For business owners, budgets are valuable planning tools that help you define your financial goals and the path to reaching them.
Life as an entrepreneur can often feel like sailing the ocean without a map. It can be challenging to steer your new business without a clear idea of where you want to go and how to get there. Budgets are valuable business maps.
In your business budgets, you set the direction for your company by projecting your future income and expenses for a given period of time, such as one year.
There are different ways to approach the forecasts that you use in budgets. Specifically, you can choose to do your forecasts before the period begins or continue to update them as you go along.
When you make budget forecasts beforehand, that’s known as a static budget, and it can be a valuable tool for budding entrepreneurs.
What is a static budget?
A static budget is a spending plan for your business that covers a defined period of time. It is made up of financial performance projections that don’t change until the budget period ends.
Typically, static budgets include projections for revenue, fixed expenses, variable expenses, and profit.
Budget forecast numbers are usually based on past data and assumptions about future performance.
For instance, say your revenue has been steadily increasing by $1m each year, and it was $9m last year. You can take that information and project a total revenue of $10m for the upcoming year.
These projections are made beforehand, and then compared with your actual performance. To create a static budget for 2023, you would make your projections in 2022, then compare them with the actual results at the end of 2023.
Static budget vs. flexible budget
In a static budget, the projected numbers don’t change during the covered period. In contrast, a flexible budget allows for changes to projections based on new information and assumptions.
For instance, take the revenue prediction of $10m from the previous example and say that it breaks down into $2.5m revenue per quarter. If you use a flexible budget, you could change your numbers based on what happens during the year.
If your actual performance is higher and you bring in $3m in Q1 and Q2, you can use that information to create a new projection. You might assume you’ll earn $3m each quarter, which changes your annual revenue projection to $12m.
In a static budget, you would keep your initial projections and compare them to your actual results after the year ends by analyzing budget variance.
Understanding static budget variance
Factors such as consumer preferences, competitor performance, and economic trends can impact your business’s sales and costs.
Given that, your business’s actual revenue and cost numbers often diverge from projections in the budget. This difference between your static budget and your actual performance is known as a static budget variance.
To get a better idea of how static budget variance works, say you have a business with the following budget projections and actual performance:
The actual performance is different from what you predicted — that difference is the budget variance.
Budget variances can be favorable or unfavorable.
Favorable results are those that end up with more money than expected — such as earning more or spending less than expected. Unfavorable variances result in less money in your accounts and happen when your revenue is lower or your costs are higher than projected.
In this example, the business had a favorable revenue variance because sales generated $0.5m more than predicted. But there was an unfavorable expense variance because actual costs were $1m higher than the budgeted costs.
All in all, this led to the business falling $0.5m short of its net profit projection.
Once you know where budget variance occurred, you can perform a budget variance analysis to understand why your actual numbers differed from the predicted amounts. The analysis can help you identify opportunities to increase revenue, lower costs, and make more accurate projections.
For instance, if the source of your increased costs was unexpected shipping rates, you can either adjust your predictions for next year or look for a cheaper shipping partner.
How to build a static budget
Here’s how to create a basic static budget in five steps.
1. Estimate revenue
The first thing to do when creating a static budget is to forecast sales revenue for the upcoming year. You can use the following formula to estimate revenue:
Estimated Revenue = Estimated Sales Volume x Projected Price Per Unit
To estimate your sales volume and price per unit, start with your most recent numbers, and then make an assumption about how they will change in the next year.
Say you sold 1m units last year. That number will either increase, decrease, or stay the same in the upcoming year.
If you expect to expand and sell more, you would assume that sales volume and revenue will increase.
You can look at your growth trends to estimate how much more you’ll sell. If your sales volume has been growing by 10% each year, you might assume you’ll sell 1.1m units in the next year.
You can make similar assumptions about sales prices depending on whether you plan to raise prices, keep them steady, or lower them.
For startup founders who don’t have a lot of historical data, Aaron Jerez, founder of culinary and entertainment brand Home Bar Select, recommends “creating a budget based on industry averages and trends or using data points from a similar business in your field” to get started.
2. Estimate variable expenses
Next, estimate your variable expenses, which are the costs that change based on your sales volume or production levels. These are also known as your cost of goods sold (COGS). Variable expenses include items like raw materials, sales commissions, packaging costs, and delivery costs.
Divide last year’s variable costs by last year’s revenue to determine how much your variable costs are as a percentage of revenue. Then, multiply that number by your revenue projection for the upcoming year to estimate variable expenses.
3. Calculate gross margin estimate
Use revenue and COGS estimates to calculate your projected gross margin (or contribution margin).
Estimated Gross Margin = (Estimated Revenue - Estimated COGS) / Estimated Revenue
This number predicts how much money you have left to pay for fixed expenses. That being said, you don’t want to spend all of this money on fixed expenses. Ideally, you want some money leftover as net profit.
4. Estimate fixed expenses
The next step is to estimate your fixed costs for the year. These costs don’t change based on your sales volume or production levels and typically include rent, payroll, business insurance, and interest payments.
You can use past data to predict your fixed expenses. For instance, if you know that your rent payments will stay the same, you can carry over that cost from the previous year.
You can also adjust your budget based on anticipated growth. If you want to hire another team member, you can budget a fixed amount for their annual salary.
5. Calculate net profit estimate
Finally, estimate your net profit by subtracting your total expected expenses from your total expected revenue.
Estimated Net Profit = Estimated Revenue - (Estimated Variable Costs + Estimated Fixed Costs)
Estimated net profit can also be calculated as:
Estimated Net Profit = Estimated Gross Margin - Estimated Fixed Costs
By estimating your net profit, you can see how your revenue and expense plans will affect your bottom line.
Should you use a static budget?
Is a static budget the right type of budget for your business? Here are some pros and cons to consider.
Benefits of a static budget
Static budgets don’t change throughout the year, so they’re helpful as financial road maps that keep the company on track. Business owners often use their ideal scenario for static budget projections, which helps them avoid overspending, stay focused on revenue goals, and achieve optimal performance.
Lilian Chen, co-founder of virtual team-building startup Bar None Games, explains that “[static budgets] are easier to maintain than flexible budgets, which is beneficial for small businesses and startups that don’t have the resources to regularly adjust their budgets.”
Limitations of a static budget
The most significant limitation of a static budget is its lack of adaptability, since the budget can’t change for the year. The budget can become less relevant if your company’s performance varies drastically from your predictions.
This may not be a huge concern for companies with more predictable sales and expenses. However, if your business is in a dynamic or high-growth industry, a fixed budget may not give you the flexibility you need to reallocate resources and respond to significant changes in the market.