Budget Constraints Explained: How a Budget Constraint Works

Picture this scenario: A men’s clothing retailer sets a budget to purchase pants and shirts for inventory in anticipation of seasonal demand. A pair of pants costs more than a shirt, and the retailer has to decide how many of each to buy without blowing through its budget. This is known as a budget constraint.

Here’s what you need to know about budget constraints and how to use them to shape your business’s spending choices.

What is a budget constraint?

A budget constraint represents the maximum amount of goods or services that a business can buy with a given amount of money. The budget is the spending plan, and the constraint is the limit built into the plan.

Two dynamics are at play in a budget constraint:

• Scarcity. This means financial resources are finite. For example, a business might want to spend $1 million for product development, but it only has $500,000.

• Trade-offs. Since resources are scarce, a business must weigh its spending options. These are trade-offs—buying more of one specific good while buying less of another. For example, the business with $500,000 for product development might decide to spend more money on revamping an existing product instead of designing a new one.

Why calculate budget constraints?

• Improved budget management
• Informed trade-off decisions
• Break-even analysis

Calculating a budget constraint is useful for several reasons, including:

Improved budget management

A budget constraint helps you concentrate on making the best use of limited resources, controlling costs, and setting priorities. Managers can evaluate current spending and resource allocation and prepare for budget challenges such as unforeseen expenses or changing business priorities. Ineffective budget management can lead to overspending, increased debt to cover unanticipated expenses, and financial instability.

Informed trade-off decisions

A business operating under budget constraints must weigh its spending choices. Trade-offs involve an opportunity cost—the cost of foregoing the purchase of one thing, which might have brought benefits to the business, and instead buying another thing. For instance, an online clothing retailer might decide to buy more shirts than pants because it expects the shirts to sell quicker, even though pants can sell at a higher retail markup price.

Break-even analysis

Your break-even point is where revenue rises to meet—and, ideally, exceed—spending. Budget constraints drive a business to forecast how much in sales it needs to cover its costs to break even and then move beyond to profitability.

How to use the budget constraint equation

Businesses often have many spending choices to consider under a budget constraint. To keep the discussion simple, let’s assume a hypothetical business has just two spending choices for goods. Constraint means the sum of spending on the two choices can equal but not exceed the total amount budgeted. Use the following budget constraint equation:

(P1 x Q1) + (P2 x Q2) = M

P1 is the price of the first choice. For example, a product that costs $10. Q1 is the quantity of the first choice, say 50 items. P2 is the price of the second choice—a different product that costs $25. Q2 is the quantity of the second choice—20 products. M is the budget constraint.

Typically, you’ll start with your budget constraint and work backward to figure out your spending from there. For example, let’s say the business has $1,000 to invest in inventory. If the business buys 50 first-choice products for $10 each ($500), and 20 second-choice products for $25 each ($500), its spending would reach its budget constraint:

($10 x 50) + ($25 x 20) = $1,000

Note that businesses disregard sunk costs (money spent that cannot be recouped) when calculating budget constraints. Budget constraints are intended for forward-looking budget management. For example, a clothing retailer might invest in market research for a potential product, only to find that demand is nonexistent. That’s a sunk cost, and a well-run business would put that behind it and move on.

Map your spending options with the budget line

Budget constraints can be depicted graphically to show the trade-offs between two things and the limit on spending for those things. Let’s illustrate this with a hypothetical company, ABC Apparel Inc., that has a budget constraint of $50,000 to spend on inventory—some combination of pants and shirts.

In the graph below, the line drawn from point T (the vertical intercept) to point P (the horizontal intercept) is the budget line, representing the spending limit. At the extremes, point P on the horizontal axis is where a budget is spent entirely on pants, and point T on the vertical axis is where it’s spent entirely on shirts. Any point on the line between P and T represents how the budget could be spent for all the possible combinations of the two product types.

To continue with the example, ABC Apparel can spend $50,000 on a combination of pants ($100 per pair) and shirts ($50 each). If ABC bought 400 pairs of pants for $40,000, it could then afford no more than 200 shirts for $10,000 (point S). Alternatively, with the same amount of money, it could buy 250 pairs of pants for $25,000 and 500 shirts for $25,000 (point R).

You can think of the budget line as a price ratio for two different things. Since pants cost $100 each and shirts cost $50 apiece, the price ratio (and the slope of the budget line) is 2:1. This means that for each pair of pants bought, two shirts are not bought. That’s another way of saying the opportunity cost of a pair of pants is two shirts.

If ABC Apparel increases its inventory budget from $50,000 to $75,000, the budget line moves outward, parallel to the previous line. This reflects its wider range of possible bundles of pants and shirts. The slope of the budget line doesn’t change; the price ratio of pants to shirts is still 2:1.

On the other hand, changes in current prices affect the slope of the budget line. Let’s say the clothing retailer’s budget is still $50,000, but the cost of pants falls from $100 to $80 per pair. This would increase the maximum number the business could purchase from 500 pairs to 625. On the graph, the budget line would flatten as the price ratio is reduced from 2:1 to 1.6:1, meaning that for each pair of pants purchased at $80, 1.6 shirts are not purchased at $50.