In the context of business management, budgeting serves a crucial purpose. It not only allows organisations to forecast income and expenditure, thereby determining operational profitability, but also provides a crucial guide to predicting cash flow which is of critical importance to financial sustainability. Budgeting also forms an integral part of the decision-making process and enables business performance to be monitored.
Despite the importance of creating and managing budgets effectively, many employees are given budgetary responsibility without proper guidance as to how they should approach this task. Below we will introduce two of the main techniques for effective budgeting.
Zero Based Budgeting
A frequently used budgeting method is Zero Based Budgeting. As the name suggests, this method of budgeting does not look at the historical picture but rather starts from the assumption of a zero base, i.e. a blank sheet of paper.
The business activity or function in question is analysed for its particular needs, the associated income and incumbent costs. Budgets are then built up around what is needed for the activity or upcoming period. Zero Based Budgeting seeks to avoid any expenses that are not considered to be essential to operational success. Instead, it enables far easier identification of the relevant items to include within a budget, resulting in a much more robust set of numbers.
When should you use Zero Based Budgeting?
Zero Based Budgeting is always used when an organisation is embarking on a new activity. With no historical financial data with which to work, creating a budget from a zero base is the only option.
In addition, due to its highly detailed nature, Zero Based Budgeting is often implemented when an organisation is seeking to scrutinise and improve a business activity or function. Rather than focusing on unavoidable operating costs, Zero Based Budgeting can be used to address discretionary expenses, with a view to fine-tuning the financial performance of a particular function or activity.
Zero Based Budgeting drills down to the bones of an activity and helps to ascertain the different steps required to complete a process. Simply speaking, imagine an organisation is looking to recruit an additional member of staff. Rather than merely taking salary and benefits into account, Zero Based Budgeting would also look at the costs involved with advertising the position, carrying out the interview process and settling the new staff member into the role. It’s then possible to put some figures against those considerations to create a stronger and more realistic financial picture.
Advantages & Disadvantages
The detail of a Zero Based Budget offers a robust benchmark for comparison. Throughout the period or activity in question, decision makers can refer back to their projected costs and compare them with the reality. This level of detail helps with the creation and management of future budgets and forecasts too, reducing the time required to create these later on.
Additionally, the Zero Based method is ideal for use when there is an urgent need for cost containment. From financial restructuring to an economic or market downturn, Zero Based Budgeting can be employed in situations that require a budget to be dramatically reduced.
However, the method can be time-consuming. Therefore, a sensible approach is to use it on a rolling basis by examining a few business activities at a time.
Incremental budgeting is the second of the most common methods of budgeting employed by businesses, primarily because it is a simple and easy to understand option. The method uses the previous year’s actual or this year’s forecast figures and adds or subtracts a percentage as appropriate, depending on current market situations, to calculate next year’s budget.
When should you use Incremental Budgeting?
Incremental budgeting is an ideal method to use if an organisation’s primary cost drivers remain the same from year to year or similarly, the operating costs are unavoidable and difficult to improve upon.
For example, let’s consider an organisation’s electricity expenses. Rather than calculating anticipated energy usage, decision makers would consider whether electricity prices are rising or falling and use this information to determine an incremental figure for the budget.
Advantages & Disadvantages
While Incremental Budgeting offers a quick and simple solution, it can ultimately result in a budget that becomes based on out of date information. Simple year on year incremental increases can create a budget that’s based on historical circumstances.
In a similar vein, Incremental Budgeting can perpetuate inefficiencies. Opportunities to economise may be ignored if budgets are simply increased or decreased blindly year on year. Likewise, budgets may be overstated to create the impression of efficiency as savings are demonstrated throughout the budget year. Incremental Budgeting is also likely to ignore external drivers of activity and performance and simply assume that certain costs will continue to grow or decline without performing sufficient analysis.
Whatever budgeting method is chosen, it’s important to ensure all assumptions are documented. It’s easy to forget how and why estimations were reached, thereby making it impossible to manage budgets in the future without robust decision-making records.
Thanks for reading! These techniques are covered in more detail in our Creating & Managing Budgets course.