Static budget definition
/What is a Static Budget?
A static budget is a budget that does not change with variations in activity levels. Thus, even if actual sales volume changes significantly from the expectations documented in the static budget, the amounts listed in the budget are not changed. This budget format is the simplest and most commonly used budgeting format.
The static budget is used as the basis from which actual results are compared. The resulting variance is called a static budget variance. Static budgets are commonly used as the basis for evaluating both sales performance and the ability of cost center managers to maintain control over their expenditures.
Advantages of a Static Budget
A static budget model 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 these situations, a static budget is quite useful for monitoring how well a business is doing against expectations.
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Disadvantages of a Static Budget
There are several important disadvantages associated with static budgets, which we note below:
Poor results in a fluid environment. 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. In this case, management wastes time tracking down variances that have no meaning, since the operating environment has changed so much since the budget was enacted.
Ineffective cost center performance evaluations. A static budget may not be effective in certain situations for evaluating the performance of cost centers. For example, a cost center manager may be given a large static budget, and will make expenditures below the static budget and be rewarded for doing so, even though a much larger overall decline in company sales should have mandated a much larger expense reduction. The same problem arises if sales are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline static budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.
Discourages management flexibility. Managers might feel constrained by the rigidity of a static budget, which discourages them from being proactive in adjusting spending or investing in growth opportunities as new information becomes available. This may result in lost opportunities, and may lead to a decline in market share.
Static Budgets vs. Flexible Budgets
A common result of using a static budget as the basis for a variance analysis is that the variances can be quite substantial, especially for those budget periods furthest in the future, since it is difficult to make accurate predictions for more than a few months. These variances are much smaller if a flexible budget is used instead, since a flexible budget is adjusted to take account of changes in actual sales volume.
Example of a Static Budget
ABC Company creates a static budget in which revenues are forecasted to be $10 million, and the cost of goods sold to be $4 million. Actual sales are $8 million, which represents an unfavorable static budget variance of $2 million. The actual cost of goods sold is $3.2 million, which is a favorable static budget variance of $800,000. If the company had used a flexible budget instead, the cost of goods sold would have been set at 40% of sales, and would accordingly have dropped from $4 million to $3.2 million when actual sales declined. This would have resulted in both the actual and budgeted cost of goods sold being the same, so that there would be no cost of goods sold variance at all.
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