Budgets play a key role in helping companies track their finances, analyze their expenses, and identify ways to maximize their profits. A static budget is one that remains constant even as other factors, such as sales volume and revenue, change. A flexible budget, by contrast, is one that adjusts based on changes in revenue or other sales activities.
How static budgets work
A static budget is based on a company's anticipated level of output and revenue at the start of the accounting period it's designated to cover. Static budgets are typically based on data that is collected and analyzed before the budget period begins. For example, if a company brought in $2 million in revenue last year, it might create a static budget based on the same revenue figure.
Once a static budget is established, a company will follow it but also keep track of its actual spending, paying close attention to any type of budget variance that pops up. A budget variance is the difference between the original budgeted amount of expense or revenue, and the actual amount of expense incurred or revenue generated during the accounting period in question. If a company brings in higher revenues than its static budget plans for, the variance is considered a favorable one. On the other hand, if a company's budget is based on revenues of $2 million and actual revenues only end up totaling $1.5 million, the variance is considered unfavorable.
Advantages of static budgets
One major advantage of the static budget is that it's easy to implement and follow, as static budgets do not need to be updated continuously throughout the accounting periods they're intended to cover. Additionally, a static budget can offer strong insight into a company's costs and profits when a variance analysis is performed. This allows a company to see where it might be overestimating or underestimating its expenses and revenues so that it can make changes or alter its strategy going forward. Also, because static budgets don't have built-in wiggle room, they can help companies control their costs and make smart spending decisions.
Disadvantages of static budgets
The greatest disadvantage of the static budget is its lack of flexibility. If a company establishes a budget based on a certain level of sales volume and that volume increases, it can't allocate additional resources to keep up. Along these lines, if a company identifies underperforming areas of the business, it can't allocate additional resources to help. This, in turn, can negatively impact a company's revenue stream. Furthermore, because static budgets are based on previous data, newer businesses may have more difficulty establishing and implementing them. Static budgets are generally most useful for companies with highly predictable sales volume and costs, whereas companies that experience greater year-to-year fluctuations can't use static budgets as easily.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.