7.2 Fixed versus Flexed Budgets

7.2 Fixed versus Flexed Budgets

Key Concept: Evaluating factory performance by comparing actual costs at one output level against a fixed budget set for another is mathematically invalid—it compares apples with oranges. A flexed budget adjusts budgeted figures to the actual level of output achieved, establishing a scientifically sound basis for isolating operational efficiency from activity volume shifts.

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PCTN scope: PCTN requires you to understand the difference between fixed and flexible budgets (learning outcome 3.1.2). Its variance calculations compare actual results with the fixed budget (Section 7.3). Full flexed-budget performance reports like the one below are developed at Level 3, but working through one shows exactly why a fixed-budget comparison can mislead.

The Concept and Inherent Flaw of the Fixed Budget

A fixed budget (also known as a static budget) is a financial plan prepared prior to the start of the control period based entirely on a single, assumed level of activity. For example, an engineering firm might draft its annual operating plan on the assumption that it will manufacture and sell exactly 10,000 machine assemblies.

While a fixed budget is vital for strategic planning, determining long-term capital expenditure, and establishing debt financing covenants, it suffers from a fatal limitation when used as an operational control mechanism:

The Fixed Budget Control Fallacy: If the factory achieves an output different from the original budget, comparing actual costs directly against the fixed budget produces completely distorted variances.

The 'Apples to Oranges' Dilemma

Consider what happens when actual production diverges from the fixed plan:

• Scenario A: Higher Actual Production (e.g. 12,000 units produced vs 10,000 planned): Because direct materials, direct labour, and variable overheads naturally scale with volume, the factory will inevitably consume more resources than planned. Comparing actual costs for 12,000 units against a fixed budget designed for 10,000 units reveals an apparent adverse cost variance. Management might unfairly criticize the factory supervisor for overspending, when in reality the supervisor merely consumed the expected resources to fulfill an extra 2,000 units of customer demand!

• Scenario B: Lower Actual Production (e.g. 8,000 units produced vs 10,000 planned): Because fewer units were made, total variable spending will naturally drop below the 10,000-unit budget. A crude fixed-budget comparison will show a large favourable cost variance, creating the false impression of outstanding efficiency, even if the workforce was grossly wasteful, idle, and inefficient on a per-unit basis.

To conduct a meaningful performance appraisal, the budget must be flexed.

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What is a Flexed Budget?

The Chartered Institute of Management Accountants (CIMA) defines a flexed budget as:

"A budget which, by recognizing different cost behaviour patterns, is designed to change as volume of output changes."

Rather than evaluating what costs were planned for a hypothetical volume, a flexed budget shows what costs and revenues should have been for the actual volume of activity achieved under standard operating conditions.

Fixed Budget (Original Plan)  ────[ Volume / Activity Variance ]────>  Flexed Budget (Standard for Actual)
                                                                           │
                                                                           │  [ Operational / Cost Variance ]
                                                                           ▼
                                                                      Actual Results (Realized Outcomes)

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Rules for Flexing Costs by Behaviour Category

To prepare a flexed budget accurately, every revenue and cost line must be categorized by its cost behaviour pattern:

1. Variable Costs

Variable costs increase or decrease in direct proportion to changes in operational activity. The standard cost per unit remains constant.

$\text{Flexed Variable Cost} = \text{Actual Output (Units)} \times \text{Original Budgeted Variable Cost per Unit}$

Where: $\text{Original Budgeted Variable Cost per Unit} = \frac{\text{Original Fixed Budget Variable Cost}}{\text{Original Budgeted Output Units}}$

2. Fixed Costs

Fixed costs remain constant in total across the relevant range, irrespective of fluctuations in production volume. Rent, business rates, factory insurance, and senior executive salaries do not increase simply because the shop floor manufactured 15% more units.

$\text{Flexed Fixed Cost} = \text{Original Fixed Budget Amount}$

Exam Trap Alert: Never calculate a 'fixed cost per unit' and multiply it by actual output when flexing a budget. In financial control and flexed budget statements, fixed costs are treated as lump sums. Multiplying standard fixed cost per unit by actual output introduces absorption volume variances, which violates the principles of cost behaviour!

3. Stepped Fixed Costs

Stepped fixed costs remain constant within specific activity brackets but jump by a discrete lump sum when output crosses a critical capacity threshold (e.g. needing an additional supervisor for every 5,000 units, or leasing a second warehouse once production exceeds 10,000 units). When flexing, identify whether actual output falls within the baseline bracket or has crossed into a higher stepped tier.

4. Semi-Variable (Mixed) Costs

Semi-variable costs contain both a fixed baseline component and a variable operational component (e.g. factory maintenance, telephone bills, equipment power).

Before a semi-variable cost can be flexed, it must be split into its fixed and variable elements. When a task gives the cost at two activity levels, the split can be found with the high-low method (a Level 3 technique, shown here for completeness):

$\text{Variable Cost per Unit} = \frac{\text{Cost at Highest Activity Level} - \text{Cost at Lowest Activity Level}}{\text{Highest Activity Level Units} - \text{Lowest Activity Level Units}}$

$\text{Fixed Cost Element} = \text{Total Cost at High Activity} - (\text{High Activity Units} \times \text{Variable Cost per Unit})$

Once split, the flexed cost is determined as:

$\text{Flexed Semi-Variable Cost} = \text{Fixed Element} + (\text{Actual Units} \times \text{Variable Cost per Unit})$

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The High-Low Method Application Prior to Flexing

Suppose Highfield Precision Engineering Ltd tracks its machine maintenance expenditure across varying operational volumes:

• At 8,000 units of output, total maintenance cost is £76,000.
• At 12,000 units of output, total maintenance cost is £100,000.

Step 1: Calculate the Variable Rate: $\text{Variable Maintenance Cost per Unit} = \frac{£100,000 - £76,000}{12,000\text{ units} - 8,000\text{ units}} = \frac{£24,000}{4,000\text{ units}} = £6.00\text{ per unit}$

Step 2: Calculate the Fixed Baseline: $\text{Fixed Maintenance Cost} = £100,000 - (12,000\text{ units} \times £6.00) = £100,000 - £72,000 = £28,000$ (Verification at lowest level: $£76,000 - (8,000 \times £6.00) = £76,000 - £48,000 = £28,000$).

If the company actually manufactures 11,000 units, the flexed maintenance budget is: $\text{Flexed Maintenance Cost} = £28,000 + (11,000\text{ units} \times £6.00) = £28,000 + £66,000 = \mathbf{£94,000}$

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Comprehensive Worked Performance Report: Highfield Precision Engineering Ltd

Highfield Precision Engineering Ltd established its original fixed annual budget based on an anticipated production and sales volume of 10,000 units. At the close of the financial year, actual output achieved was 11,500 units.

Baseline Standard Cost Data (per unit at 10,000 units)

• Selling Price: £80.00 per unit
• Direct Materials: 3 kg @ £8.00 per kg = £24.00 per unit
• Direct Labour: 1.5 hours @ £12.00 per hour = £18.00 per unit
• Variable Production Overhead: 1.5 hours @ £4.00 per hour = £6.00 per unit
• Semi-Variable Overhead: £88,000 total at 10,000 units (Comprising £28,000 fixed plus £6.00 per unit variable, as calculated above)
• Fixed Production Overheads: £120,000 (lump sum)
• Fixed Administration Overheads: £50,000 (lump sum)

Actual Financial Results Achieved (11,500 units)

• Sales Revenue: £908,500 (average £79.00 per unit)
• Direct Materials: £289,800
• Direct Labour: £212,750
• Variable Overheads: £71,300
• Semi-Variable Overheads: £99,200
• Fixed Production Overheads: £124,000
• Fixed Administration Overheads: £49,500

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The Three-Way Budgetary Performance Report

The table below presents the full side-by-side performance schedule, comparing the Original Fixed Budget, Volume Variance, Flexed Budget, Actual Results, and the resulting Operational Variances:

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Analytical Breakdown of Results

1. Calculation of Flexed Figures (11,500 units):

   • Sales Revenue: $11,500 \times £80.00 = £920,000$
   • Direct Materials: $11,500 \times £24.00 = £276,000$
   • Direct Labour: $11,500 \times £18.00 = £207,000$
   • Variable Overhead: $11,500 \times £6.00 = £69,000$
   • Semi-Variable Overhead: Fixed element £28,000 + ($11,500 \times £6.00 = £69,000$) = £97,000
   • Fixed Overheads: £120,000 and £50,000 (remain constant)

2. Reconciliation of Operating Profit:

Why This Distinction Matters to Management

If the managing director had simply compared the actual profit of £61,950 against the original fixed budget profit of £62,000, they might have concluded that performance was 'on target' (a trivial £50 shortfall).

However, the flexed budget reveals the true reality:

• Because sales volume surged by 15% (1,500 units), the company should have earned £101,000 in profit.
• Instead, operational inefficiencies, price discounting, and uncontrolled cost spending eroded £39,050 of expected earnings.
• The fixed budget completely concealed this major operational failure, whereas the flexed budget highlights it with absolute clarity.

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Distinguishing Activity (Volume) Variances from Operational Variances

The two kinds of variance answer different questions:

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Common Exam Traps in Budget Flexing

• Trap 1: Flexing Fixed Overheads. Multiplying the fixed overhead per unit by actual volume is an error that turns a fixed cost into an artificial variable cost. In a flexed budget schedule, total fixed costs must remain unchanged.
• Trap 2: Ignoring Semi-Variable Cost Splits. Flexing a mixed cost in its entirety by multiplying the original total cost by the percentage change in output distorts the fixed baseline.
• Trap 3: Inverting Cost Variance Directions. For revenues, Actual > Budget is Favourable. For costs, Actual > Budget is Adverse (spending more money than permitted reduces profit!).