Budget Planning: Fixed, Flexible, and Flexed Approaches - Accountancy Coach (2024)

Fixed, flexible, and flexed budgets are tools used by organizations to plan, monitor, and control their financial performance. Each type serves a different purpose and is used in different scenarios depending on the level of control and predictability required. Understanding how each budget works is key to financial planning and analysis.

A budget which remains unchanged regardless of activity level is called fixed budget.
It is also known as original budget. A fixed budget is prepared based on an estimated production plan at the start of a period. Regardless of the fact that actual activity level during the period might be quite different fixed budget is not adjusted. It does not give like with like comparison. Commonly used in service industries where most costs is fixed (rather than manufacturing industries where many costs are variable). It does not give fair performance evaluation if variable costs are significant. It can be said, therefore, that fixed budget is only prepared for planning purpose. It is very useful for service organisations.

Characteristics of a Fixed Budget:

Static Nature: It does not change or adapt once it is set, even if business conditions change.

Planning Tool: Useful for planning purposes, setting a clear benchmark for expected performance.

Simplicity: Easier to manage and understand because it does not fluctuate with changes in business activity levels.

Cost Control: Facilitates cost control by setting fixed targets for departments to achieve.

Advantages of a Fixed Budget:

Consistency: Provides a consistent framework for performance evaluation.

Ease of Preparation: Less complex to prepare as it does not require constant updates.

Benchmarking: Serves as a clear benchmark for assessing performance.

Disadvantages of a Fixed Budget:

Inflexibility: Does not accommodate changes in activity levels or external factors affecting the business.

Potential for Inaccuracy: Can become quickly outdated, leading to variances that are more reflective of the budget’s rigidity rather than actual performance.

Limited Usefulness: May not be helpful for managerial decision-making when conditions change significantly after the budget is prepared.

Fixed budgets are commonly used in stable environments with predictable patterns of business activity. However, in dynamic business settings where rapid changes are the norm, flexible budgets that adjust with varying levels of activity may be more appropriate.

Multiple budgets are prepared at the start of the period at different capacity levels are called flexible budgets. At the end of the period, the budget which is same or close to the actual activity level is used for comparison. They provide better performance measurement as compared to fixed budgets. It determines
the cost behaviour patterns.

A flexible budget adjusts to changes in actual revenue or other activity measures. This type of budget provides businesses with a more useful, dynamic tool for performance evaluation and control because it can reflect the business’s actual operating environment. The flexible budget is developed by identifying fixed and variable costs, and how the variable costs change in relation to activity levels.

Characteristics of a Flexible Budget:

1. Adaptability: It is designed to change in relation to the level of activity achieved.
2. Variable Costs: Includes variable costs that adjust according to actual activity levels.
3. Performance Evaluation: More effective for performance evaluation as it provides a more relevant comparison of actual versus budgeted costs based on the actual revenue or production levels.

Advantages of a Flexible Budget:

1. Relevance: It offers a more accurate comparison of budgeted to actual performance by accounting for the actual volume of output.
2. Control: Enables management to identify discrepancies in spending that are not due to changes in sales volume or activity level.
3. Decision-Making: Provides valuable information for managerial decision-making, as it reflects the current operating environment.

Disadvantages of a Flexible Budget:

1. Complexity: More complex to prepare as it requires an analysis of cost behavior patterns and the development of cost formulas.
2. Time-Consuming: The preparation process can be more time-consuming than that of a fixed budget.
3. Estimation Errors: If the estimates of how costs behave relative to activity levels are incorrect, the flexible budget can be as misleading as a static budget.

In practice, flexible budgets are often prepared in spreadsheet software that automatically adjusts cost and revenue lines based on inputted activity measures. They are particularly useful in industries where costs are heavily dependent on volume, such as manufacturing or retail. By using a flexible budget, managers can get a better understanding of variances between expected and actual performance, and therefore make more informed decisions.

A budget that flexes the budgeted level of costs and revenues according to the level of activity actually achieved is called flexed budget. It is prepared at the end of the period at actual activity level, if budgeted and actual activity is not same. It provides like with like comparison. It provides realistic performance
measurement. It determines cost behaviour patterns. For variance reporting, actual costs are compared with the flexed budget for the same volume of production and sales. Variance can be either favourable or adverse. Appropriate control action is then taken to control variances. Remember only sales and variable costs are flexed, fixed costs are taken as it is from the original budget.

Benefits of a Flexed Budget:

• Accuracy: Provides a more accurate basis for comparison by adjusting for the actual level of activity.
• Control: Helps in controlling costs by highlighting variances that can be examined for efficiency and performance.
• Responsiveness: More responsive to changes, which can help in agile decision-making and planning.

Challenges of a Flexed Budget:

• Requires Understanding of Cost Behavior: To flex a budget accurately, a clear understanding of which costs are fixed, variable, and semi-variable is necessary.
• Complexity in Preparation: Adjusting budgets to reflect actual activity can be complex and may require sophisticated accounting software or models.

Flexed budgets are particularly valuable in scenarios where there are significant fluctuations in activity levels, making it challenging to estimate costs and revenues in advance. They allow organizations to maintain more accurate financial control and make appropriate decisions based on the current economic environment and the organization’s performance.

In summary, fixed budgets provide a simple but rigid framework that is best used in stable conditions. Flexible budgets offer an adaptable model that can adjust to changes and provide accurate cost control, making them suitable for a dynamic environment. Flexed budgets, meanwhile, are used to provide an accurate basis for performance comparison after accounting for the actual levels of activity.

Choosing the right type of budget is crucial for an organization’s financial health, as it directly affects the planning, monitoring, and control of financial performance. It is essential for businesses to understand their operating environment and select the budgeting method that best suits their needs to maximize efficiency and profitability.