by It is a budget known as constant budget, never registers the changes in the preparation of a budget, being prepared for irrespective level of output or production. This budget is mainly meant for the fixed overheads of the firm which are constant in volume irrespective level of production. The ultimate utility of the budget is to control the cost as a cost controlling measure, but the fixed budget is meaningless in having comparison with the actual performance.
A fixed budget is a financial plan that is not modified for variations in actual activity. Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:
- The industry is not subject to much change, so that revenues are reasonably predictable.
- Costs are largely fixed, so that expenses do not change as revenues fluctuate.
- The company is in a monopoly situation, where customers must accept its pricing.
Mitigate
A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where a new budget period is added onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, the most recent projections are incorporated into the budget, while also maintaining a full-year budget at all times.
Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.
The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected – the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavourable variances, even though they are simply doing what is needed to keep up with customer demand.
Features of Fixed budget
- The performance report does not contain useful information and misleading one.
- Fixed budget is rarely prepared and used. The reason is that the actual output is differing from the budgeted output. Hence, the management cannot exercise cost control.
- If units are overlooked in the cost-to-cost comparison, accurate result is not available.
- Fixed budget is limited by the costs and expenses which are affected by fluctuations in volume. This is a well known accepted fact.
- The performance report gives merely whether the actual costs are higher or lower than budgeted costs.
- There is no meaning of comparing one activity level with some other activity level. A fixed budget can be usefully employed when budgeted output is close to the actual output.
Example
let’s assume that a company pays a 5% sales commission on all of its sales. If the company prepares a fixed budget and it is projecting sales of Rs.1 million, the budget for sales commissions will be fixed at Rs.50,000. If the actual sales end up being only Rs.900,000 the budget for sales commissions will remain unchanged at the fixed amount of Rs.50,000. If the actual sales are Rs.1,100,000 the budget for sales commissions will also be Rs.50,000.
Had the company prepared a flexible budget, the budget for sales commissions would be expressed as 5% of sales. This means that the budget for sales commissions will be Rs.50,000 only when sales are Rs.1 million. If the company has actual sales of Rs.900,000, the budget for sales commissions will flex and will be Rs.45,000 (5% of Rs.900,000). If the actual sales are Rs.1,100,000 the budget for sales commissions will be Rs.55,000.
