Businesses benefit from creating a budget that helps to control how income is spent. Creating the ideal budget arrangement will involve considering both a fixed and flexible budget strategy, ultimately choosing the approach that will produce the greatest level of benefit. While the two budget types share a number of characteristics, there is a key difference between them that must be well understood before making that final choice.
As the names for the two strategies imply, the single most important difference between a fixed and flexible budget is that the former does not provide any room for making changes to budget line items when and as various events or circumstances change. In contrast, a flexible budget does provide some room for shifts in allocations to different line items, making it possible to transfer funds from one item to another if the need should arise. Depending on the type of business operation involved, this makes the flexible budget approach more practical.
One of the easiest ways to understand this key difference between a fixed and flexible budget is to consider a company owner that is preparing an operating budget for an upcoming accounting period, such as the next calendar or fiscal year. Budget line items will include allocating funds for raw materials, utilities, labor costs and other expenses that may or may not change at some point during the year. If the company currently has vendor agreements in place that guarantee pricing for raw materials and utilities as well as contracts that prevent changes in labor costs for that period, a rigid budget that does not allow for any adjustments may work quite well. Since most businesses cannot guarantee at least some shifts in operational costs, allowing for at least some flexibility is important.
Since the ability to adapt is important in deciding between a fixed and flexible financial strategy, projecting possible shifts in generated revenue, taxes, utility costs, and labor is important to the process. It is still possible to go with a fixed budget even if there is anticipation of some changes, assuming the income level and the reserves of the business are sufficient to used what is known as padding for each of the line items. Padding is simply choosing to increase the anticipated allocation for the line items by a certain percentage, effectively creating a financial cushion that can be called upon if needed. Since there is nothing to compel company owners to spend all of the funds allocated to each line item, it is possible to use a fixed budget approach and achieve a balanced budget for the year.
Since not every company has surplus to devote to each line item, choosing between a fixed and flexible budget may involve structuring a budget that makes it easier to transfer funds from one line item to the next, when and as certain events occur. For example, the flexible budget would make it easy to move funds set aside for raw materials if lower rates for those materials are negotiated, and use that difference to cover increased labor costs. The overall budget remains balanced, since the same amount of money is involved.
When considering the merits of both the fixed and flexible budget, there is no one right choice that fits every situation. Budget planners must realistically consider the circumstances surrounding the operation and plan the budget accordingly. Doing so will provide the best possible working platform for managing company finances and improve the chances that all resources are used to best effect.