Types of Budgets – The Four Most Common Budgeting Methods
As a business grows and becomes more complex, creating a budget becomes a necessity for continued growth, planning and expansion.
Budgets are basically a spending plan for your business that estimate anticipated needs such as spending, available capital, and a solid budget will help you predict revenue.
Many businesses in the past have used a traditional approach to budgeting where you simply adjust the current state of your financials for a future period.
In other words, the current year’s actuals serve as the reference for the following years budget.
While there certainly isn’t anything wrong with this method, there are a few other types of budgeting methods that are worth knowing before your next budget meeting.
There are several different approaches to budgeting for businesses but these four types of budgets are the most commonly used: incremental budgets, activity-based budgets, value proposition budgets, and zero-based budgets.
Each of these budgeting methods have their own advantages and disadvantages and in this article, we are going to learn about each one so that you can be knowledgeable and ready to plan for the future of your business.
The Incremental Budgeting Method is perhaps the most commonly used budgeting method because it is simple and easy to understand.
This budgeting method simply uses last years actual numbers and adds or subtracts a percentage to be used on the future year’s budget.
The incremental budgeting method is a great method to use if your costs are more predictable and tend to be similar year over year.
PROS of Incremental Budgeting Method
- Simple and easy to understand – no complex calculations are required since it uses current numbers and adjusts them to account for inflation or revenue growth.
- Saves time because of how simple it is to create and calculate.
- Budgets remain pretty consistent over time.
- Incremental funding helps with funding stability because expenses are pretty easy to predict year over year.
- Less internal challenges between departments because the budget usually allocates equal incremental changes across the board.
CONS of Incremental Budgeting Method
- This method could promote unnecessary spending because year over year this type of budget is usually increased by a certain percent. This could make departments feel like they need to spend all of the money in their budget, even though there perhaps was not an actual change in current expenses. Some departments may not need any additional spending dollars but will be allocated them anyways in this method.
- This method tends to be used more in conservative business environments where innovation isn’t as much of a priority. New budgets are based on figures from the previous year and are adjusted little by little, leaving little room for innovative growth.
- Doesn’t account for unforeseen changes or external factors that may come up.
- Could discourage management from taking a deeper look into expenses and savings.
The main reason a lot of companies use the incremental budgeting method is because of its simple and straightforward approach.
However, as you can see, this type of method can lead to some other challenges such as over-spending and oversight, as well as being surprised by unforeseen changes.
This type of method is best used if a company has minimal changes year over year and you are confident that spending will remain stable.
Rather than using actual numbers from a current year, the Activity-Based Budgeting method uses a top-down approach that focuses on the key outcomes a business wishes to achieve in the next period.
Activity-Based budgeting is great for companies that perhaps do not have enough historical information to create the next periods budget, for example, newer companies that are growing.
It is also a great method for firms that are undergoing a lot of material changes where historical information may no longer be a useful basis for future budgeting.
For example, say a company is expanding and developing a new product that will require an aggressive sales process.
The companies goal is to generate $4 million in revenue from this new product in the coming year and to do so, they will require a sales force as well as the production team to manufacture the new product.
Because there is no historical data on this product, the activity-based budget will use a top-down approach where they will work backwards from their revenue goal of $4 million.
Management will have to determine how much product they need to sell, how many sales events they need to make, and the size of the pipeline they need to generate, etc.
In other words, what will is take to get to our goal of $4 million in revenue.
Budget items will include the cost of staffing, production, technology, PR, and other resources needed.
PROS of Activity-Based Budgeting Method
- Forward looking view gives managers insight into were improvements can be made rather than just taking what was done in the previous period and allocating costs based on that.
- More likely to identify inefficiencies in processes or areas that need more or less in their budget for the future.
- Helps companies stay goal-focused because the budget uses a top-down approach that allocates resources based on a final end result or goal.
- Easier to make changes based on climate or current events and helps identify capacity issues.
CONS of Activity-Based Budgeting Method
- Activity-based budgeting is a lengthy and time consuming process that can become cumbersome and counter productive if too much time is spent on analyzing.
- Requires individuals who have experience with budgeting, fiscal planning, and are able to find gaps and or overlaps.
- Activity-based budgeting can sometimes lead to short-term thinking of goals and the overall big picture may be lost in the process.
- This method is based on future forecasting which can be unreliable if the end results are not as planned. This can lead to serious cash flow issues if the budget is not carefully and thoroughly thought out.
Activity-based budgeting definitely uses a more strategic approach to budgeting than the other methods listed in this article.
It requires more time and a significant amount of resources in order to be done correctly.
However, this can also be a very powerful tool for companies that are innovative and are able to make quick changes and adapt as needed.
They can use this top-down approach to stay on track, hit certain metrics throughout the year, and meet a desired end goal.
Zero-Based Budgeting is, as the name suggests, a zero starting point, or blank slate.
With this budgeting approach, managers must create their budget categories and items and justify each item without reference to the prior year’s numbers.
An item that was on the budget last year doesn’t necessarily need to be on the budget in the future, unless it can be justified and a continued need is identified.
This budgeting method is time-consuming because budget owners must literally explain every proposed expense.
This is an excellent method for eliminating unnecessary expenses and identifying key expenses that the company cannot live without.
PROS of Zero-Based Budgeting Method
- Excellent method for eliminating unnecessary expenses or waste.
- Holds managers accountable for costs and aggressively streamlines inflated budgets.
- Helps companies bring costs under control while minimizing any negative impact on operations.
CONS of Zero-Based Budgeting Method
- This is a very time-consuming method that requires time, resources, and review.
- This method may reward short-term thinking rather than long-term, big-picture thinking. For example, research and development is often considered a long-term investment but may be left with less allocation of funds, even though they are needed in the short-term.
- Possible manipulation by savvy managers who are looking to squeeze more resources into their departments.
Zero-based budgeting is great for companies that are innovative and are looking to run more efficiently.
It forces managers to really think about every dollar they are spending in a budgeting period.
On the flip side, some critics argue that the benefits of zero-based budgeting do not justify its time cost.
While this method takes a lot of time, it can indeed lower costs by keeping expenses in check.
Value Proposition Budget
The Value Proposition Budgeting method is a happy medium between incremental budgeting and zero-based budgeting.
In a nutshell, this approach analyzes each budget category or line-item and asks the following questions:
- Why are we spending this money?
- What value does this provide to our stakeholders, employees, and customers?
This method is used to justify expenses by looking for the value they create.
Incremental budgeting perhaps doesn’t scrutinize each item or category on the budget enough while zero-based budgeting perhaps scrutinizes each item or category too much.
This is why the Value Proposition Budgeting method falls somewhere in between.
PROS of Value Proposition Budgeting Method
- This method helps leaders identify items that bring the most value and remove the ones that bring no value or don’t benefit the business concept statement.
- Helps create a strong differentiate between you and your competitors by identifying the companies key value points, helping you emphasize on those for the next period.
- Value proposition budgeting helps businesses stay more customer centered by focusing on how they can add value to their customers, stakeholder and employees.
- Directs your marketing efforts to concentrate on those activities that will generate the greatest results.
- Great for deeper budget analysis and cutting wasteful spending.
CONS of Value Proposition Budgeting Method
- “Value” can be a difficult thing to quantify.
- This can lead to more short term thinking rather than long-term thinking. Sometimes items are more complex than just identifying their value, and this can lead to perhaps cutting items that are important, but do not have an immediate value.
- Perceived value may not always be stable and can change based on cultural, social, economic, or technological factors.
Value proposition budgeting is not for every company, but when properly executed, can drive profit, build value to your brand, and establish customer loyalty, which leads to success.
Each budgeting method listed here has its own set of pros and cons and we can’t really say one is better than the other.
When deciding on a budgeting method, you need to look at the needs of your business and your goals for each budget period.
One year you may not anticipate much change and can use the incremental budgeting method.
The next year you may have goals for a new product or innovation, and perhaps the top-down goal setting approach of the activity based budgeting method is better suited for that period.
Creating a budget is an involved process and the more time you put into it, the more accurate and beneficial the budget will be for helping your organization stay on track for success.