A fixed budget has two characteristics
- It is geared towards only one level of activity. It is thus defined by only one level of activity
- It is not adjusted to reflect actual activity level when change occurs. Actual results are always compared against budgeted costs at the original level of activity and not against the adjusted budget.
Fixed budget has the following limitations:
It provides little assistance at the planning stage. It does not give implications of various alternative strategies which management may wish to consider.
- It fails to provide relevant and reliable base against which to measure actual performance where actual activity differs from the budget; for instance, if the actual output differs significantly from the budgeted, the base of comparison and evaluation of performance of managers shall not be reliable.
- Little motivation to management to use the budgeting control system as a control aid. Fixed budgets are used as a production control tool in that they serve to ensure that production goals in terms of output are met. It does not make any sense to compare costs at different levels of activities thus does not serve as a cost control tool.
Flexible budget is a budget that is designed to change in accordance with the level of activity attained. It involves budgeting at various levels in anticipation of changes. In other words, it does not confine itself to only one level of activity, but rather is geared toward a range of activity. The original budget is adjusted (flexed) to reflect the actual conditions in which the performance was done.
If actual costs are incurred at a different level of activity from what was originally planned, the manager(s) construct a new budget on which the actual results shall be compared against.
A flexible budget is more useful than fixed budgeting because:
- Planning: It provides a range of information at the planning stage, which will assist in short term planning.
- Control: It provides control data when compared with actual performance. Various budgets can be prepared at various levels of performance. It is geared toward all levels of activity within the relevant range, rather than toward only one level of activity as in fixed budgets. This enables the comparison between the budgeted and actual costs at the same level of activity thus able to come up with realistic variances.
- Motivation: More likely to be acceptable to management to provide a positive motivational stimulus because the control data is adjusted to conform to current activity level. In addition manager’s performance is evaluated on both aspects of production and cost control. Production data indicates whether production was met while cost data shows how well cost was controlled for the actual output thus they strike a balance between the two by ensuring that the production was met at the minimum cost.
To flex any budget, one needs to understand the cost behavior patterns. There are various steps that should be followed while preparing a flexible budget. These are:
- Determining the relevant range over which the activity is expected to fluctuate during the period under consideration.
- Analyzing costs that will be incurred over the relevant range in terms of determining cost behavior patterns. A cost can either be variable, fixed or mixed.
- Separation of costs by behavior patterns, determining the formula for variable and mixed costs. You may use any cost determination method such as linear regression to separate mixed costs into variable and fixed elements.
- Using the formula for the variable portion of costs, prepare a budget showing what costs will be incurred at the various points throughout the relevant range.
The most appropriate flexing basis should be considered in that it assists in the comparison of alternative budget data at the planning stage and for the comparison of budget and actual data at the control stage.
Different organizations use different flexing bases but the following are most commonly used:
- Machine hours
- Direct labour hours
- Input to a cost centre
- Output from a cost centre
For the above flexing bases to be used, a number of requirements must be fulfilled:
- The flexing bases should be correlated with the way in which costs vary e.g. does the number of miles traveled by distribution vehicles affect the repairs and maintenance expenses?
- The flexible bases should be easily understood by the management and not subject to manipulation.
- The flexible bases should be readily obtainable.
- It should be independent of other factors.
