Classification based on capacity (fixed budgets, flexible budgets)

Classification based on capacity is another way to categorize budgets. Here are the two main types based on their capacity to adjust to changes:

1. Fixed Budgets: A fixed budget, also known as a static budget, is designed for a specific level of activity or capacity. It remains unchanged regardless of the actual level of activity achieved. In a fixed budget, the revenue and expense figures are predetermined and do not adjust with changes in sales volume, production levels, or other activity measures. Fixed budgets are typically prepared in advance based on forecasts or historical data. While fixed budgets provide a benchmark for comparison, they may become less relevant if actual activity levels deviate significantly from the budgeted capacity.
2. Flexible Budgets: A flexible budget, also referred to as a variable budget, is designed to adjust according to changes in activity or capacity. It provides a more realistic and dynamic view of financial performance by incorporating different levels of activity. Flexible budgets are typically based on a formula or set of assumptions that allow for adjustments based on the actual level of activity achieved. Revenue and expense figures in a flexible budget change proportionately with changes in activity levels. Flexible budgets are useful in industries where activity levels fluctuate or where there is uncertainty in demand or production capacity.

The key difference between fixed budgets and flexible budgets lies in their ability to adapt to changes in activity or capacity. Fixed budgets remain static regardless of actual activity levels, while flexible budgets are designed to adjust and reflect the impact of different activity levels on revenues and expenses. Flexible budgets provide more accurate insights into performance and facilitate better decision-making in situations where activity levels are variable or uncertain.