Last editedFeb 20233 min read
You probably already know just how important budgeting is when it comes to planning revenue and expenditure over time. Setting and sticking to a budget helps you manage cash flow, investments, and everyday operations. There are several different types of budgeting methods to choose from, each with its own pros and cons. So, what is the best budgeting method for you? In this guide, we’ll cover the four main types of budgeting methods to help you find the right fit.
1. Incremental budgeting method
One of the most common strategies used in business, the incremental budgeting method is straightforward and easy to learn. It uses last year’s figures as the basis for the current year’s budget. You adjust last year’s figures by an increment (or percentage) to arrive at the current figures. There’s no formula associated with this method. Instead, your business assumes that last year’s expenditures will be similar to this year’s, adjusted for inflation or growth.
For example, imagine that last year’s sales budget was £50,000. The team ended up spending £60,000, or £10,000 over budget. You can then adjust the budget by an increment £10,000 to set this year’s at £60,000.
While simplicity is one of its main benefits, the incremental budgeting method isn’t as accurate as some other methods. There’s the potential for spending more than you need to because you’ve adjusted the budget upward. It’s also unsuitable for start-ups who don’t have historic figures to use as the jumping-off point for making a new budget.
2. Zero based budgeting method
Another type of budgeting method is called zero based because it starts from zero every year. With a zero based budgeting method, your managers need to justify each expense as if it’s brand new. This means going through each expense, line by line, to determine if it’s necessary.
The benefit of the zero based budgeting method is that it reduces any unnecessary spend. It’s a good option for businesses operating with thin margins or limited cash flow. For example, if the markets are in a downturn, it ensures you can drastically slash the budget to compensate. By cutting unnecessary spending, companies have more cash on hand to focus on the big picture. They can reduce production costs and open room for future investment.
The downside of this type of budgeting method is that it’s quite time-consuming and requires continual adjustment. But if you’re trying to save for a specific goal and need to cut corners, it might be a good option.
3. Activity based budgeting method
A third option is the activity based budgeting method, considered a top-down approach because it looks at your goals first. You then break down the goals or targets into required inputs, allocating an amount for each input or activity. For example, if your target output is £100,000 in revenue, you will need to look at the activities needed to meet this target. The next step is to calculate the cost of each activity.
This type of budgeting method is more accurate than others, but it also requires more research and planning. Your business must identify all cost drivers and their associated activities, project the total units for each activity, and then estimate their cost per unit. Activity based budgeting is used by larger companies with bigger budgets and lofty revenue goals. It gives a clear overview of where your money is going, looking at the future of growth.
On the other hand, it’s expensive and time-consuming for smaller businesses to implement this type of budgeting method. You’ll need to use experienced accountants familiar with this type of financial planning.
4. Value proposition budgeting method
Our final budget method is value proposition, which looks at the value created by each expense. It’s similar to some other methods in that you need to justify expenditures. Yet the key purpose here is to ensure that the budget delivers the highest possible business value. To get started, you’ll need to clarify your desired outcome or goal for the budgeting period. The next step is to identify relevant services and allocate funds to each service.
It's a good strategy for businesses who want to keep a close eye on spending, without being as strict as with a zero based budgeting method. The downside is that the concept of ‘value’ is difficult to quantify for budgeting purposes at times. It can also change due to external technological or social factors, requiring an adjustment.
What is the best budgeting method for your business?
The best budgeting method will depend on your business’s size, goals, and strategies. While the incremental method is simple and straightforward, it’s dependent on using historic data so isn’t reliable for new businesses. If you need to cut corners, consider using zero-based or value proposition budgeting methods. As your business grows, activity-based budgeting can be quite useful for meeting specific targets for growth.
Any budget requires close monitoring of income and expenditure. It’s worth using automated accounting software to keep close track of the income statement,balance sheet, and invoices. GoCardless partners with budgeting software like Zoho Books,QuickBooks,Xero, and others to help you manage your accounting finances from a central dashboard.
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