The discussion of the master budget and its components in the preceding section was based on the assumption of fixed level of activity. In other words, the budgets were related to a specific level of operation implying thereby that a firm can accurately and precisely forecast the level of its behavior operations in a given period of time. If the business environment is capable of accurate prediction, this approach to budgeting is likely to yield dependable results. If. however, changes take place during the period budget will serve no useful purpose. Such a budget is technically referred to as a fixed static budget. In other words, budgets prepared at a single level with no prospect of modification in the light of the changed circumstances, are fixed or static budgets. The alternative to fixed budgets are flexible/variable/sliding budgets. The term flexible is the most apt description of the essential features/characteristics of these budgets and is used here to refer to such budgets.
A flexible budget estimates costs at several levels of activity. The merit of a flexible budget is that instead of one estimate it contains several estimates/plans in different assumed circumstances. Since business activities cannot be accurately predicted as the business conditions/environment are uncertain, it is a useful tool in real business situations, that is, an unpredictable environment. In view of its significance as a more realistic basis of budgeting the setting up of a flexible budget is demonstrated in the discussions that follow.
It may at the outset be noted that the construction of a flexible budget i, similar to that of a fixed budget except in one respect. While the fixed budget is based on costs and other business operations/activities at one level, the flexible budget considers several alternatives levels-volumes of activity The term volume/level of activity refers to the usage of capacity. In other words, volume/level of activity signifies the percentage use of capacity. The term capacity means the installed capacity of plant and personnel, that is, the fixed amount invested in these. For instance, if a plant when fully operated can produce 5,000 units, us capacity is 5,000 units of production. Assuming 2,500 units of production in a given period, the volume/level of activity is 50 per cent.
Thus, the essence of a flexible budget is the presentation of estimated cost data in a manner that permits their determination at various levels of volume. This means that all costs must be identified as to how they behave with a change in volume whether they vary or remain fixed. The conceptual framework of flexible budgeting, therefore, relates to: (i) Measure of volume and (ii) Cost behavior identified with change in volume.