Setting standards and flexing - Flexed budgets vs static bud...

Learning Outcomes

After reading this article, you will be able to explain the purpose of setting standards in budgeting, distinguish between static and flexed budgets, identify common pitfalls in performance evaluation, and accurately flex a budget to match actual activity for meaningful variance analysis. You will be prepared to apply these concepts directly in ACCA Performance Management (PM) exam questions.

ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand how budgets serve as tools for planning, control, and performance assessment. This article focuses your revision on:

• The purpose and process of setting standards for budgeting and performance monitoring
• The differences between static (fixed) budgets and flexed budgets
• How to construct a flexed (flexible) budget at the actual level of activity achieved
• Recognising when performance measures based on static budgets are misleading
• Application of cost behaviour knowledge for accurate budget flexing
• Incorporation of flexed budgets in variance analysis and performance appraisal

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. If actual output is 12,000 units but the original budget was set for 10,000 units, what is the correct method for evaluating production performance?

   • a) Compare actual results to the original budget
   • b) Flex the budget to 12,000 units and compare
   • c) Ignore cost variances
   • d) Compare variable costs only

2. Which statement best describes a static (fixed) budget?

   • a) Adjusts for different production volumes
   • b) Remains unchanged regardless of actual activity
   • c) Includes only variable costs
   • d) Used solely for variance analysis

3. True or false? If a manager is appraised using a static budget when output differs from plan, the performance evaluation will always be fair.

4. Briefly explain the main advantage of a flexed budget compared to a static budget.

Introduction

Standards are essential in budgeting, providing a consistent basis for planning, controlling costs, and evaluating performance against pre-set targets. However, the usefulness of budgets depends on their relevance to actual operations. When activity levels shift from the original plan, direct comparison between actual results and a static (fixed) budget is often misleading, particularly for variable costs.

To address this, flexed budgets are used to provide a fair, consistent benchmark by adjusting the original budget to the actual level of activity. ACCA PM candidates must understand why flexing is required, how to do it, and how misapplying static budgets can distort variance analysis and managerial assessments.

Key Term: static (fixed) budget
A budget prepared for a single, specific level of activity, which does not change regardless of actual output.

Key Term: flexed budget
A budget that is recalculated ("flexed") to reflect the actual level of output achieved, showing what costs and revenues should have been for that activity.

SETTING STANDARDS AND THE ROLE OF BUDGETS

Setting standards in the budgeting process involves estimating what a business expects to achieve under defined operating conditions. Standards should be realistic and set at a level that motivates staff without being unattainable. They provide the basis for establishing budgets, which in turn serve as targets for operations.

Static budgets, set at the beginning of the period, remain unchanged regardless of what actually happens. These are useful for planning and setting initial targets. However, for control and review purposes, particularly for variable costs that are expected to change with output, relying solely on the static budget leads to unfair or inaccurate performance assessments.

LIMITATIONS OF STATIC (FIXED) BUDGETS

Static budgets assume that all key conditions, especially output volume, will match the original plan. This is rarely the case in practice. If actual activity (such as sales or production) is higher or lower than budgeted, many costs—especially variable costs—will naturally differ.

Evaluating a manager's performance by comparing actual variable costs for, say, 12,000 units, to a static budget for 10,000 units is unfair. The budget did not allow for the higher cost that would arise from producing more units. This results in misleading variances, usually overestimating cost overruns and possibly penalising good performance.

Exam Warning

Never compare actual results at one activity level to a static budget set for a different output. This is a common error in ACCA PM exams and loses easy marks.

ADVANTAGE OF FLEXED BUDGETS

A flexed budget adapts the original budget to the actual output level achieved, adjusting variable costs and leaving fixed costs unchanged (provided they are within the relevant range). This offers a "like-for-like" comparison—actual costs against what those costs should have been for the activity that actually occurred.

The result: variances that are meaningful and highlight real operational performance rather than differences simply due to changes in activity.

Worked Example 1.1

A company budgets to produce 10,000 units. Budgeted variable costs are $5 per unit, and fixed costs are $20,000. Actual production in the month is 12,000 units and total actual costs are $84,000.

Prepare a statement comparing actual results to both the static and flexed budgets, and calculate the variance.

Answer:

Static (original) budget (10,000 units):

• Variable costs: 10,000 × $5 = $50,000
• Fixed costs: $20,000
• Total budgeted cost: $70,000

Flexed budget (12,000 units):

• Variable costs: 12,000 × $5 = $60,000
• Fixed costs: $20,000
• Total flexed budget: $80,000

Actual total cost: $84,000

Variance (flexed budget vs. actual): $84,000 – $80,000 = $4,000 Adverse

If you had compared actual costs to the static budget, you would report a $14,000 over-spend ($84,000 – $70,000), which is misleading and unfair.

COST BEHAVIOUR IN FLEXED BUDGETS

When flexing a budget, treat each cost using its correct classification:

• Variable costs: Adjust proportionally to actual output.
• Fixed costs: Remain the same, provided production is within the planned capacity range.
• Semi-variable (mixed) costs: Split into fixed and variable elements and flex only the variable part.

Failing to apply the correct behaviour leads to faulty analysis.

Worked Example 1.2

A department's electricity cost is $1,400 at 1,000 machine hours and $1,700 at 1,500 hours. What would be the flexed budget for 1,200 machine hours?

Answer:

First, use the high-low method to estimate variable and fixed components:

Variable cost per hour = ($1,700 – $1,400) / (1,500 – 1,000) = $0.60 per hour
Fixed cost = $1,400 – (1,000 × $0.60) = $800

Flexed budget at 1,200 hours: $800 (fixed) + 1,200 × $0.60 = $1,520

FLEXED BUDGETS IN VARIANCE ANALYSIS

Variance analysis compares actual results to budget. Using a flexed budget ensures:

• Variances reflect operational efficiency or inefficiency, not just volume changes.
• Managers are held accountable for what they could control, not penalised for output changes outside their control.

STATIC VS FLEXED BUDGETS – AT A GLANCE

Revision Tip

If a question gives actual output or sales that differ from budget, always calculate a flexed budget before calculating any variance.

Summary

Using a static (fixed) budget for performance comparisons can mislead if actual activity differs from plan. Flexed budgets adjust for actual output, yielding fair and relevant analysis of cost variances and managerial performance. Clear understanding and proper application of flexing techniques are essential for exam success and real-world control.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain why static (fixed) budgets are unsuitable for control when actual activity differs from plan
• Describe how a flexed budget is constructed and when it should be used
• Distinguish how variable and fixed costs are treated when flexing budgets
• Recognise the importance of cost behaviour in flexing budgets accurately
• Apply flexed budgets to produce meaningful variance analysis for performance evaluation

Key Terms and Concepts

• static (fixed) budget
• flexed budget