According to level of activity or capacity, budgets are classified into flexible budget and fixed budget.
Flexible Budget Definition
In contrast to a fixed budget, a flexible budget is one which is designed to change in relation to the level of activity attained. The
underlying flexible budget definition is that, a budget is of little use unless cost and revenue are related to the actual volume of
production. Flexible budgeting has been developed with the objective of changing the budget figures to correspond, with the actual output achieved. Thus a
budget might be prepared for various levels of activity, say, 70%, 80% 90% and 100%/ capacity utilization. Then whatever the level of output actually
reached, it can be compared with an appropriate level.
A fixed budget is one that is prepared keeping in mind a single level of output. It is defined like a budget which is created to remain the same irrespective of the level of activity gained. If actual output varies from budgeted level of output, variances will come up. Fixed budget is prepared on the assumption that sales and output could be estimated with a good degree of accuracy. This implies that in those situations in which output and sales cannot be correctly estimated, fixed budget does not suit.
Flexible Budget Example
Flexible budgets are prepared in those companies where it is extremely difficult to forecast output and sales. Such a situation may arise in the following
cases as flexible budget example:
1. Where nature of business is such that sales are difficult to predict e.g. demand for luxury goods is quite unpredictable.
2. Where sales are affected by weather conditions, e.g., soft drink industry, woolen garments etc.
3. Where sales are affected by changes in fashion e.g. readymade garments.
4. Where company frequently introduces new products.
5. Where large part of output is intended for export.
The Purpose of a Flexible Budget is to
The figures in flexible budgets are usually adaptable to any provided set of operating conditions. It is therefore, a lot more realistic compared to a
fixed budget that is true only in one pair of operating conditions. The purpose of a flexible budget is to control viewpoint. Actual
efficiency of an executive needs to be compared with what he need to have achieved in the actual conditions and not with what he should have attained under
quite various circumstances.
In short, flexible budgets are more practical, realistic and useful. Fixed budgets, on the other hand, possess a limited application and are suited just
for items such as fixed costs.
How to Prepare a Budget
The preparation of flexible budgets necessitates the analysis of all costs into fixed and variable components. This analysis, of course, not peculiar to flexible budgeting, is more important in flexible budgeting than in fixed budgeting. This is so because in flexible
budgeting, varying levels of output are considered and each class of overhead will be different for each level. In flexible budgeting, a series of budgets
are prepared for every major level of activity so that whatever is the actual level of output, it can be compared with appropriate budget or can be
interpolated between budgets of the activity levels on either side. For example, budgets may be prepared for, say, 60%, 70%, 80%, 90% and 100% levels of
activity. If the actual level of activity is 85%, then the budget allowance for 85% activity should be computed.