Budgeting is extremely important in running a business. Your budget determines how much money you can spend on each aspect of your business and ultimately dictates your business's plan of action. Another function of a budget is that it helps you assess how efficiently your business is spending its money. Deciding how to build your company’s budget can be confusing, especially when there is no one-budget-fits-all approach. Before getting started on your company’s budget, it’s imperative to understand the differences between fixed, flexible and zero-based budgeting processes.
TL;DR (Too Long; Didn't Read)
A fixed budget, also called a static budget, is set up in advance and remains constant, no matter how the activities and needs of a company shift. Flexible budget accounting is meant to shift with the activity needs of the business. The most important features of a flexible budget are that it is dynamic and easily adjustable. Zero-based budgeting is basically starting from zero on each budget, and then justifying all relevant needs and costs for the new budget.
Fixed Budget Accounting
A fixed budget, also called a static budget, is set up in advance and remains constant, no matter how the activities and needs of a company shift. For example, say your company decides to set aside $20,000 for the development of a new product. In a fixed budget situation, this $20,000 remains the only money dedicated to the project, no matter how the project develops. There is no flexibility to change the budget once it’s fixed. So, even if the project ends up using significantly more resources than anticipated, the budget remains the same.
In many cases, it can be difficult to fully anticipate your company’s needs because it’s impossible to predict the future. For this reason, fixed budgeting is usually recommended for shorter-term use, or for businesses that have highly predictable operations. For example, if you have been producing and selling approximately 10,000 units of your product each quarter for the past 10 quarters, it stands to reason that you will likely continue to do so. In this case, it might make sense to use a quarterly fixed budget for certain aspects of your business, unless your needs drastically change.
You can also use fixed budgeting for your business’s fixed costs, such as rent. Your rent remains the same each month, so you can predictably budget for it without having to worry about constant variances in cost. Many businesses start with a fixed budget as a jumping-off point and then use other budgeting methods, such as flexible budget accounting, to build on the fixed budget.
Flexible Budget Accounting
Flexible budget accounting is meant to shift with the activity needs of the business. The most important features of a flexible budget are that it is dynamic and easily adjustable. This type of budgeting is seen as more useful than fixed budgeting because it factors in the actual costs of operation and then adjusts as necessary.
For example, say your company pays a 10-percent commission rate to sales reps. With flexible budgeting, your sales commission budget would be written as “10 percent of sales.” That means if you sell $10,000 worth of product, your sales commission budget ends up being $1,000. If you sell $20,000 worth of product, your sales commission budget changes to $2,000. Ultimately, the budget is contingent upon the actual activities of your business. Compare this to a fixed budget in which you set the sales commission budget at $1,000. Now, if you happen to sell $20,000 of product, your sales commission budget is way off, and you have no flexibility to change it.
Consequently, the difference between fixed and flexible budget accounting is that fixed budgeting remains the same no matter what, and variable budgeting can be shifted with the changing needs of the business. Both budgeting styles have their place. An accountant can help you decide which is best depending on the needs of your business.
Zero-based budgeting is basically starting from zero on each budget, and then justifying all relevant needs and costs for the new budget. The budget is then constructed based on the needs of the business for a certain period. Each budget item is assessed to decide how much money it should be allocated. In a zero-based budgeting system, each manager is called in to justify the budget of her department, and each program is assessed for its effectiveness and value.
Zero-based budgeting is different from traditional budgeting, where incremental increases are added to the budget each period regardless of performance. Therefore, under a traditional method, you might add 2 percent to your sales budget each year. However, under a zero-based budget, you would start your sales budget from scratch, assessing each aspect of your sales strategy. Then you would decide how much money should be allocated to each part based on your assessment. Because of this attention to detail, a zero-based budget often carries less waste. However, the downfall of the zero budgeting model is that it can prioritize short-term gain over long-term growth.
Chelsea Levinson earned her B.S. in Business from Fordham University and her J.D. from Cardozo. She is a small business owner who has created content for Bank of America, H&R Block, CNBC, AOL and many more.