Going over budget can be financially damaging for any company. But the idea that it’s “inevitable” during the course of business is flawed. In fact, one of the best ways to prevent this is by choosing business budgets that map to your size, format, industry, and operations.
Did you know that a third of all small businesses exceeded their budgets within the past fiscal year? That’s a significant number of businesses at risk of facing cash flow challenges.
Whether you’re a new business owner or restructuring your existing company’s spending methods, you need to know how to choose the best business budgeting method for you and your organization.
In this article, we’ll unpack the five most commonly used business budgeting methods that you can use to help you increase profits, as well as the advantages and drawbacks of each.
How to create a business budget: Five types of budgeting methods
If you’re a business owner, you already understand the importance of a budget.
You know that they’re there to serve as a road map for your organization’s revenue, expenses, and profit, typically over a 12-month period.
Budget creation should be done in a simple, readable way so you can better predict your organization’s financial future. This way, you can analyze your year-end results and make smarter spending decisions that align with your business goals.
After reading through the top five budgeting methods, you can also look at the three types of budget involvement techniques.
Budget involvement is how involved you want the rest of the company to be in budget-making. You may wish to receive input from the whole team (negotiating budgeting) or stick with company partners’ opinions (imposed budgeting).
Some types of business involvement are better suited for certain budgeting methodologies, which is why it’s essential to become familiar with both parts of the budgeting process. Let’s dive right in.
Method #1: Incremental budgeting
The incremental budgeting method is one of the most frequently used techniques. All you have to do is adjust the existing or last fiscal period budget by an increment or percentage to obtain the new or current year’s budget.
As you can see in the example shown below, the predicted operating budget for the new year adjusts according to the previous year’s expenditures:
There is no set formula for incremental budgeting — simply follow the assumption that the expenditures that occurred in the previous fiscal period will be the starting point for the new fiscal period.
Who it’s for
You can use this budget if you’re an established business with a historical record of your profits and losses. It’s also ideal for companies that want to build the value of their departments, create fast and efficient budgeting processes, and for companies whose funding requirements are predictable and consistent.
An example of incremental budgeting in action
Say that the sales department of an office supplies chain has an allocated budget of $100,000 for the fiscal period. By the end of the budgetary period, the managers determine that they’ve spent $110,000, so they are over budget by $10,000.
Although not an ideal situation, this exceeded budget will tell upper management that they need to allocate a higher amount than the original $100,000 for that department the following year.
Advantages of incremental budgeting
Incremental budgeting is one of the easiest ways to stay on track and ensure that budgets remain stable over the fiscal period. There are no complex calculations for arriving at the new budget. Essentially, budget analysis is unnecessary, which makes this methodology fast and cost-effective.
Drawbacks of incremental budgeting
Since incremental budgeting uses the previous period’s totals to determine the new budget, the company will increase each department’s cost allocation if they spent all their money from last year’s budget, even if the department doesn’t truly need it. This can promote unnecessary spending. Incremental budgeting is also likely to ignore external factors such as inflation or changing market conditions.
Is incremental budgeting right for my business?
Incremental budgeting takes last year’s figures as a starting point for the new year’s budget, making it the simplest budgeting method. It’s a good choice if you believe your company’s budget won’t change much each year.
However, higher-ups should prevent unnecessary spending and keep in mind that departments may overspend to avoid receiving a smaller budget the following fiscal period. If the budget keeps increasing year after year, it may be time to look at specific expenditures and spending habits.
Method #2: Activity-based budgeting
The activity-based method (ABB) is a top-down approach that thoroughly analyzes activities to predict operating budgets and future costs. In this context, “activity” refers to anything that incurs a cost and that accountants can examine for different ways to create efficiencies.
The current year’s budget is formed based on this information.
There are three main steps to determining the new budget under the ABB approach:
- Identify cost drivers and relevant activities, which are the items responsible for revenue and expenses for the company.
- Determine the projected total units for these activities, which is the baseline for calculating the following year’s budget.
- Estimate the cost per unit of activity, which gets multiplied by the activity level.
In other words, under ABB, a new budget is determined by a simple formula: Overhead cost per activity x Number of activities = Allocated overhead
Who it’s for
Large companies generally use this type of budgeting method. It’s popular in major industries, such as manufacturing, construction, and healthcare. ABB is ideal for companies with large budgets and considerable revenue that are undergoing material changes as well as new companies looking to start on the right foot.
An example of activity-based budgeting
ABB requires plenty of research. Management must determine which activities the company needs to take to meet specific goals and then evaluate the costs of carrying out those activities.
Say that Company A anticipates receiving 80,000 sales orders (X) in the upcoming fiscal year, with each order costing $3.00 to process (Y). The ABB for these expenses (Z) is then determined by multiplying those two numbers:
80,000 * $3.00 = $240,000
If this budget calls for $240,000 of sales order processing expenses and sales are expected to grow 10%, $264,000 is budgeted. Here’s the formula for determining how much money to allocate depending on expectant growth:
$240,000 + ($240,000 * 10%) = $264,000
Advantages of activity-based budgeting
ABB is an excellent budgeting method because you can see the exact costs for every operational activity, which provides a clear lens into where every dollar goes. This makes it easier to reduce costs and obtain profits from sales.
Plus, ABB is a useful method for businesses that prioritizes a forward-looking view rather than looking at previous activities rather than just allocation of costs according to previous activities. Using this method, you can eliminate unnecessary activities and offer services and products for a lower price.
Drawbacks of activity-based budgeting
ABB can be very expensive to implement and highly time-consuming compared to traditional budgeting. A team of analysts needs to identify the company’s activities and the costs of each. Then, they have to determine the appropriate budget for each department accurately.
And you can’t just hire anybody to analyze your business records: You need experienced accountants who have a deep understanding of this type of budgeting process.
Is ABB budgeting right for my business?
Activity-based budgeting is an effective method for identifying the exact cost of activities and expenditures so that businesses can better manage their money and eliminate unnecessary expenses. In turn, eliminating these costs can increase profits while strengthening relationships with customers.
However, ABB is a time-consuming method that requires accountants of particular expertise, which can be costly. It is suitable for companies looking to restructure their material output or newer businesses that need to reduce spending.
Method #3: Zero-based budgeting
Zero-based budgeting is a method that starts fresh: It begins by assuming that all department budgets are zero and must be rebuilt from scratch each fiscal period.
Each department needs to plan out and justify every dollar spent to build the budget from the ground up. Although zero-based budgeting requires a line-by-line justification of what’s being spent, it is a flexible method that can change as needed.
Who it’s for
Zero-based budgeting is ideal for companies of all sizes that want to focus on specific goals for a fiscal period. It’s a relatively common method for large corporations — more than 300 large global companies use the zero-based budgeting method.
An example of zero-based budgeting
Say that a growing family business plans to expand during the next fiscal year and wants to hire a delivery driver. New costs may include buying a van, paying for insurance, and hiring an employee with a salary and benefits.
When determining the following year’s budget, they will begin by placing their starting amount at $0. Then, based on last year’s budget and revenue, the company can determine how much they’re likely to make and where to move income so they can pay for a delivery driver.
Advantages of zero-based budgeting
Zero-based budgeting ultimately allows company leaders to focus on their top goals and avoid unnecessary spending. This method may also prevent the misallocation of resources since it’s easy to see where you can save and spend at a granular level.
This can turn into more focused operations, lower costs, and better strategizing for the future, allowing room to adapt to different plans as changes come up.
Drawbacks of zero-based budgeting
Zero-based budgeting offers new insights on how to build your budget, but it’s known to be a very time-consuming approach because of how often budgets need to be evaluated and adjusted.
That’s why it’s not a very common method, and many companies only use it occasionally. Company leaders can expect consistent readjusting with plenty of trial and error.
Is zero-based budgeting right for my business?
Zero-based budgets are created around the monetary needs of each fiscal period, which means you start your budget sheets assuming everything is at $0.
It’s effective for companies looking to focus on a specific goal and cut costs in the financial planning process. However, a zero-based budget is time-consuming because it must be done during a particular period, whether that’s monthly, quarterly, or annually.
Method #4: Value proposition budgeting
The value proposition method — also called priority-based budgeting — is a happy medium between incremental and zero-based budgeting. This methodology aims to eliminate unnecessary expenses by addressing expenditures and deciding whether their value justifies the cost.
It’s done through a three-step process:
- Determine and clarify the company’s vision or desired results
- Identify the programs and services
- Allocate resources to the programs
It’s important to ask questions like these during priority-based budget meetings:
- Why is this amount included in the budget?
- Does this item create value for the company?
- Does the value of this item outweigh its cost?
- What value does this provide to our business, employees, and customers?
As the name implies, every budget line item is analyzed to determine if it provides value for the business. Each activity and item needs to be justified, or it will become a cut cost.
Who it’s for
This budgeting method is ideal for businesses looking to become more conscious of their budget and eliminating unnecessary expenses but not to the extent of zero based budgeting. The value proposition budget at its core is asking if the cost of the item in question is justified by the value it creates for customers over what your competition is offering.
Examples of value proposition budgeting
During the budgeting process a company will list all expenses, then assign the value of each expense. They’ll ask questions like is this expense essential to keep the business running? Does this expense generate sales? Does this expense result in something your customers or employees will love? Once the list has been created, leadership will then rank the list from most important to least. As a result, they might end up pouring a lot of their budget into the specific areas that are prioritized based on their value to the company and its customers. For example, a company that values its company culture might consider sponsoring an event for all employees and their families to attend. While other companies might extend customer service hours to include weekends. Value is sometimes hard to quantify and it is constantly changing based on the current environment.
Advantages of value proposition budgeting
The value proposition method helps business leaders identify what brings the most value and remove the items that bring little value. Therefore, companies can be more value-focused by providing services and products that offer more value to their buyers.
Drawbacks of value proposition budgeting
Unfortunately, value is not easy to quantify. And without a clear understanding of value, some decisions may lead to short-term initiatives that negatively impact long-term plans.
Additionally, value can always change depending on multiple factors, whether social, economic, or technological.
Is value proposition budgeting right for my business?
A value proposition budget (or priority-based budget) focuses on assessing what’s most valuable to a company’s customers. The logic behind this approach is that customer choices ultimately determine business performance — so if you want to link budgeting to performance, look to what the customer values.
This method aims to eliminate unproductive expenses and to focus on creating what customers want most.
However, it’s not always easy to decide what’s essential, even with the numbers in front of you, since society and its needs (and wants!) are ever-evolving.
Method #5: Flexible budgeting
Unlike static budgets, which remain the same no matter what, a flexible budget goes with the ebbs and flows of a business.
Who it’s for
You can use this budget method if you have varying incomes and need to assess how you’ll flexibly use your money without going into debt. It’s ideal for new businesses and seasonal businesses that depend on worker availability.
Therefore, flexible budgets are standard among businesses that experience significant highs or lows during peak seasons. Companies need to adjust their income depending on staff and customer revenue changes, which will help prevent debt during slow times and increase sales during busy months.
An example of a flexible budget
An outdoor store like Bass Pro Shops needs to have a flexible budget for popular summer items and popular winter items.
Winter typically means more clothing accessories and sporting equipment, for example. With a flexible budget, company leaders can adjust spending for larger purchases that may only occur during this time of year.
Advantages of a flexible budget
Flexible budgets allow entrepreneurs and business leaders to cope with change and “roll with the punches,” so to speak.
The fact is that business growth hardly ever happens the exact way you plan it to, so getting used to adjusting costs and making changes to your budget and inventory will make you a better leader in the long run.
Drawbacks of a flexible budget
Unfortunately, a flexible budget involves a little trial and error, as it requires consistent monitoring without any guaranteed rewards. In some cases, the time spent analyzing and making modifications to a budget might not be worth it if trends or objectives end up changing.
Is a flexible budget right for my business?
Using the flexible budgeting method can help you keep up with the ups and downs of business. Still, it’s not for everyone. Instead, it should be reserved for companies that require a flexible budget, like businesses that experience seasonal changes and that can afford the more complex accounting involved.
Budget involvement strategies
Once you’ve decided on the budgeting method, you need to figure out how involved you and your employees will be.
Ask yourself: Will you make all the significant decisions or work together as a team?
Executives have three types of budget involvement options: imposed, negotiating, and participative.
Strategy #1: Imposed budgeting
Imposed budgeting is a top-down budgeting process where company executives set a budget to meet a specific goal. They will ask managers to follow that goal and impose these budget targets and activities onto lower-level employees. This method is ideal for companies that need to meet challenging objectives.
Pros of imposed budgeting
- Since management stays in control, the imposed budgeting method decreases the possibility of inputs from misinformed lower-level employees.
- Since fewer people are involved, less time is taken to analyze and draw up the new master budget, making budget creation fast and straightforward.
Cons of imposed budgeting
- Imposed budgets can leave employees feeling ignored or neglected by higher-ups and executives, which may cause team spirit and motivation to plummet.
- Identifying the right goals and objectives could be difficult since there is a smaller pool of opinions and inputs.
Strategy #2: Negotiated budgeting
A negotiated budget is a combination of top-down and bottom-up budgeting processes. Executives may outline some goals that they would like the company to meet, but there is a shared responsibility between managers and lower-level employees.
This method of involvement is best for small businesses. Here’s why: In small business structures, the chain of command is smaller, and executives are familiar with the company’s day-to-day operations.
The top-down and bottom-up system becomes more complicated in larger businesses because the chain of command is longer.
Pros of negotiated budgeting
- Lower-level employees feel more involved and may have more personal interest in the budget plan and the company as a whole.
- Information is freely shared between top executives, middle management, and department-level employees and staff members, which allows everyone to voice thoughts or concerns.
Cons of negotiated budgeting
- This method can be time-consuming since preparation starts from the department level to the top executives. Too much participation can mean longer deliberation, which means a longer time to reach an agreement.
- Lower-level employees may be unfamiliar with the actual costs of a business and may overestimate the revenue projections, which can cause loss or disagreement among the chain of command.
Strategy #3: Participative budgeting
A participative budget is a bottom-up budgeting process where employees recommend targets and goals to managers and executives.
While upper management can make recommendations and changes, the input from employees who are familiar with the day-to-day operations is taken seriously.
This budgeting method works best for small businesses with high levels of trust, communication, and teamwork.
Pros of participative budgeting
- Managers are given more freedom in determining and adhering to their department’s budget.
- This method increases the entire company’s morale, sense of belonging, and job satisfaction, which, in turn, may motivate employees and managers to work harder to achieve their agreed-upon goal.
Cons of participative budgeting
- There is a tendency for department heads to over-budget since they want that to translate into the following year’s budget.
The process could be long and arduous since many people are involved, and lower-level employees may not be familiar with what is realistic.
Keeping your business budgeting methods efficient
Whether you are getting ready to launch or you’re focused on growth, don’t be part of the 46% of small businesses and startups left behind without a budget. Your business will always benefit from having an accurate picture of existing and projected financial health.
Picking your budgeting method is the first step — your next step is finding a way to store all your spending information so you can keep records and track patterns. Budgeting software can help by simplifying the entire process.