Setting up a budget can be challenging, and so is choosing the right budgeting method that best fits your business’ model and needs. In this article, we will shed light on the five most common approaches to budgeting, as well as their pros and cons.
The 5 most common approaches to budgeting
1. Incremental budgeting
Incremental budgeting computes a budget by applying adjustments to the preceding period's actuals. The change typically comes in percentage term and could either be an increase or a cutback depending on many factors, primarily the organisation's needs and situation. To some extent, it helps reflect the growth of the business and changes in the market.
Carried through on the basis of historical data, this conservative approach to budgeting is generally preferred by businesses whose cost drivers remain static, suggesting that they manage to maintain a sluggish growth and steady profitability, and are subject to everything from little to no fluctuation or competition in the market, at least until the cow comes home.
Given many of this method’s flaws, some have avoided it for good, notably after the Great Recession in 2008. Nonetheless, if businesses find their model is as we described above, they could still reap some benefits from incremental budgeting.
Advantages of Incremental Budgeting
- Straightforwardly simple: Incremental is relatively easy to implement as financial records of prior periods, the ground where this method is based upon, are usually available.
- Easy to standardise: The methodology is as simple as adding or subtracting a proportion of percentage to historical figures, which helps scale down the timeframe for implementing the process and eliminates the need for conducting hands-on training.
- Easy to ensure continuity: Incremental budgeting facilitates a steady flow of fund into every facet of the organisation’s activities and functions, which helps identify and resolve any inconsistencies emerging through the life of the business.
Disadvantages of Incremental Budgeting
- Perpetuated resource allocation: Since with incremental budgeting, different departments tend to have the same percentage rise in share over the years, the approach fails to adjust the allocation of resources to accommodate their various needs. In the worst-case scenario, the flow of funds is channelled into those areas that are no longer operational.
- Incremental in nature: The method only studies the slight changes from the previous budget at the expense of any number of radical changes in the external landscape that might call for a re-evaluation at best, or a revamp of the whole system at worst.
- Susceptible to overspending: Any drop in a budget inevitably leads to a cutback which may encourage managers to tighten the budget to its brim to ensure that they have access to a large fund in the upcoming years.
- Susceptible to budgetary slack: Managers are incentivised to manipulate the budget by underestimating revenue growth and/or exaggerating expenditure so that the variance between the two is in their favour.
- Detrimental to innovation: As conservativeness is a characteristic that lies at the root of incremental budgeting, it does not foster or reward innovative ideas.
2. Zero-based Budgeting (ZBB)
To create a new budget, zero-based budgeting (ZBB) necessitates the justification of all manner of budget expenditures and line items on the balance statement. On this account, this approach is implemented irrespective of the previous period's spending, as opposed to the above-mentioned traditional method of modifying past actuals.
In other words, ZBB compels businesses to build a new budget from scratch; starting from the baseline of "zero" as the name suggests. People in charge, i.e. analysts, will evaluate and justify every bit of expenses.
First introduced in the 1970s, as an attempt to align resource allocation and corporate strategy, ZBB is downright a regimented discipline in its earnest effort to justify which activity adds real value and is worth keeping, and which is a futile effort that needs to be disposed of.
At the outset, ZBB is structured to optimise cost containment and management, an imperative in this ever-changing world. Aside from that, it is also a value generator that facilitates any number of functions.
Advantages of ZBB
- Improved accuracy: ZBB ensures that every apartment is catered with the exact amount of resources and funds they need.
- Increased efficiency: ZBB centres on current needs and future objectives rather than past results, ensuring that every nickel spent adds value and contributes to the organisation's strategic objectives.
- Optimised resource allocation: ZBB allows for the identification and elimination of the poor values, enabling businesses to free up more resources that could instead be mobilised into other critical functions.
- Aligned with business objectives: ZBB establishes a strong tie between the way money is spent and the overall strategy.
- Fostered congruence: ZBB is a top-down approach that requires an active engagement of every department and an organisation-wide collaboration across the business, fostering a culture of communication.
ZBB, for all that, has long been a subject of debate as it is undeniably a cost centre that drains resources out of the organisation.
Disadvantages of ZBB
- Depleted resources: Starting from scratch entails the concerted effort of manpower, a substantial investment of time and money, not even excluding the endless pile of paperwork and reports, making the practice an intimidating nuisance.
- Unable to measure the unmeasurable: ZBB falls short when it comes to determining the budget for activities or departments having intangible outcomes such as Marketing and Research & Development, an issue that remains unresolved.
- Extensive training: Limited expertise on the method, or rather the lack thereof, could be a severe problem that presses organisations to conduct intensive training for employees, which not only deprives time and effort but also may stir up attrition in people to which ownership are assigned.
3. Rolling (Continuous) Budgeting
Rolling budgeting is a rigorous method where people continuously add a new budget period to replace the previous one as it expired. We have discussed this approach and its implication at great length in the last blog post.
Advantages of rolling forecasting
- Stay ahead of the curve: Rolling forecast keeps you stay on top of all changes, threats and opportunities.
- Drive performance: Rolling forecast allows for the refinement of the financial plan and the broader strategy.
- Mitigate risk: The approach supports scenario planning, and thus, drives decision-making.
- Stay relevant: Rolling forecast is key in aligning your Planning and Budgeting process with your strategic goals.
Disadvantages of rolling budgeting
- Time-consuming: Budgeting now is a monthly or quarterly activity instead of being done once a year.
4. Activity-based Budgeting (ABB)
Activity-based budgeting (ABB) calculates the total cost needed to hit the target of the anticipated level of activities (thus its name).
This top-down method first calls for the identification and thorough scrutiny of all the activities that drive cost. This analysis will then give grounds for allocating resources to achieve the level of activities that was anticipated beforehand.
To give an example, you run a small toy manufacturer. Your forecast for the next year says that sales would be 10,000 units, each of which is assigned the same Cost of Goods Manufactured (COGM) at $5. Employing ABB, you should compute a budget of $50,000 (10,000 * $5).
ABB could be easily confused with ZBB: Rather than starting from the basis of zero, ABB allocates resources by studying the efficiencies of the activity that is under review. Instead of starting everything from scratch, people leverage activity-based analysis to streamline the process.
Advantages of ABB
- Enhanced efficiency: By linking every function and department with their spending, ABB provides a complete picture of the organisation. Based on this visibility, the organisation are enabled to identify and close the performance gap as well as seize opportunities that may arise
- Cost management: By taking into account each and every activity that incurs costs, ABB delivers better cost containment, thus improving the bottom line.
- Eliminated redundancy: With the help of ABB, any non-value-added activity or function will be easily diagnosed for taking corrective measure or removing
Disadvantages of ABB
- Suck out scarce resources: Just like any other discipline with structural implications, ABB greatly expands the workload and requires the devotion of workforce and financial resources.
- Foster short-termism: ABB focuses on the contemporary goal rather than the long-term strategy.
5. Performance-based Budgeting (PBB)
Performance-based budgeting (PBB) is another advanced approach where budgets or funds are associated with specific objectives.
With PBB, a set of goals or desired outcomes is first set. These objectives will then act as the rationale for the course of activities that the organisation expects to undertake as well as its associated cost.
By revolving around objectives, that is, the "results" that the organisation wants to achieve, PBB helps build a result-oriented culture.
On a side note, some performance indicators, i.e. KPIs (Key Performance Indicators), are now widely employed to facilitate this practice.
Advantages of PBB
- Assign clear ownership: By quantifying goals and objectives, PBB hold all the involved entities accountable for the process.
- Prioritise key activities: As it emphasises achieving the organisation's goals and objectives, PBB is tightly integrated into the broader strategy. This helps management identify which activities or functions are critical and set them in order of priority.
Disadvantages of PBB
- Require engagement: Performance budgeting calls for both top-down and bottom-up buy-ins, exacerbating disengagement in employees.
- Encourage subjectivity: As this practice is inherently subjective, it encourages management to make decisions based on gut feelings.
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