a) Distinguish between fixed and flexible budgeting.

The fixed budget sets out the plans for the business for the next accounting period based on various assumptions of sales and sales growth, inflation (in particular labour inflation), interest rates, taxation and capital expenditure. It is known as the fixed budget as it is based on these fixed assumptions of trading performance and financial outlook. Thus the fixed budget represents the overall plan for the organisation for the next accounting period.

Flexible budgeting can be used to assist in budgetary control when comparing actual performance with the budget. From a control perspective comparing actual performance to a fixed budget may not provide much useful information if the actual activity varied significantly from the original plan. It is far more informative for the business to compare performance under similar conditions. Thus the use of flexible budgets allows the fixed budget to be adjusted (flex the fixed budget) to allow for actual activity in making the comparison between actual and budgeted performance. The flexible budget therefore substitutes the actual volume achieved into the fixed budget, keeping the unit costs and the fixed cost as agreed in the fixed budget.

For example, there is little value in comparing a hotels performance based on forecast sales of 80,000 bed-nights compared to actual sales of 120,000 bed-nights as we are not comparing like with like. Not alone will sales be different, but also variable costs will differ as they will vary with sales. Fixed costs may be greater than budgeted due to the fact that the hotels sales performance has exceeded the relevant range. Part of the process of comparing budgeted performance with actual involves flexing the fixed budget to the same activity level as actual, and then comparing actual sales and costs with the flexible budget. It is important to remember that there is still a positive volume variance of 40,000 bed-nights, but once this is identified, it is important to go on and compare costs and revenues under similar conditions. It is also important to remember that the fixed budget still remains as the target for the year. The flexible budget is only used as a tool to improve management control information.

b) What are the main features of a control system?

• The business should be organised into various centres where costs and revenues can be traced to individual managers with responsibility for making the decisions and controlling the costs and revenues of these departments or cost centres.
• Each centre should develop a fixed budget to provide a benchmark from which to compare performance.
• Actual performance should be measured frequently. Actual performance can be measured on a daily, weekly, monthly or quarterly basis depending on the size of the business and its control system.
• Actual performance should be compared to budgeted targets with variances (differences) identified and categorised as favourable or adverse. This can ensure early detection of problems and hence ensure timely corrective action is taken.
• Management should consider which variances are significant and thus require further investigation and action.
• Management should understand and be able to explain the causes of significant variances and decide whether or not they are within their control. For example variances may be due to:
• Unreasonable targets set in the budget.
• Once-off or random events that distort actual performance.
• Inefficiencies within the organisation.
• Where possible management should take corrective action.