All businesses regardless of their size, and turnover require budgeting methods and strategies to maintain a healthy bottom line. When growing a business, it can feel like going over budget may even be inevitable.
However, with good budgeting strategies in place from day one, overspending can be completely avoided. Budgeting strategies vary according to the industry in which the business operates, its size, and the overall economic climate.
What are the main types of budgeting methods?
There are a whole host of budgeting techniques that will suit different companies depending on the stage they are at, and what business model they follow. Here are just some of them which are the most commonly used:
This is one of the most commonly used budgeting methods because it is straightforward to understand. It involves taking the previous year’s total expenditure and adding or subtracting a percentage to arrive at the new budget. The technique is useful for businesses that have established themselves and have a good track record or at least, a good history of accounts which show patterns. When a business is steadily growing, it’s natural to assume that it will grow at a similar pace year on year, and so expenditures as well as budget, will slightly increase. If the business has managed to grow without having to use the full allocated budget, the budget for the following year may remain the same as the previous year to accommodate growth.
One of the disadvantages of incremental budgeting is that if staff members anticipate that the budget will always increase every year, they may not rein in departmental spending habits or try to cut costs to save money for the business. This may then lead to the perception that the department is consistently under budget. Incremental budgeting also assumes that the primary cost drivers do not change from one year to the next and doesn’t always take into account external factors such as inflation.
Popular in industries such as healthcare, manufacturing, and construction, activity-based budgeting (ABB) is more suited to large companies with impressive revenue. It is also beneficial for new, ambitious companies with good levels of investment that want to be lean in their expenditure. ABB requires research and analysis. This is because the budgeting process essentially works backwards – management decides where the company wants to be in a year’s time and what activities must be carried out in order to reach those financial goals.
The three main steps that are taken in this top-down approach are:
- Identifying cost drivers and required activities to reach targets.
- Determining how many times these activities need to be carried out.
- Estimating the cost of each activity.
Unlike incremental budgeting, which is backward-looking, ABB is forward-looking. Because of the level of analysis required to reach exact costs for every operational activity, this is a more time-consuming budgeting system but is well worth the effort.
Zero-based budgeting (ZBB) literally starts from zero across all departments and asks managers to justify each expense allocated to the previous year’s budget in order to set the current year’s budget. By analysing line items individually to weigh up whether they were worth the spend or unnecessary, a tighter budget can be set for the following year’s forecasting.
Whereas incremental budgeting may be one of the most popular budget plans because it requires little input, ZBB is popular because it requires a lot of input which then leads to reliable outputs. ZBB can help cut budgets effectively without impacting operations by spotting inefficiencies. This bottom-up approach can help companies reach specific goals or cut back significantly in times of economic crisis.
Value proposition budgeting
This methodology blends elements of incremental budgeting and zero-based budgeting. Involving a less cut-throat process than ZBB, this form of strategising seeks to weigh up the value of each line item against the company’s vision.
Some of the questions that managers and the finance team may look to answer are:
- Why is this amount in the budget?
- Does this expenditure create value for customers, stakeholders, or staff?
- Does the value outweigh its cost?
The value it returns may not be monetary, it may be reputational, for example. This method is useful for companies in a stable position that are looking to set themselves apart from competitors.
A traditional budgeting system, this method only really works in the early stages of a small business. Envelope budgeting is exactly that – placing the cash allocated to each business activity physically into an envelope and only spending what is inside each envelope each month. As most business is now done online, this one may not be so easy to carry out in practice anymore.
However, the idea has been replicated by digital financial service businesses that allow customers to keep various pots for big spend items such as a holiday or a car, separate from their checking account balance. Prepaid credit cards follow a similar philosophy, ensuring that the amount allocated to a certain activity is not overspent.
Most types of budgets tend to be static, however, flexible budgeting adjusts according to events. Seasonal businesses may find this budgeting approach more suitable for their financial planning needs as it can accommodate unexpected expenses and upticks in revenue.
The flexibility that it offers requires extra accounting support so it may not be ideal for everyone. It also entails some trial and error, monitoring figures from quarter to quarter, and sometimes month to month.
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Budgeting is a key element of financial management alongside financing, risk assessment, and capitalisation. The world has experienced a global pandemic, the effects of climate change, and the outbreak of war in the past few years, all of which affect business, impacting supply and demand. Budgeting in volatile times requires a keen eye for world economic trends, whether in the global supply chain or in cryptocurrency, and the reflexes and experience to react accordingly.
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