A budget is a crucial planning tool for every business. It estimates your future expenses, revenue, and profits. It helps you better control spending and identify situations where revenue may not be sufficient to cover expenditures. Moreover, a budget allows you to realize potential growth opportunities when you may have extra cash available to invest in new ventures.
This article will look into four different budgeting methods used widely among businesses and help you find the one that best suits your current situation and type of organization.
4 Types of budgeting methods: Which one is right for your business?
Below are the most common types of budgeting methods that you may want to consider for your business.
Budgeting method #1: Incremental budgeting
One of the most popular approaches is incremental budgeting. There’s no fixed formula for incremental budgeting – you simply change last year’s budget by an increment or percentage to obtain this year’s budget figure.
This method focuses on small changes from the actual or budgeted results from the preceding period. It’s perfect when your primary cost-driving factors don’t regularly change. Without the need for complex calculations, incremental budgeting is the quickest of all budgeting methods. However, be aware that your company’s departments may overspend to avoid receiving a smaller budget the following fiscal year. It’s best to look into specific expenditures and spending habits to prevent any kinds of budgetary slack.
Best for: Those who are limited on time but need a method that is effective and reasonable. It’s also well-suited if you have an established business with predictable and consistent cash flow and financial activities.
Budgeting method #2: Activity-based budgeting (ABB)
Activity-based budgeting (ABB) is a budgeting method in which every activity that incurs costs is tracked and analyzed to identify areas for improved cost-saving. After figuring out how to enhance cost-efficiency, a business will create a budget based on those findings. Companies typically employ this budgeting method to cut expenses, boost productivity, gain a competitive advantage, and improve overall operations efficiency. Rather than just using the past budgets to determine a new budget like the incremental budgeting method, the ABB system digs deeper into the company’s performance.
The ABB system gives you more control over the budgeting process. Since the budget uses relatively precise data for the projections, it helps managers align the budget with overall company goals much easier. Due to its complexity, the ABB method is more expensive and time-consuming to implement and maintain.
Best for: New companies without historical budgeting data should consider this method. The ABB method is also popular in major industries, like manufacturing, construction, and healthcare. Companies that are going under significant changes, such as new subsidiaries, large clients, business locations, or products, are likely to use the ABB technique as well.
Budgeting method #3: Value proposition budgeting (VPB)
Value proposition budgeting (VPB), or priority-based budgeting, is all about driving value. With this method, you go through every cost item to decide whether the value it brings justifies its cost. This allows your business to focus on true value drivers while avoiding wasteful spending. One of the main downsides of the VPB method is that value is not easy to determine as it depends on multiple factors like politics or economic trends. If there isn’t a clear understanding of value, business owners may make short-term decisions that negatively influence long-term goals.
When preparing for the VPB method, businesses have to answer these essential questions:
- Why are we spending this amount of money?
- What value does it bring to our customers and stakeholders?
- Does the value outweigh the cost?
Best for: This method best suits companies aiming to reduce unnecessary expenses and refocus on creating what customers want most. Many government entities also favor this budgeting method because it involves a lot of financial restructuring throughout the year, and VPB can help them identify which services are most valuable and most needed within the community.
See also: Are You Maximizing Your Business Budget?
Budgeting method #4: Zero-based budgeting (ZBB)
Zero-based budgeting (ZBB) is another common budgeting method. When applying the ZBB method, you assume that all department budgets are zero and must be rebuilt from scratch. In other words, past budgets’ numbers are not considered. Budget planners must justify every penny spent. The ZBB method is very strict, attempting to eliminate any expenses that do not contribute to the company’s profit. It’s difficult and time-consuming to carry out a zero-based budget, so many companies only use this approach on occasion.
Best for: This extreme budgeting method is very useful when a business has an urgent need to reduce cost, for example, a financial restructuring.
The bottom line
Employing a suitable budgeting method for your business is an effective way to save costs, increase productivity, and bring in more profits.
By understanding the basics of commonly-used budgeting methods among businesses, you can gain a deeper insight into your own business’s situation to improve your financial performance.
In order to determine your ideal budgeting method, it’s important that you have accurately recorded expenses. In order to do so, you need to have your receipts organized and stored safely.
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