makes changes in its product mix.
- Industries that are engaged in make-to-order businesses like construction or ship-building also rely on flexible budgeting since their production levels on based on a customer’s order.
- Similarly, industries influenced by changes in fashion use flexible budgeting too. Fluctuations in demand cause output levels to change from period to period, which necessitates having a budget adjustable to changing outputs.
Preparation of flexible budget
Preparation of flexible budgets requires an in-depth cost analysis and perfect knowledge about the factors of production. To prepare a flexible budget, categories of cost must be examined individually in order to determine how different categories of cost respond to changes in volume. (source)
Costs are categorized into three types:
Fixed costs: Fixed costs are primarily concerned with the passage of time and are unrelated to the degree of production or sales volume.
Variable costs: The volume of activity has a direct and proportional effect on variable expenses. Variable expenses will not exist at zero levels of activity.
Semi-variable costs: The semi-variable costs fall somewhere in the middle of fixed and variable costs. A portion of these costs is variable, while the rest is fixed.
In fact, by categorizing costs into ‘fixed’ and ‘variable,’ each department’s budget can be constructed along the lines of a flexible budget. The degree of variability for each item of cost could be evolved based on past experience in order to appropriately fix up the costs for different volumes. For instance, commission costs may be fixed up at 2% of sales effected. This necessitates a close examination of the individual items of expenditure, as well as their nature and variability.
Steps to Prepare a flexible budget:
1. Select the activity level (generally in terms of output)
2. Decide the range of activity to develop a flexible budget
3. Determine the cost behaviour – fixed, variable, and semi-variable to each element of cost
4. Prepare the budget at each activity level
Let us see how a flexible budget is prepared with the help of an example:
Suppose for the production of 10,000 units of output, a company fixes the following budgeted expenses:
Now, the company wants to prepare a flexible budget for its cost of production because it expects that the units of output could vary from 6,000 to 8,000 units. So, it seeks to gauge the budgeted costs at 6,000, 7,000, and 8,000 units of output respectively.
The company feels that if it has a tailor-made budget for each level of activity, it would become very convenient to compare actual costs with budgeted costs. For instance, if it turns out to produce 6,000 units, it can easily refer to the flexible budget commensurate with 6,000 units and implement cost control measures.
For the preparation, the company would first fix the degree of variability of all items of costs in relation to the level of output. It would classify costs into fixed, variable, and semi-variable in the following manner.
Variable costs = Direct material, direct labour, variable factory overheads, direct variable expenses.
Fixed costs = Fixed production overheads, administration expenses.
Once costs are segregated, the budgeted costs would be computed for each level of activity.
Difference between fixed and flexible budget
The following table shows a list of differences between fixed and flexible budgets.
|Fixed budget||Flexible budget|
|It is unaffected by the actual volume of activity achieved. As a result, it is referred to as a rigid or inflexible budget.||It can be recast based on the level of activity to be attained. As a result, it is not rigid.|
|It operates at a single level of activity and under a single set of circumstances. It assumes that nothing will change in the present conditions, which is unrealistic.||It is made up of various budgets for different levels of activity. A flexible budget can also be viewed as a series of static budgets for different levels of activity.|
|Costs are not analysed individually.||Each element of cost is analysed according to its behaviour, i.e., fixed, variable, or semi-variable.|
|If budgeted and actual activity levels differ significantly, then the budget does not serve any purpose. A comparison of actual performance to budgeted targets is pointless.||It provides a logical basis for comparing actual performance to budgeted targets.|
|It is very simple to prepare.||It is relatively complex to make since computations have to be made for all possible scenarios.|
|It assumes that business conditions remain the same.||It is designed to change in accordance with changes in external and internal conditions.|
|It has limited application and is ineffective in cost control.||Flexible budgets are dynamic and can be used as a tool for cost control.|
Hope the information provided in this blog proves helpful to you!