Creating a budget can be incredibly useful for businesses aiming to minimise operating costs and improve business processes. With a robust data-driven plan, companies can spend only what’s necessary to ensure things run effectively.
In the past, many businesses used a conventional approach to budgeting where they would adjust the present state of their financials for a future period.
Where there certainly isn’t anything wrong with this approach, there are a few other budgeting methods that you should know before your next budget meeting.
What Is Budgeting?
Budgeting is creating a financial plan for your business while keeping business goals and resources in mind. It’s the basic tactical implementation of your business plan that sheds light on your available capital and considers your business plan’s estimated outflows and inflows over a particular period in the future.
A budget can allow you to plan your business activities and serve as a benchmark for setting financial objectives. It can help you deal with both short-term problems and long-term planning.
Budgeting Methods for Businesses
The budgeting method you use for your business planning depends on your situation. There’s more than one way of approaching budgeting.
Keep in mind that there’s no right or wrong budgeting method. Thus, you need to pick the one that suits your organisation or the environment in which you’re currently operating.
1. The Incremental Budgeting Method
Incremental budgeting is based on minor changes from the actual or predicted results for the prior period. For instance, if your business saw a 10% decline in sales in 2021, you would also reduce your budget by 10% across the board.
It’s ideal when only minor changes to your business or the business environment exist. Moreover, it’s the fastest of all the budget techniques. Therefore, it’s well-suited for companies with time constraints but needs excellent and quick results.
In summary, incremental budgeting is easy to perform and makes company-wide adjustments quickly. Nevertheless, it doesn’t factor in the impact of market trends or inflation.
2. Activity-Based Budgeting
Activity-based budgeting is a top-down type of budget that determines the number of inputs needed to support the goals established by the company. For instance, a business sets an output goal of $100 million. The company will first need to calculate the activities that need to be undertaken to achieve the sales target and then estimate the costs of performing those activities.
There are three critical steps to determining the new budget using this approach.
Step #1
Identify the appropriate activities and cost drivers, which are the items responsible for expenses and revenue for the business.
Step #2
Determine the estimated total units for these activities, which is the baseline for determining the following year’s budget.
Step #3
Estimate the cost per unit of activity and multiply it with the activity level.
Large companies typically use this method of budgeting. It’s popular in significant industries, including construction, healthcare, and manufacturing. Activity-based budgeting is perfect for businesses with large budgets and considerable revenue going through material changes. Nevertheless, it also works for new companies that wish to start on the right foot.
3. Value Proposition Budgeting
The value proposition budgeting method puts all the elements of financial planning under scrutiny. You can look at it as a kind of budgeting microscope. This budgeting method considers why particular items are present in a budget, the value they provide, and if it’s financially feasible to pay for them.
This budgeting method enables businesses to cut down unneeded expenditures from their plans and figure out the primary cost drivers. It’s one excellent way to make sure your business isn’t spending money on unnecessary items by putting the core emphasis on the value various areas of operations provide to consumers, employees, and stakeholders.
4. Zero-Based Budget
This is the most popular budgeting method, particularly during periods of financial distress, and works based on absolute zero. The zero-based budgeting method assumes that every department’s budget is zero, and everything needs to be done from scratch. All expenses are scrutinised to ensure every purchase and cost has an undeniable and unmistakable value to be accounted for.
Zero-based budgeting is exceptionally tight and removes all expenses that don’t lead to profits. This kind of bottom-up budgeting can be helpful in times of urgent need, such as market downturn, financial restructuring, or economic distress when organisations need to cut down their budgets significantly.
Which Budgeting Method Is Right for Your Business?
All the four budgeting methods listed in this article have their benefits and drawbacks, and we cannot say that one way is better than the other.
When selecting a budgeting method, you should pay attention to your company’s requirements and your targets for every budget period. For instance, you might not anticipate change in a particular year and opt for the incremental budgeting method. In the subsequent year, you might have targets for a new innovative product, and you might think that the top-down approach of the activity-based budgeting method is more appropriate for that particular year.
Keep in mind that developing a budget is a highly complicated process. The more resources you invest into it, the more beneficial and accurate the budget will be for letting your company stay on the path to success.
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