• A business creates a budget when it wants to match its actual future performance to an ideal scenario that incorporates its best estimates of sales, expenses, asset replacements, cash flows, and other factors.
• Static budgeting. This is the classic form of budgeting, where a business creates a model of its expected results and financial position for the next year, and then attempts to force actual results during that period to align with the budget model as closely as possible. This budget format is typically based on a single expected outcome, which can be extremely difficult to achieve. It also tends to introduce a great deal of rigidity into an organization, rather than allowing it to react quickly to ongoing changes in its environment.
• Flexible budgeting. A flexible budget model allows you to enter different sales levels in the model, whch will then adjust planned expense levels to match the sales levels that have been entered. This approach is useful when sales levels are difficult to estimate, and a significant proportion of expenses vary with sales. This type of model is more difficult to prepare than a static budget model, but tends to yield a budget that is reasonably comparable to actual results.

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• Static vs. Flexible Budgets for New Businesses

                by Lisa Bigelow
• A static budget is planned ahead of time based upon the owner's best educated guess about future actual activity. Static budgets are usually planned a year in advance, broken out into smaller reporting periods such as months and quarters.
• A big disadvantage for new businesses is the lack of actual data upon which to build a budget. If actual data differ significantly from the static budget, there's no way to change the budget or to determine if the costs to produce the revenue were properly controlled. Instead, the owner must produce a forecast. The forecast is a new document that predicts the remainder of the reporting period's activity and compares it to the static budget and the actuals.
• The best reason to use a static budget is the variance analysis. The variance analysis tells the owner how much she's over or under the original budget, via percentage and dollars. Even for new businesses, it may be easier to plan for future years when you know you have a comparison between what was expected and what actually occurred. In future years, you can adjust the budget up or down depending upon the variance percentages. Static budgets work best when the owner has a reasonable amount of certainty what revenues and costs will be, barring extraordinary circumstances.
• Flexible budgeting is a more sophisticated method, according to AccountingCoach.com, because the new business owner can make changes to the budget in the middle of the reporting period. However, a new business owner may not have the time, experience or inclination to adjust the budget frequently. Also, there may be unexpected effects from an unexpected change in volume, for which the new business owner won't know to plan. Flexible budgets require knowing in advance which costs are fixed or variable, and how expenses are affected by changes in revenue.
• Because the flexible budget changes based upon volume, it provides a greater level of control. New businesses need to keep a tight lid on costs; capping certain flexible expenses to a percentage of volume helps accomplish this. A new business could vary a great deal from what was originally planned, and flexible budgets offer a real-time view of a business's expenses and revenues. The savvy business owner may not have time to go through the trouble of issuing a forecast for the static budget. The flexible budget accomplishes the forecast in one step.

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• A static budget is most useful when a company has highly predictable sales and expenses that are not expected to change much through the budgeting period (such as in a monopoly situation). In more fluid environments where operating results could change substantially, a static budget can be a hindrance, since actual results may be compared to a budget that is no longer relevant.

• A flexible budget, or “flex” budget, incorporates different expense levels into the budget, depending upon changes in the amount of actual revenue generated. This approach varies from the more common static budget, which contains nothing but fixed expense amounts that do not vary with actual revenue levels.
• In its simplest form, the flex budget uses percentages of revenue for certain expenses, rather than the usual fixed numbers.  This allows for an infinite series of changes in budgeted expenses that are directly tied to actual revenue incurred.

• Advantages of Flexible Budgeting

   

  Since the flexible budget restructures itself based on activity levels, it is a good tool for evaluating the performance of managers - the budget should closely align to expectations at any number of activity levels. It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.

• Disadvantages of Flexible Budgeting

   

  Though the flex budget is a good tool, it can be difficult to formulate and administer.  Several issues are:

   
   
  • Many costs are not fully variable, instead having a fixed cost component that must be derived and then included in the flex budget formula.  
   
  • A great deal of time can be spent developing step costs, which is more time than the typical accounting staff has available, especially when in the midst of creating the more traditional static budget.  Consequently, the flex budget tends to include only a small number of step costs, as well as variable costs whose fixed cost components are not fully recognized. 
   
  • The flexible budget model usually only works within a relatively limited revenue range; the budget analyst is unlikely to spend the time developing a more wide-ranging model if it is considered unlikely that outlier revenue amounts will be encountered.
• There may also be a time delay between when there is a change in revenue and when a supposedly variable cost changes.
• Given the considerable amount of time required to maintain a flexible budget, some organizations may instead opt to eliminate their budgets entirely, in favor of using short-range forecasting without the use of any types of standards (flexible or otherwise). An alternative is to run a high-level flex budget as a pilot test to see how useful the concept is, and then expand the model as necessary.

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