Understanding the difference between a fixed and a flexible budget is key for any business owner looking for financial stability and growth. The choice between these budgets depends on two main things: how predictable your costs are and how much you expect your economic situation to change.
This article will break down fixed and flexible budgets, how they differ and when to use each type. The goal here is to help you, the business owner, pick the budget that fits your business best. This will improve your decision-making and help your business succeed financially.
Fixed Budget Vs. Flexible Budget
A fixed budget doesn’t change, while a flexible budget changes with your business activity. Both these approaches have advantages depending on your situation.
Fixed Budget: Pros and Cons
Consider a small boutique retail store that plans its budget for the upcoming year. The owner decides on a fixed budget, allocating $5,000 monthly for rent, $2,000 for utilities, $10,000 for employee salaries and $8,000 for inventory purchases. Despite potential seasonal fluctuations in sales, such as a significant increase during the holiday season or a decrease during off-peak months, this budget won’t change.
Here are some of the main advantages of a fixed budget like this.
- They provide control over costs. Your business or team is allocated a set budget and expected to work within it. This promotes discipline.
- They are predictable. You know exactly how much you have to work with up front.
- They are easy to implement. Fixed budgets require less frequent monitoring and adjusting.
- They encourage efficiency. You must find ways to deliver results with limited resources.
Of course, there are disadvantages to fixed budgets as well.
- They lack leeway. Fixed budgets cannot adapt to changing business conditions. This can lead to bad or obsolete budgeting.
- They discourage growth. Requiring managers to stick rigidly to previously set numbers may prevent beneficial new spending.
- They lower morale. Employees forced to follow unrealistic budgets may become frustrated and demotivated.
- They result in waste. Money gets spent just because it was budgeted, not because the spending is worthwhile.
Overall, fixed budgets encourage discipline and control but limit your ability to respond to changes outside your control. We’ll explore the best situations for using this type of budget in a later section.
Flexible Budget: Pros and Cons
Let’s go back to the retail store example. If the owner had chosen a flexible budget instead, they would have set a percentage of sales for each expense category. If sales increase during the holiday season, the budget for inventory purchases would also increase to meet demand. Similarly, if sales decreased in off-peak months, the budget for employee salaries may decrease accordingly.
Here are some primary advantages of a flexible budget.
- It adjusts to changes in activity, allowing for a fair comparison between actual results and the budget. If sales volume decreases, costs are expected to decrease as well.
- It helps you manage costs more effectively. You can break down cost changes into two types: changes due to how much you produce and changes due to how efficiently you use resources. This helps you figure out exactly why your spending deviates from what you planned.
- It motivates you to find ways to reduce costs and increase efficiency as production activities change.
- It prevents overspending during periods of low production by tying budgeted expenses to actual output.
And here are some potential challenges of a flexible budget.
- It requires more effort and analysis to update the budget frequently as production changes.
- It relies on accurately tracking costs and how they relate to production volume. If the cost-volume assumptions are wrong, the flexible budget will be inaccurate.
- You may struggle to separate costs based on sales and effective use of resources. You need training to do this properly.
Essentially, flexible budgets help assess performance better when sales and production vary, and it’s worthwhile for creating better cost control. But you need to do additional analytical work.
Which One Is Best for Your Business?
How do you decide between a fixed and flexible budget? It all depends on a variety of environmental and business factors. Here’s a breakdown of the factors directly influencing the right approach for your business.
Market Conditions
Let’s start with market conditions. What should you look for when determining your budget type?
Volatility
Account for the level of market volatility or unpredictability. If the market experiences frequent fluctuations, a flexible budget may be more suitable. And the opposite is true for a stable market.
Competitive Landscape
How competitive is your industry? If you need to quickly adapt to changes, a flexible budget can help respond to competitive pressures by investing in new tools and platforms or hiring more people.
Technology
You need to have a budget that stretches if your tech stack and business practices continuously evolve as technology evolves. Using older tools and platforms can set you back, and it’s critical to leverage new technologies with a flexible budget. For businesses with minimal changes, however, like agriculture or textile manufacturing, a fixed budget works fine.
Seasonality
Evaluate if your business experiences seasonal variations in sales or activity levels. For example, the holiday season means more gift shopping and your business thrives, whereas you have moderate sales at other times. A flexible budget can help accommodate these fluctuations.
Revenue Patterns
These are the revenue patterns you should consider when deciding whether to implement either fixed or variable budgets.
Revenue Stability
Examine the stability of your revenue streams. If sales and revenue are relatively stable over the budget period, a fixed budget may be appropriate.
Growth Potential
Analyze the potential for revenue growth and expansion. A flexible budget is good when growth is promised and allows you to adjust your spending dynamically.
Risk Levels
Assess risk and uncertainty in your business. A flexible budget can help mitigate risks by allowing you to make changes in response to unexpected events.
Uncertainty
Consider the level of uncertainty or risk associated with your business. Do you expect strong variations in income? Flexible budgets provide you with the ability to adapt to changing circumstances and mitigate risks.
Other Factors
Here are additional things to consider when crafting your budget.
Long-Term Planning
Consider the importance of long-term planning versus short-term adjustments or your business. Use a fixed budget for longer-term planning and a flexible budget for shorter-term versatility.
Industry Best Practices
You can follow recommended best practices depending on your industry. For example, healthcare business budgeting studies recommend adopting a flexible budget, incremental budget and other types rather than a fixed one. And governmental institutes could benefit from a fixed budget to provide regular services every year.
New Vs. Established Ventures
When launching a new business or product, it’s difficult to predict exact revenue and activity levels. A flexible budget could help you adjust to necessary expenses. A fixed budget, however, is useful for making sure you don’t overspend.
Long-Term Capital Projects
For major projects spanning years, like building an office, a fixed budget with specific long-term allocations can help control investments.
Your business is unique, and you should keep your needs foremost in mind when planning budgets. These considerations can help you make an informed decision about which budget type will check the most boxes for you and your team.
Take Control of Your Business Budget
Proper budgeting requires adaptability, strategic foresight and an understanding of business dynamics. By carefully assessing the factors influencing your operation, you can craft a budgeting approach that aligns with your financial goals and operational needs.
Work with a professional financial advisor to ensure your budget is realistic and effective. You should also use budgeting tools, accounting software and other business management software to keep you on track.
A budget, whether fixed or flexible, is not just a financial document but a road map toward financial stability and growth. Start with the tips shared here to help your business thrive, and you’ll soon elevate your brand to new heights.
