Budgeting is one of the most important aspects of financial management.
But did you know that there are actually different kinds of budgets? Depending on your specific scenario, you might wish to implement a static budget, a flexible budget, or even a zero-based budget.
In this guide, we’ll be exploring static budgets.
We’ll explain what static budgets are, when and why they are used, how they compare to flexible budgets, and the benefits and limitations associated with them.
What is a static budget?
A static budget is a financial plan created for a specific level of activity or revenue. It remains fixed, regardless of changes in the actual level of revenue, activity, or expenses during the budget period.
For example, you create a business budget based on the idea of earning $1m in revenue in the coming period. Your budget for various expense categories remains unchanged, whether you make $1m, $1.2m, or $800k.
Purpose and use of a static budget
The main reason for using a static budget is to help plan and control your financial activities.
Purposes and uses include:
- Financial planning and resource allocation
- Performance benchmarking
- Cost control
- Strategic planning and decision-making
Example of a static budget
To give you a better idea of how static budgets work, let’s explore an example.
Say a company prepares a static budget for the upcoming quarter based on an expected production level of 10,000 units.
These are the figures the finance team builds into the budget:
- Revenue: $200,000 (10,000 units x $20/unit)
- Direct Costs: $50,000 (10,000 units x $5/unit)
- Fixed Costs: $30,000
- Net Profit: $120,000
However, during the period in question, the company actually produced 12,000 units, which means its actual figures look like this:
- Revenue: $240,000
- Direct Costs: $60,000
- Fixed Costs: $30,000
- Net Profit: $150,000
Despite these performance differences, the finance team does not update the budget, since it is using a static budget model.
The discrepancy between the budget and the actual figures is represented as a variance, which can then be analyzed to understand business performance and budgeting accuracy.
Differences between static budgets vs flexible budgets
The most common alternative to the static budget is the flexible budget. A flexible budget is a more dynamic financial plan for spending that can adjust to a company’s actual activity levels.
Here are the key differences between the two kinds of budget.
Comparison of advantages and disadvantages
Both static and flexible budgets have pros and cons.
Static budgets are simple, easy to prepare, and provide a clear and consistent benchmark for performance evaluation. They are useful for fixed-cost environments.
However, they are inflexible, can lead to misleading conclusions during variance analysis, and don’t account for changes in activity that can occur, especially in unpredictable environments.
Flexible budgets, on the other hand, do adjust to actual performance, improving accuracy in analysis. They are better at identifying cost and operational inefficiencies variances and are better suited to businesses with fluctuating activity levels.
However, flexible budgets are more complex and time-consuming to prepare, require very accurate data on cost behavior, and increase administrative burden due to the need to continuously update them.
Suitability for different business scenarios
So, what kind of businesses and scenarios are each kind of budget best suited for?
Static budgets are best for:
- Organizations with predictable revenues and expenses
- Fixed-cost environments
- Projects with clearly defined and stable scopes
Some examples of suitable business scenarios for static budgets include annual school budgets, manufacturing firms with steady production levels, and long-term fixed-cost contracts.
Flexible budgets, on the other hand, are a better fit for:
- Businesses that operate in dynamic environments with variable costs and revenue
- Companies where activity levels fluctuate frequently
- Situations that require more precise variance analysis
Some examples of business scenarios that benefit from using flexible budgets include retail businesses that have seasonal sales, serviced-based industries where demand varies such as airlines, and manufacturing firms that have variable production levels.
Benefits of using a static budget
Why should you use a static budget to aid with financial planning?
Here are five important benefits.
1. Improved cost control and financial planning
A static budget provides a nice clear framework for expected expenses and income.
It helps your organization monitor and control costs effectively. You set clear, fixed financial targets, which encourage departments to stay within their allocated resources and reduce overspending, improving your overall control over costs.
2. Enhanced decision-making process
A static budget acts as a benchmark for evaluating financial performance. It makes it easier to identify where adjustments are needed, such as reducing expenditure in a given category.
Decision-makers can use this budget to assess whether actual spending aligns with organization goals and objectives, and make more effective decisions as to what to do when this is not the case.
What’s important here is the stability of the static budget, which improves clarity and reduces confusion in financial evaluations.
3. Efficient resource allocation
By clearly outlining priorities and spending limits, a static budget helps ensure that the business’s resources (which are naturally limited) are allocated to the most critical areas. It ensures that business leadership makes the decision as to what those critical areas are.
Static budgets help avoid unnecessary expenditures and foster accountability within departments that are given a clear understanding of their financial boundaries.
4. Simplicity and ease of preparation
One of the biggest benefits of using a static budget in place of a more complex option like a flexible budget is that they are incredibly simple to create and implement. This is especially true for organizations with predictable operational conditions.
This makes static budgets more accessible to teams without requiring that they have complex financial expertise.
5. Consistency in performance evaluation
Since the budget remains fixed, it provides a consistent benchmark against which the business can measure its performance over time.
The static budget makes it easy to analyze variance in actuals vs. budgeted figures, highlighting areas for operational improvement.
Limitations of static budgets
Just as static budgets provide some important benefits, they also come with a number of limitations. If you’re thinking about using a static budget format, it's a good idea to be aware of the ways in which static budgets might hold you back.
1. Inflexibility in adapting to changing circumstances
Static budgets are designed to remain fixed throughout the budget period, regardless of any change in actual activity.
This makes them less effective in dynamic situations where costs, revenues, and operational needs frequently fluctuate.
This means that some companies that use static budgets end up struggling to adjust priorities or resources when new challenges or opportunities pop up.
2. Difficulty in accounting for unexpected expenses
Unplanned costs such as emergency repairs, market shifts, or sudden demand increases are not accounted for in a static budget.
As such, this limitation often leads to budget overruns, which forces organizations to find an alternative funding source or cut costs in other areas.
3. Challenge in accurately predicting revenue
Creating a corporate budget naturally requires making assumptions about future revenue. But revenue is heavily influenced by market trends, economic conditions, and customer behavior.
This means that actual revenue can significantly differ from projections, which can lead the static budget to lose relevance. The end result here is that businesses make ineffective decisions and don’t allocate resources efficiently in line with what their actual income is.
4. Limited insight for performance analysis
When using a static budget, variance analysis, an important part of financial management, can be misleading.
That’s because differences between actual and budgeted figures may simply result from changes in activity levels rather than any internal efficiency or lack thereof.
This means that static budgets make it harder to pinpoint areas for improvement or to evaluate team performance accurately.
5. Lack of responsiveness in complex operations
Many businesses have variable costs that cannot be accurately predicted in advance or have diverse operations with a high degree of complexity. For these organizations, static budgets might not provide the flexibility or the granularity required to address changing needs.
This can easily lead to a missed opportunity in an environment that requires adaptability. For instance, if actual revenue is much higher than budgeted, an agile budget should have a plan for reinvesting that additional income. Static budgets do not provide those plans.
How to create a static budget:
Thinking of using static budgets in your organization?
Here’s a quick step-by-step guide to creating your own static budget to help you get started:
- Define the budget period. Decide on the timeframe for the budget, such as a month or a year.
- Identify and categorize expenses. List all of your expected expenses, dig into historical data to identify trends, and categorize them into fixed and variable costs.
- Set realistic revenue targets. Use market research, economic forecasts, and historical sales data to estimate expected revenue. Consider external factors like competition and seasonality here.
- Allocate resources. Distribute your available funds across categories based on expected needs and business priorities.
- Build a contingency plan. Even though a static budget is fixed, it's a good idea to allocate a small percentage of the total as a buffer for unforeseen expenses.
- Consolidate and review. Combine all figures to create the full budget, making sure that the projected revenue exceeds or at least matches total expenses.
- Finalize and approve. Finalize the budget by gaining approval from all decision-makers or stakeholders to ensure you have buy-in and are aligned with company goals.
- Communicate and implement. Share the budget with relevant teams, clearly communicating spending limits and performance expectations.
- Monitor and evaluate performance. Though static budgets will not be adjusted during the period, it's still a smart move to monitor actual performance against the budget to see how accurate your projections are. You can then analyze variances to improve the accuracy of future budgets.
Monitor your static budget in BILL
Static budgets are a simple and straightforward method for managing business expenditures.
A financial operations platform like BILL can further simplify the process, providing you with a powerful method to create a budget and then put spend controls in place such as:
- Giving employees different levels of control based on their role
- Analyzing spend in real time
- Creating spend policies to avoid overages
Discover BILL’s budget management software today.
