Let's Talk Budgets

With the rising livings costs and inflation rates, now is the best time to think about budgeting. Not all budgeting is to do with penny pinching, when used correctly it can ensure you reach the target profit margins and stay on track for projects.

There are four main types of budgets:

1. Incremental
2. Activity Based
3. Value Proposition
4. Zero Based

In this blog we will discuss the different budgeting styles.

1. Incremental budgeting

Incremental budgeting takes last year's actual figures and +/- a percentage to obtain the current year's budget. It is the most common method of budgeting because it is simple and easy to understand.

Incremental budgeting is appropriate to use if the primary cost does not change from year to year. However, there are some problems with using this method:

• It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economise.
• It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team needs so it appears that the team is always under budget.
• It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

2. Activity-based budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.

For example, a company sets an output target of £100 million in revenues. The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

3. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following questions:

• Why is this amount included in the budget?
• Does the item create value for customers, staff, or other stakeholders?
• Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures - although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

4. Zero-based budgeting (ZBB)

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch. Managers must be able to justify every single expense.

Zero-based budgeting is very tight, aiming to avoid all expenditures that are not considered absolutely essential to the company's successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to "shake things up". The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs. However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.

Levels of Involvement in Budgeting Process

We want buy-in and acceptance from the entire organization in the budgeting process, but we also want a well-defined budget and one that is not manipulated by people. There is always a trade-off between goal congruence and involvement. The three themes outlined below need to be taken into consideration with all types of budgets.

Imposed budgeting

Imposed budgeting is a top-down process where executives adhere to a goal that they set for the company. Managers follow the goals and impose budget targets for activities and costs. It can be effective if a company is in a turnaround situation where they need to meet some difficult goals, but there might be very little goal congruence.

Negotiated budgeting

Negotiated budgeting is a combination of both top-down and bottom-up budgeting methods. Executives may outline some of the targets they would like to hit, but at the same time, there is shared responsibility for budget preparation between managers and employees. This increased involvement in the budgeting process by lower-level employees may make it easier to adhere to budget targets, as the employees feel like they have a more personal interest in the success of the budget plan.

Participative budgeting

Participative budgeting is a roll-up approach where employees work from the bottom up to recommend targets to the executives. The executives may provide some input, but they more or less take the recommendations as given by department managers and other employees (within reason, of course). Operations are treated as autonomous subsidiaries and are given a lot of freedom to set up the budget.

What are your thoughts on budgeting? Did this blog help answer any questions you may have had? If not, why not pop us an email or even book a free, no-obligation consultation.