A static budget is fixed for the entire period covered by the budget, with no changes based on actual activity. 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.
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 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.
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 sales performance. However, they are not effective 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 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 static budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.
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.
For example, 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.