Why is a flexible budget better than a static budget?

Sometimes, things are actually intuitive. That just so happens to be the case here: static and flexible budgets are pretty closely related to what they’re called! In this video we’ll discuss different advantages and disadvantages of both styles. Which budget style you choose for your company or client will largely depend on the nature of that business.

Put simply, a static budget is one where the budget doesn’t change over the given period. Budgets for various departments are set, and then must be adhered to regardless of changing circumstances over the period. The period used doesn’t have to be the fiscal year; it could be a quarter or another determined period of time. A static budget may work well for short periods of time and/or for organizations that work with predictable revenue and expenses.

A flexible budget allows you to set expenditure goals as percentages of revenue. This allows an organization to manage spending based on more recent information, rather than looking at the year ahead and hoping circumstances don’t change much.

Your first step in building a flexible budget is to determine what all of your costs are. Identify those that are fixed and group them together. Then build your budgetary model where fixed costs are established and variable costs are set as a percentage of an activity or of a per-unit cost. Next, enter those activity costs into the model. Finally, compare the model to a completed period to determine how similar they are.

Notice that a flexible budget will still include fixed costs – rent/mortgage, utilities, etc. Very few businesses will have exclusively fixed or entirely variable costs. A variable budget allows you to take all of those costs into account. Another benefit to a flexible budget is the variances you get from the budget to actual are smaller and more significant, since you modulate your budget as you go.

There are a handful of disadvantages to a flexible budget, however:

As we’ve already seen, most costs are not exclusively fixed or variable. Wages may be variable while rent may be fixed, but only within a certain range – if your staff grows or shrinks too much you may need to adjust the size of the office, and the rent will change, not to mention other incidental costs you’ll incur as part of that transition process.
They’re also more difficult to build and take longer to close out.
Finally, you can’t compare budget to revenue, since your budget intentionally tracks your revenue.

Static budgets, on the other hand, are simpler to set up and simpler to use. But that ease of use means that the model is less helpful in certain circumstances.

I hope this short introduction was helpful, and if it was, I’d love it if you’d subscribe and give us a thumbs-up! See you next time.

Do you think preparing budgets is a waste of time? If so, you're probably doing it wrong. More than likely, you dutifully prepare a static budget each year and put it in your desk drawer – and it's not seen again until it's time to prepare a new budget. You should be creating flexible budgets, not static ones. Flexible budgets have distinct advantages over static budgets. After you get used to flexible budgets, they will become one of your favorite management tools.

What Is a Flexible Budget?

First, what is a static budget? It's a budget that is prepared at the beginning of the year and not changed until it's time to make a new one at the start of the next year. A static budget is just that – static. The numbers do not change for the entire year, regardless of anything that happens in the business environment.

A flexible budget, on the other hand, is a series of budgets prepared for various levels of activities, revenues and expenses. Flexible budgets get modified during the year for actual sales levels, changes in cost of production and virtually any other change in business operating conditions. This flexibility to adapt to change is useful to owners and managers.

Take Advantage of Opportunities

Variable expenses in flexible budgets are defined as percentages of sales. For example, if sales were to increase dramatically, flexible budgets would get adjusted to increase spending on marketing to take even more advantage of unexpected increases in revenues.

Similarly, while a static budget would limit hiring more employees, a flexible budget would adapt to the need for more staff to meet increased demand by increasing the budget for payroll expenses.

Adjust for Changing Costs and Profit Margins

With static budgets, costs of operations and product profit margins are set at the start of the year, based on historical data. Unfortunately, real life doesn't let everything stay the same. Flexible budgets can handle these changes.

Suppose material costs for a product suddenly increase during the year, making this item unprofitable. A flexible budget would spot this variance, and management could take corrective actions. It might be a price increase or an effort to find cost savings in manufacturing expenses.

Better Cost Controls

Flexible budgets react more quickly to adverse conditions. Suppose the budget was set up with the expectation that sales would be $200,000 per month and labor cost was budgeted at $50,000 per month, or 25 percent of sales.

If sales declined to $150,000 per month, then labor cost should be reduced to $37,500 (25 percent of $150,000). A static budget would not adjust to the decline in revenues and would keep labor costs at the original level.

Updated With Current Data

Revenues and expenses are constantly adjusted in flexible budgets for current operating conditions. New environmental regulations might increase the costs of production and could require the purchase of different types of machines. Weather conditions could increase shipping costs and result in delayed shipments to customers.

With flexible budgets, managers are constantly updating their projections and cost controls with current information. The most significant advantage of flexible budgets over static ones is the ability to adapt to changes in the real world. Nothing ever stays the same, and management has the responsibility to respond to unanticipated adverse conditions and to take advantage of unexpected opportunities.

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