Fixed Budget vs Flexible BudgetComparing these two types of budgets

Budgeting is a meticulous but very important process for any business.

Without a budget, a business might have no direction with its income.

There’s no set target for revenues, so a business’s management team wouldn’t know whether it is performing well or is already underperforming.

There’s also no set amount for expenses, so who’s to say if the business is overspending, right?

Without a budget, it’s harder to gauge a business’s performance and growth.

A budget is an important and useful tool for any business.

With one, it’s easier to maintain financial stability.

It helps a business set goals for revenue generation. It also helps in managing expenses.

If there’s a reasonable set limit for expenses, it’d be easier to track if a business is still within budget or is already overspending.

Indeed, a budget is essential for a business’s success and security.

In this article, we will be taking a close look at two certain types of budgets: fixed budget, and flexible budget.

While these two types of budgets have the same purpose of guiding a business, they do have their differences.

We will be exploring each type of budget first, then we’ll be comparing both to identify their differences.

By the end of the article, we should be able to distinguish one from the other as well as identify situations in which a particular type of budget is more suitable.

What is a Fixed Budget?

A fixed budget (a.k.a. static budget) is a type of budget plan that doesn’t change with the increases/decreases in the level of activity.

For example, whether the sales volume increases or decreases, the budgeted costs and expenses will remain the same.

In a way, a fixed budget is an estimate of predetermined revenue and expenses.

Because of its static nature, a fixed budget is best-suited for businesses that operate at the same or predictable level over the year.

It can also work for businesses that are not easily influenced by external factors such as inflation or competition.

These considerations make it easier to forecast a static budget plan.

The static nature of a fixed budget makes it easier to create.

Since it operates on a single activity level, it requires less time to prepare than a budget plan that considers different activity levels.

However, this static nature is also its biggest drawback.

It assumes that a business’s existing conditions will not change, which rarely happens in real life.

Most businesses are affected by external factors one way or the other.

This results in most fixed budgets lacking accuracy.

After all, a fixed budget is still an estimation of future revenue and expenses.

And you know what they say about the future – it’s hard to accurately predict it.

However, regardless of the nature of a business, a fixed budget may still be useful as a way to control costs.

Sure, the actual outcome of business may be different from what’s stated in the fixed budget, but it can still help the management in setting a guideline on how the business should perform in the future.

Management can also use it to understand why certain targets aren’t met.

Is it a mistake in estimation? Or is the business just underperforming?

What is a Flexible Budget?

A flexible budget is an easily adjustable budget plan that caters to different levels of activity.

It changes along with the increases and decreases in the activity level.

For example, if management anticipates that the level of output will decrease for the rest of the year, it can adjust the budget easily if it’s a flexible budget.

In a way, it’s like an evolution of the fixed budget.

So what makes a flexible budget easily adjustable? Well, first of all, a typical flexible budget will divide its costs into three categories: fixed, variable, and mixed.

Fixed costs are those that don’t change along with the increases/decreases in the activity level.

On the other hand, variable costs are those that increase or decrease depending on the activity level.

Finally, mixed costs are those that have fixed and variable components to them.

In a flexible budget, we have to further divide mixed costs into their fixed and variable portions.

Multiple flexible budget plans may also be prepared for different levels of activity.

Fixed costs will eventually increase or decrease when a business reaches a certain level of activity.

For example, the cost of renting a plant will typically remain the same no matter the level of output.

However, if the production volume increases enough to require the renting of another plant, then the cost of rent will increase.

Because of its easily adjustable nature, a flexible budget is best-suited for businesses that have varying levels of activity or those that have tons of variable expenses.

It also works for businesses that belong to industries that are highly influenced by external factors.

Preparing a flexible budget requires more knowledge and time though.

Improperly labeling a fixed cost as a variable cost (and vice versa) can result in a faulty budget plan.

Fixed Budget VS Flexible Budget

While both fixed and flexible budgets provide guidance to the business, they still have their differences.

For one, a fixed budget is static, while a flexible budget is dynamic.

Here are some of the major differences between the two:

Nature

A fixed budget is static by nature.

This means that it will not change no matter the level of activity.

On the other hand, a flexible budget is dynamic by nature.

This means that it will change according to the changes in the level of activity.

A fixed budget is more suited for a business that doesn’t vary in its level of activity.

This makes it easier to prepare a static budget as the costs are predictable.

It could also be suitable for a business that mostly has fixed expenses.

A flexible budget is more suited for a business that has varying levels of activity.

For example, the production volume is highly dependent on customer demand.

This means that if the level of demand changes, management can easily adjust the budget if it’s a flexible budget.

Simplicity

Preparing a fixed budget is simple.

Since it ignores any assumption of changes in the level of activity, you would only have to prepare a fixed budget with the assumption that it will remain the same no matter the activity level.

However, this simplicity is a double-edged sword as it is also a big drawback.

Most flexible budgets hardly ever hit the mark because they ignore a lot of factors.

On the other hand, a flexible budget is more complex.

First, you will have to categorize costs into fixed, variable, and mixed.

Then, you may also have to prepare an alternative for every level of activity.

As such, preparing a flexible budget requires more knowledge and time on the part of the preparer.

Assumptions and Estimates

A fixed budget typically uses a business’s past data (e.g. previous year’s budget) as reference.

Assumptions about future events are then applied to the data.

For example, if management anticipates that costs will increase by 5% this year, they will simply have to increase the previous year’s budget by the same rate.

On the other hand, a flexible budget requires more input in its preparation.

It still uses past data as a reference, but it also considers other factors such as the market condition.

This makes a flexible budget easier to compare with the actual performance of the business.