Definition
A fixed budget, also known as a static budget, is a budget that does not change or adjust to variations in business and economic activity levels. On the other hand, a flexible budget adjusts and changes based on the actual levels of output, activity, or revenue. The key difference lies in their adaptive nature; fixed budgets remain constant regardless of changes while flexible budgets fluctify with changes in operational levels.
Key Takeaways
- Fixed Budget is a budget that remains unchanged regardless of the volume of activity or output. It is based on static estimates made at the beginning of the accounting period, which may cause discrepancies if the actual costs or revenues fluctuate significantly.
- Flexible Budget, on the other hand, is designed to change in accord with variations in output levels or other activity measures. Its values can be scaled up and down by adjusting the budget amounts to the actual level of activity achieved in a period, providing more accurate financial information.
- While both budgets are valuable tools, the choice between Fixed or Flexible Budget depends on the needs of the manager or the organization. While a Fixed Budget is simpler to implement, a Flexible Budget allows for better planning and control by considering potential changes in business circumstances.
Importance
The finance terms: Fixed Budget and Flexible Budget are important because they assist in the financial planning and control of a business, each playing different yet pivotal roles. A fixed budget is prepared at the beginning of a period and is static and unalterable as it sets an absolute target for expenses and revenues.
It is most effective when a firm’s operations are not significantly affected by market or environmental changes. On the other hand, a flexible budget adjusts throughout the duration of a period based on actual business activity levels.
Its variable nature allows for more accurate profitability predictions and facilitates real-time decisions. Therefore, understanding and utilizing both types of budgets can lead to more careful planning, efficient control, better decision-making, and ultimately improved financial performance within a company.
Explanation
A fixed budget, also known as a static budget, is primarily designed to remain unchanged irrespective of the volumes of output or sales. The main purpose of a fixed budget is to establish stringent financial control over certain areas of business that can easily be regulated.
This is particularly useful for businesses wanting to maintain strict parameters on expenses that do not change with shifts in revenue generation. For instance, rent, salaries, and insurance costs remain constant regardless of the performance of the service or product and thus, can be closely monitored under a fixed budget.
On the other hand, a flexible budget, also known as a variable budget, is designed to adjust in accordance with changes in the activity or volume levels of a business. Its primary purpose is to provide a more accurate benchmark for evaluating performance by taking into consideration the changing business environment.
For instance, businesses can use flexible budgets to account for changes in sales, manufacturing costs, or other operational costs that fluctify depending on the volume of business activities. This makes it a useful tool for businesses that seek to adapt their cost structure to actual revenues or produced quantities, providing a more adaptive approach to financial management.
Examples of Fixed Budget vs Flexible Budget
Personal Household Budgeting: Perhaps the most common example of a fixed versus flexible budget can be found in personal finance or household budgeting. For example, someone may have a fixed budget for monthly rent or mortgage payments, since this remains constant. On the other hand, their grocery budget is more flexible because it can vary month to month based on changes in food prices, dietary needs or shopping habits.
Corporate Budgeting: In a business context, consider a company that manufactures a product. They might have a fixed budget for certain overhead costs like rent or salaries that don’t change over the proposed budget period. However, they may also have a flexible budget for costs like raw materials. If demand for their product suddenly spikes, they need the flexibility to spend more on raw materials to increase production and meet this demand.
Government Budgeting: Governments also use both fixed and flexible budgets. Fixed budgets might be applied to areas like infrastructure projects or staff salaries, where the costs are relatively predictable. Conversely, a flexible budget might be used for areas like social services or emergency response, where the need for funding can fluctuate dramatically based on external factors, such as natural disasters or economic downturns.
FAQs: Fixed Budget vs Flexible Budget
What is a fixed budget?
A fixed budget, also known as a static budget, is a budget that does not change or adjust to the actual volume of revenue or expenses that a company has during a certain period. It is set at the beginning of a financial period and remains unchanged, regardless of changes in factors like sales volume or revenue.
What is a flexible budget?
A flexible budget is designed to change in line with fluctuations in activity levels, revenue, or costs. This budget type adjusts and changes throughout the budget period to correlate with the actual results of business operations, making it more dynamic and adaptable than a fixed budget.
What are the advantages of a fixed budget?
A fixed budget is simple to prepare and easy to understand. It provides a straightforward financial plan with clear expense limits, which can encourage discipline in spending. It also provides a consistent benchmark for performance evaluation, as it does not change once set for the period.
What are the advantages of a flexible budget?
A flexible budget allows companies to adapt to changes quickly – they can allocate more or less budget as revenue or costs increase or decrease. This budget type better facilitates planning, control, performance evaluation, and decision making as it adjusts to actual operational results. It can also provide more accurate costing and efficiency data.
Which budget is better: Fixed or flexible?
Neither budget is universally better or worse, as the ideal method depends on the individual company’s context, requirements, and circumstances. A fixed budget may be sufficient for businesses with predictable and constant expenses, while a flexible budget could be more suitable for companies in fluctuating or unpredictable markets.
Related Entrepreneurship Terms
- Variances
- Cost Behavior
- Performance Evaluation
- Forecasting
- Contingency Planning
Sources for More Information
- Investopedia: It is a comprehensive website providing definitions and explanations of financial concepts and terms, including Fixed budget and Flexible budget.
- AccountingTools: This site offers detailed insights and articles about finance and accounting concepts like budgeting methods.
- Corporate Finance Institute (CFI): CFI provides courses, articles, and resources about various financial topics, including budgets.
- Harvard Business Review (HBR): HBR features articles for professionals to understand complex business topics, including finance and budgeting.
