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What Is A Budget

There are four main types of budgets that companies use: incremental, activity-based, value proposition, and zero-based. Incremental budgeting takes last year's figures and adjusts them, while activity-based budgeting determines resource needs to support targets. Value proposition budgeting justifies expenses based on value created, and zero-based budgeting requires justifying all expenses from scratch each year. Budgeting can also involve different levels of participation, from imposed top-down budgets to participative bottom-up budgets.

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96 views

What Is A Budget

There are four main types of budgets that companies use: incremental, activity-based, value proposition, and zero-based. Incremental budgeting takes last year's figures and adjusts them, while activity-based budgeting determines resource needs to support targets. Value proposition budgeting justifies expenses based on value created, and zero-based budgeting requires justifying all expenses from scratch each year. Budgeting can also involve different levels of participation, from imposed top-down budgets to participative bottom-up budgets.

Uploaded by

Fentahun Amare
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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What is a Budget?

Definition: A budget is a financial document used to project future income and


expenses.

To put it simply, a budget plans future saving and spending as well as planned income
and expenses. Budgeting may be carried out by individuals or by companies to estimate
whether or not they can continue to operate with its projected income and expenses.

A budget can be drawn up for each financial year and contain information on the
estimated value of sales and value of costs. From this you can see how the coming
accounting period is likely to end. The actual performance of the business can be
measured against this proposed plan.

Different budgets can be created depending on what particular aspect of the business
requires focus. See three popular kinds of budgeting plans below.

Forecast Budget
Forecast is usually recognized as an adjusted budget. Estimates are prepared for some
time within the year, when a part of the outcome is known. Preparing a forecast includes
adding the results from another period, and reporting those in the budget for the
remainder of the year.

That way you get a more realistic picture of the outcome for the full year. Often you will
additionally adjust the budget in terms of already known budgetary deviations. This is
called an adjusted forecast.

Performance Budget
It implies that one makes an assessment of expected income and expenses. Budgets are
typically based on its results for the corresponding period a year earlier (small firms).
Many companies base their budget on the outcome from the same period a year earlier.
Each item is assessed as a percentage of expected change.

Budgets are based on a specific project, utilization rate and number of employees
(service). The bigger the company gets, the harder it will be by simple means to create
an overview of all events affecting the year. Many service providers therefore choose to
budget specific projects that are currently in the company.

In addition, a budget may be created of anticipated projects. With an overview of the


various projects, budgets will then portray a picture of the expected revenue. Costs are
usually calculated on the basis of the previous year's results because costs are easier to
predict in this way.

Budgets may also be based on the sum of each department within the company (little
larger firms). One can also base its budget on the various departments of the company.
Often both income and expenses are taking into account in each budget before creating
an overview of its total budget.

Cash Budget
Equally important as an outcome budget is a cash budget. A cash budget covers a
forecast for how the cash is included in the company.

The cash flow budget is a prediction of future cash receipts and expenditures for a
particular time period. It usually covers a period in the short term future. The cash flow
budget helps the business determine when income will be sufficient to cover expenses
and when the company will need to seek outside financing

The Four Main Types of Budgets and Budgeting


Methods
There are four common types of budgets that companies use: (1)
incremental, (2) activity-based, (3) value proposition, and (4) zero-
based. These four budgeting methods each have their own
advantages and disadvantages, which will be discussed in more detail
in this guide.

Source: CFI’s Budgeting & Forecasting Course.

1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or


subtracts a percentage to obtain the current year’s budget.  It is the
most common type of budget because it is simple and easy to
understand.  Incremental budgeting is appropriate to use if the
primary cost drivers do not change from year to year.  However, there
are some problems with using the method:

 It is likely to perpetuate inefficiencies. For example, if a


manager knows that there is an opportunity to grow his budget
by 10% every year, he will simply take that opportunity to attain
a bigger budget, while not putting effort into seeking ways to
cut costs or economize.
 It is likely to result in budgetary slack. For example, a manager
might overstate the size of the budget that the team actually
needs so it appears that the team is always under budget.
 It is also likely to ignore external drivers of activity and
performance. For example, there is very high inflation in certain
input costs.  Incremental budgeting ignores any external factors
and simply assumes the cost will grow by, for example, 10%
this year.

2. Activity-based budgeting

Activity-based budgeting is a top-down type of budget that


determines the amount of inputs required to support the targets or
outputs set by the company.  For example, a company sets an output
target of $100 million in revenues.  The company will need to first
determine the activities that need to be undertaken to meet the sales
target, and then find out the costs of carrying out these activities.
Source: CFI’s Budgeting & Forecasting Course.

3. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following


questions:

 Why is this amount included in the budget?


 Does the item create value for customers, staff, or other
stakeholders?
 Does the value of the item outweigh its cost? If not, then is
there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure


that everything that is included in the budget delivers value for the
business. Value proposition budgeting aims to avoid unnecessary
expenditures – although it is not as precisely aimed at that goal as
our final budgeting option, zero-based budgeting.

4. Zero-based budgeting

As one of the most commonly used budgeting methods, zero-based


budgeting starts with the assumption that all department budgets
are zero and must be rebuilt from scratch.  Managers must be able to
justify every single expense. No expenditures are automatically
“okayed”. Zero-based budgeting is very tight, aiming to avoid any
and all expenditures that are not considered absolutely essential to
the company’s successful (profitable) operation. This kind of bottom-
up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent


need for cost containment, for example, in a situation where a
company is going through a financial restructuring or a major
economic or market downturn that requires it to reduce the budget
dramatically.

Zero-based budgeting is best suited for addressing discretionary


costs rather than essential operating costs. However, it can be an
extremely time-consuming approach, so many companies only use
this approach occasionally.
Levels of Involvement in the Budgeting Process

We want buy-in and acceptance from the entire organization in the


budgeting process, but we also want a well-defined budget and one
that is not manipulated by people.  There is always a trade-off
between goal congruence and involvement. The three themes
outlined below need to be taken into consideration with all types of
budgets.

Imposed budgeting

Imposed budgeting is a top-down process where executives adhere


to a goal that they set for the company.  Managers follow the goals
and impose budget targets for activities and costs.  It can be effective
if a company is in a turnaround situation where they need to meet
some difficult goals, but there might be very little goal congruence.

Negotiated budgeting

Negotiated budgeting is a combination of both top-down and


bottom-up budgeting methods.  Executives may outline some of the
targets they would like to hit, but at the same time, there is shared
responsibility for budget preparation between managers and
employees. This increased involvement in the budgeting process by
lower-level employees may make it easier to adhere to budget
targets, as the employees feel like they have a more personal interest
in the success of the budget plan.

Participative budgeting

Participative budgeting is a roll-up approach where employees work


from the bottom up to recommend targets to the executives.  The
executives may provide some input, but they more or less take the
recommendations as given by department managers and other
employees (within reason, of course).  Operations are treated as
autonomous subsidiaries and are given a lot of freedom to set up the
budget.

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