A fixed budget is a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained i. e. it is a single budget with no analysis of cost. On the other hand a flexible budget is a budget which is designed to adjust the permitted cost levels to suit the level of activity actually attained. The process by which this is done is by analysing costs into their fixed and variable elements so that the budget may be 'flexed' according to the actual activity.
The procedures for developing a flexible budget are simple enough but the results obtained from 'flexing' a budget are only accurate if the costs behave in the ways predicted. Frequently, simplistic assumptions are made about cost behaviour which are unrealistic and potentially misleading. The fact that often all variable costs are flexed in relation to the same activity indicator (e. g. sales or output) when in reality different variable costs vary in sympathy with different activity indicators. These and other problems make it necessary to treat any flexed budget with caution.
A flexible budget is essential for the control aspect of budgeting but it is an important part of the planning process to consider what control procedures will be necessary, it is usual to carry out the required cost analyses and breakdowns at the planning stage so that the budget may be flexed in due course if this is necessary. This is sometimes known as the limiting factor or principal budget factor. This is a factor, which is a binding constraint upon the organisation i. e. the factor, which prevents indefinite expansion or unlimited profits.
It may be sales, availability of finance, skilled labour, supplies of material or lack of space. Where a single binding constraint can be identified, then the general objective of maximising contribution can be achieved by selecting the alternative which maximises the contribution per unit of the key factor. It will be apparent that from time to time the key factor in an organisation will change. For example, a firm may have a shortage of orders, it overcomes this by appointing more salesmen and then there is a shortage of machine capacity.
The expansion of the production capacity may introduce a problem of lack of space and so on. Note: The 'maximising contribution per unit of the limiting factor' rule can be of value, but can be used where there is a single binding constraint and where the constraint is continuously divisible i. e. it can be altered one unit at a time. Where several constraints apply simultaneously, the simple rule given above cannot be applied. This is not usually a problem for examination purposes, but in real life is rarely that simple.