In budgeting and management accounting, what is the key difference between a fixed budget and a flexible budget?

Introduction / Context:
Questions about fixed and flexible budgets commonly appear in management accounting, cost accounting and finance interviews. Budgeting is a planning and control tool, and understanding the difference between fixed and flexible budgets helps in evaluating performance. A clear explanation shows that you understand how managers deal with changes in activity levels when comparing actual results with planned figures.

Given Data / Assumptions:

• Organisations prepare budgets to estimate revenues and costs for a future period.
• Actual output or sales volume may differ from the planned or budgeted volume.
• Some costs are fixed, some are variable and some may be semi variable.
• Managers want to compare actual performance against an appropriate benchmark.

Concept / Approach:
A fixed budget, also called a static budget, is prepared for one specific level of activity, such as producing 10,000 units or providing 5,000 service hours. Once set, the figures do not change, even if actual output is higher or lower. This can cause misleading variance analysis because differences in cost may be due simply to volume changes rather than efficiency. A flexible budget, on the other hand, is designed to adjust to different levels of activity. It recalculates budgeted variable costs (and sometimes mixed costs) based on the actual volume achieved, making comparisons more meaningful.

Step-by-Step Solution:
Step 1: Define a fixed budget as a budget drawn up for one planned level of activity, with all costs and revenues based on that single level. Step 2: Note that when actual activity differs from the planned activity, a fixed budget remains unchanged, so variances mix volume effects with efficiency or price effects. Step 3: Define a flexible budget as a budget that can be re stated or adjusted for different activity levels, often using cost behaviour classifications such as fixed and variable costs. Step 4: Recognise that under a flexible budget, variable costs are recalculated based on actual output, while fixed costs remain the same within the relevant range. Step 5: Conclude that the key difference is the ability of a flexible budget to adapt to actual activity, improving performance measurement compared to a fixed budget.

Verification / Alternative check:
Imagine a company prepares a fixed budget to produce 10,000 units with Rs 200,000 in variable costs and Rs 100,000 in fixed costs. Later, actual production is 12,000 units, and actual variable cost is Rs 240,000. Comparing this to the original fixed budget shows an apparent unfavourable variance, even though variable cost per unit remained constant. Under a flexible budget, the budgeted variable cost at 12,000 units would be Rs 240,000, matching reality, and only differences in efficiency or price would appear as variances. This example confirms that flexible budgets adjust for activity levels, unlike fixed budgets.

Why Other Options Are Wrong:
Option B incorrectly ties fixed and flexible budgets to types of organisations rather than to their structure. Option C confuses time period (monthly versus yearly) with the nature of the budget. Option D is wrong because both fixed and flexible budgets can include fixed and variable costs; the distinction lies in how they respond to changes in activity. Option E is incorrect because both budgets rely on assumptions and forecasts; a flexible budget simply allows those estimates to be recalculated at different activity levels. Only option A accurately captures the fundamental difference.

Common Pitfalls:
Students often think flexible budgets are only used after the period ends, but in reality they can also be used in planning multiple scenarios. Another mistake is assuming that flexibility means changing targets arbitrarily, when in fact it means adjusting cost expectations to reflect actual volume. In exams and interviews, clearly state that a fixed budget is static and prepared for one activity level, whereas a flexible budget adapts costs to actual or alternative levels of activity to make performance comparisons fairer and more informative.

Final Answer:
A fixed budget is prepared for a single level of activity and does not change with actual output, whereas a flexible budget can be adjusted to different activity levels to provide more realistic cost comparisons.