Business have different options for how they prepare and handle their budgets. Two basic forms of budgeting include static budgeting and flexible budgeting. These budgets have distinct definitions and functions, but they have a close relationship. Because the two budgets are so closely linked, most companies end up using both.
A static budget is geared toward one level of activity, such as the amount your company produces. It estimates your costs within a set period of time. You compare results actually achieved against the budget only at the original activity level. In layman's terms, this just means the budget is fixed and doesn't change regardless of what your volume is. For instance, if you budgeted $50,000, this figure would remain constant regardless of whether you sold 1 million, 2 million or even 50 million units.
A flexible budget is one in which you address a range of activity instead of just one level. Unlike the static budget, flexible budgets change based on the amount of volume or activity you have. For example, if your actual sales are 1 million units, you budget may be $2 million. If your actual sales are 1.5 million units, however, your budget might increase to $2.5 million. If your sell just 500,000 units, your budget might decrease to $1.5 million.
Often, activity or volume in a business differs from what managers estimate. For example, a company may sell $10,000-worth of a product when sales were projected for only $5,000. To take this difference into account and plan financially with more accurate numbers, managers compare the results they achieved to what was listed in the static budget. This tells the managers what costs should have been. The result is the flexible budget. Flexible budgets adjust the static budget for what actually happened. In addition, because management usually ends up working off the adjusted budget, the adjusted budget essentially becomes the new static budget, which managers will adjust again later. Some managers see flexible budgets as merely a series of static budgets for these reasons.
Ideally, businesses should use both static and flexible budgeting. The fixed or static budget provides a starting point for the company's activity. However, it is almost impossible to always have results that match exactly what you plan. Flexible budgeting accommodates this and lets you plan based on your current situation. Looking at your static and flexible budgets is important because you have to identify whatever caused the volume to deviate from what you expected. If you can do this, you can control your finances to a better degree and have more control over your operations. This is why businesspeople view static and flexible budgeting as invaluable managerial tools.
- Hemera Technologies/Photos.com/Getty Images