Budgeting is a vital activity that every healthy business performs. Budgets have a variety of uses and are often referred to as a fiscal road map for the upcoming year.
They are immensely important for the effective management of any enterprise, and there are several types. Because of this, it is important to have a basic understanding of the various approaches to budgeting and how to identify which one is right for your business.
In this article, we will discuss what a budget methodology is, why adopting the correct one is important, and the various types of approaches to budgeting.
What Is a Budgeting Methodology?
A budget methodology is the approach used to create a fiscal budget. There are several ways to create budgets, each one being referred to as a different method. Choosing the correct budget methodology is important as different approaches are used for different reasons.
One common aspect of choosing the proper budgeting approach is to have a good grasp of the business’ goals.
For example, if one of the goals of the business is to reduce cost, it would make sense to employ the use of an activity-based budget. The same might apply if the business is new and there is not enough sufficient historical data to create a budget using another method.
Why Choosing The Best Budget Methodology Matters
Remember that the budget is considered the roadmap for the upcoming year. This useful planning tool provides management with its objectives and goals and aligns staff with the overall strategy of the firm.
Because of its vast importance and how much it is relied upon for decision making, choosing the most relevant methodology will yield the most useful information for management.
This can sometimes be difficult because each budget methodology has its own unique resource demands. Some take a vast amount of time and attention, while others are faster and easier to complete.
Understanding the relationship between value and costs is important when choosing which approach to adopt. Make sure that the benefits yielded from any approach justify the time required.
The 4 Budget Methodologies
While each business might have their own unique way of doing things, there are four primary types of budgets. It is important to note that while there are different types of budgets, such as cash budget and static budget, there are four primary methods for creating a budget.
The difference between budget methodologies and budget types is that a methodology is a process for creating a budget and a budget type is concerned with the contents of the budget.
All budget processes are typically categorized as top-down or bottom-up. Top-down budgeting occurs when management creates the budget and then pushes it down to the organization’s departments.
Bottom-up budgeting is a process where individual departments create their own budgets that management agrees to and aggregates into one larger budget.
Regardless of how management chooses to create and communicate the budget, there are four primary budgeting methodologies.
Incremental
In an incremental budget, historical figures are adjusted for future expectations. The basis of the budget is typically the prior year’s actual values. These actual values are then adjusted by some assumption factor created by management.
Incremental budgets are most commonly adopted when cost drivers remain relatively stable. One drawback of using this approach is that it is often likely to result in perpetuating inefficiencies as the approach does not scrutinize expenses intensely.
Activity-Based
An activity-based budget is a type of top-down budget that attempts to calculate the amount of activity required to achieve desired outcomes.
Understanding the relationship between revenue and the cost drivers behind it is a time consuming process that results in a comprehensive understanding of all cost drivers associated with one dollar of revenue.
Value Proposition
When using the value-proposition approach, analysts attempt to understand and justify the value of including each item in the budget.
This approach is primarily concerned with ensuring that anything that goes into the budget creates value for the business. This typically results in cost reduction even though that is not a primary objective of this methodology.
Value proposition budgeting can be time consuming as it requires an understanding for how each expense delivers value. This can sometimes be subjective and not quantifiable.
For example, the added cost of having a 24/7 call-center to field customer inquiries might not add direct dollar value to the firm, but rather provide value in the form of customer satisfaction and loyalty.
Zero-Based Approach
The zero-based budget is one of the most widely adopted forms of budgeting. At its core, the zero-based budget assumes that each functional area of the business has a zero budget base.
Then, every single expense is analyzed and justified. Nothing is automatically adjusted based on prior values, and all activities are heavily scrutinized.
This approach yields the most benefit in terms of cost savings and understanding of the cost drivers behind a business. However, it is immensely resource intensive and requires a great deal of time and effort.
Larger, more stable businesses might find this approach overkill as processes have likely been streamlined over the years.
Newer businesses might find this approach to be the best way to establish a budget framework without the aid of historical data. It also forces new businesses to be very cost-focused and conscious of every expense it incurs.
Using Datarails to Build Your Budget
Every finance department knows how tedious building a budget can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails is an enhanced FP&A software that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.