A fixed budget is a financial plan that does not change through the budget period, irrespective of any changes in actual activity levels experienced. Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:
- Costs are largely fixed, so that expenses do not change as revenues fluctuate
- The industry is not subject to much change, so that revenues are reasonably predictable
- The company is in a monopoly situation, where customers must accept its pricing
Most companies use fixed budgets, which means that they routinely deal with large variations between actual and budgeted results. This also tends to cause a lack of reliance by employees on the budget, and in the variances derived from it.
A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where you add a new budget period onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, you gradually incorporate the actual results of the most recent period into the budget, and also maintain a full-year budget at all times.
Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.
The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.
The reverse of a fixed budget is a flexible budget, where the budget is designed to change in response to variations in activity levels. There tend to be much smaller variances from the budget when a flexible budget is used, since the model tracks much closer to actual results.
A fixed budget is also known as a static budget.