Budgeting is a key performance management tool and play a vital role in planning, forecasting, performance management and control measure. The most common method of producing a budget is simply printing out the financial statements and make necessary adjustments on historical expenses to account for the inflation as well as adding the project revenues based on growth prospect. This is called traditional budgeting approach. However, in a modern advance business environment, this method is no longer suitable. It requires other approaches to budgeting which is suitable for each types of business environment.
There are various types of budgeting where each entity can adopt depends on their situation and preference. So what are those types of budging?
Before, we jump into more detail about different types of budgeting, let’s see what is the objective of budgeting and why budgeting is important for a business?
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Objectives or Important of Budgeting
Budget is commonly known as a quantified plan of actions for a future accounting period. This is typically for one year period. However, the budget can be breakdown in two monthly, quarterly and annually depends on each entity.
Below are the 7 objectives of budgeting system or we can call them as the important of budgeting:
- The budget helps to ensure the achievement of organizational ‘s objectives:
These objectives are typically set at an entity as a whole or for each individual operation or department in such entity. It normally act as a target that each entity as a whole or at individual department to achieve within a given timescale of such budget plan.
- A budget is typically acts as a compel planning;
This means that the budget encourage management to plan ahead and set a clear detail plan of actions to be carried out to reach objective or targets.
- It helps to co-ordinate activities:
Each department or operation cannot work alone. It requires interaction or co-ordination from one to another. Thus, this budget help to co-ordinate activities of different departments or operations to ensure that the organization and entity reach the common goals and objectives.
- The budget helps to provide a framework for responsibility accounting:
Responsible accounting refers to the controllable or accountable of the budget centres of each department or cost centre. A budgetary planning help to ensure that each department manager are responsible for the achievement of each budgeting target of their departmental or operational budget.
- The budget also helps to establish a system of control:
Budget acts a tool or KPI to help to assess or measure the actual performance. Meaning, we can compare the actual performance against that budget to see whether the target is achieved or not and at what level.
Commonly, in order to measure the performance against the budget, we need to think of two words; controllable and uncontrollable factors. Even though the target is not achieved, but if it is due to the uncontrollable factors, thus we cannot blame the department manager. For performance evaluation purpose, each entity shall focus on the controllable factors.
- It helps to motivate employees to improve their performance
The budget helps to retain the interest as well as the commitment of staff through the system of feedback of actual result from the performance assessment and evaluation. It helps employees to know how badly or well they have performed during the course of operation so far. In addition, the proper identification of controllable factors for each department or budget centres would provide as an incentive or motivation in order to improve performance in the future.
Now you we have covered the key important or objectives of budgeting. Therefore, we can go further to different types of budgeting as follow:
Types of budgeting
There are different types of budgeting each of which have different process to prepare and for different types of company or business environments. These are:
- Incremental Budgeting
- Fixed and Flexible Budgeting
- Zero-Based Budgeting (ZBB)
- Activity-Based Budgeting (ABB)
- Rolling Budgeting
- Beyond Budgeting.
Below are the brief of each type of budgeting. For detail of each types of budgeting, you can refer to different articles that will be referred at the end of each briefing of the budgeting types.
1. Incremental Budgeting
This is also known as traditional budgeting approach or method. This type of budgeting is done by using the historical financial information regarding the revenues and expenses and make certain adjustment based on both internal and external factors. Those factors include the inflation, market trend or prospect, the target growth, economic conditions as well as the political factor. We can call the external factors as PESTELS. This word stands for:
For more detail about incremental budgeting, you can visit another article called “What is Incremental Budgeting, A Traditional-Approach”
2. Fixed and Flexible Budgeting
Fixed budget, by its name, refers to the budget in which it remains unchanged throughout the budgeting period. There would be nothing changes regardless of differences between actual results and the budget.
Typically, in a fixed budgeting approach, the master budget is used to prepare the budget, commonly at the beginning of accounting period, and after such budget is approved, there will be nothing changes.
Whereas, flexible budgeting refers to the budgeting methods which adapts changes based on the level volume of output and sales changes. In this budgeting approach, an entity shall need to recognize cost behavior patterns for example the changes in sales revenue and variable costs as result of changes in sales volumes. In addition, it also applies to the fixed costs as result of the activity levels rises or fall more than any particular amount.
3. Zero-Based Budgeting (ZBB)
The Zero-Based Budgeting or ZBB is one budgeting method where all activities need to be justified before any financial resources are allocated for these activities. The budget approach is quite difficult as we need to work out from scratch. That means in the zero-based budgeting, “all budgets start with a zero base, with each cost element (activity) need to be justified prior to the budget allocation”.
The zero-based budgeting has 3 main steps approach as follow:
- Prepare The Decision Packages
- Evaluation Ranking the Decision Packages
- Resource Allocation
For more detail about zero-based budgeting, you can visit another article called “What is Zero-Based Budgeting (ZBB)?
4. Activity-Based Budgeting (ABB)
Activity-Based Budgeting (ABB) is another types of budgeting method where costs are allocated based on the activities level. This involves the 3 steps process as follow:
- Identification of key activities of the company, and cost drivers associated with these activities
- Forecasting the total number of cost driver units
- Calculating the cost drivers rate
For more detail about activity-based budgeting, you can visit another article called “What is Activity Based Budgeting (ABB)?”
5. Rolling Budget
Rolling budget is a type of budgeting approach where an entity shall need to roll forward or update the budget on a monthly or quarterly basis. This method is commonly used for a dynamic business environment where the market keep changing.
The rolling budget is superior to forecasting techniques. When forecasting is difficult due to a rapidly changing business environment or lack of data internally, the rolling budget technique would provide a useful alternative approach for decision making.
Typically, rolling budget is also called a continuous budget approach. This is because the budget is updated on monthly or quarterly basis.
For more detail about rolling budget, you can visit another article called “Rolling Budget: A Robust Approach to Budgeting”.
6. Beyond Budgeting
Beyond budgeting is known as one budgeting model which contradicts with the incremental budgeting or traditional approach to budgeting. This model proposes that the traditional approach should be abandoned.
There are two fundamental concepts of beyond budgeting that distinguish it from traditional approach to budgeting as follow:
- Beyond budgeting uses adaptive management process for decision making. The decision making does not stick to the rigid annual budget. Typically, traditional budgeting tie managers to predetermined actions which are not suitable for a dynamic business environment.
The budget shall be planned in a more adaptive approach with a rolling basis plus a more focus on cash forecasting rather than purely cost control. If company wants to grow, let’s spend and the spending shall be on the right thing. Typically, performance shall be assessed and monitored against the world-class benchmarks and competitors as well as to prior period.
- This approach of budgeting encourages to move towards a decentralized or devolved networks instead of centralized approach. This means that an entity shall give power or control or any decision making to the departmental or line managers. This is also called responsibility accounting.
For more detail about beyond budgeting, you can visit another article called “Beyond Budgeting vs Traditional Budgeting”.
Best practice of budgeting process
Having a good budget is difficult; however, if we try to incorporate relevant and useful information as much as possible will lead to a more appropriate budget even though it is not perfect.
Below are the common best practice of the budgeting process that you should know and you can apply in your real world budgeting process:
- Reduce the number of accounts: This involves grouping accounts into relevant groups; thus help to reduce the time needed to enter and update in the budget model.
- Reduce the number of reporting periods: This can be done by consolidating the 12 months budget into by quarter. Working detail on monthly basis will take a great amount of time. Therefore, by working from the quarterly basis will save a lot of time. Then, after finalization, the budget can be breakdown from quarter to monthly and input into the accounting system accordingly.
- Use percentages for variable cost updates: When we use formula as percentage to link for any variable costs, it would reduce a lot of lot time when we need to change any key activities; for example revenue or level output.
- Use a budget procedure and timetable: There should be proper budget procedure and clear timetable in place. As the budgeting process involves interaction from various departments and stakeholders, having a clear procedure and timetable is very important. Typically, it is the best approach to prepare or construct a budgeting procedure. The budget coordinator shall be clearly present. In the budgeting procedure, an entity shall specifically identify the clear job functions that must submit the budgeting information to the budgeting coordinator. In addition what type of information is required and the due date of such information to be submitted shall be clear identified in the procedure.
- Preload historical actual result of each line items or sometimes we call budget driver: This is the starting point for each department managers who are responsible for providing the input on the budget. Some line items as straightforward, thus the person responsible for inputting the budget just need to see the historical data then make the projection accordingly. This approach leave sufficient time for each department manager to focus on other dynamic line items that they need to carefully budget for.
- List down the corporate strategy: This is also the key factor during the budgeting process. If we do not know the corporate strategy, how can we set the budget to achieve such strategy? Thus the strategy and other related tactical goals that each entity wants to achieve shall be itemized clearly at the beginning of budgeting process.
- Issue a summary-level model for use by senior management: Basically, senior management does not want to see all detail information of the budget. They just need to see the key summary of the budget for each department or division. Therefore, the budget owner shall prepare such summary information and submit to senior management teams.
- Link budget to an employee goals and reward system: This encourage each employee to work hard toward the accomplishment of the set budget or target.
Budget is a tool to track and measure the performance by comparing the actual result against the set budget or target. There are several types of budgeting and each of which has pros and cons and use in different circumstances and business environment. In addition, a good budget shall have a proper budgeting procedure and clear timetable and follow the best practice of the budgeting process.