The Best Budget Management Methods For Your Business
Keeping on top of your company’s finances by regularly developing and managing a budget is essential if you want your business to survive – let alone thrive and fulfil its long-term potential.
Through effective budgeting, a company’s owners and management can consistently determine whether they have enough money to fund their ongoing operations, generate income, and turn a profit. Conversely, without a proper budget, a company is likely to overspend, fail to retain enough funds to cover its operating expenses, or even fail to spend enough to achieve its long-term objectives.
Despite this, many businesses fail to budget properly – or create budgets at all. Small businesses are especially likely not to have a budget in place, with studies showing that as many as 50% of small businesses don’t have a documented budget.
One of the reasons for this is that many business owners and senior management find the budgeting process difficult and/or tedious – and skirt over or avoid it as a result. The underlying problem, however, is that most people don’t realise there are different ways to create and manage a budget. Subsequently, it’s likely that a business owners or managers have previously adopted a budgeting technique incompatible with their company and have struggled as a result.
With this in mind, this post explores different budget management methods, looks at the pros and cons of each technique, and helps you match the right budgeting method to your business.
What is Budgeting
Let’s begin by defining what budgeting is and what it involves.
What’s the Definition of Budgeting?
A budget is a financial plan for a set period for which a business estimates its income and expenditure. Budgeting allows a company to retain better control over its finite resources, become more efficient, and track its performance and financial health.
What is the Process of Budgeting?
As we’ll explore in this post, there are several ways for a company to approach their budget. That said, any budgeting method involves the following steps at a minimum:
- Establish a Goal: what are you trying to achieve with this budget? For example, are you trying to cut costs to increase efficiency? Or are you trying to find the capital to fund a purchase or project?
- Estimate Income:project your company’s revenue for the budget period. This can be based on prior performance, market conditions, etc.
- Estimate Expenditure: project your company’s costs for the budget period. This can be based on previous overheads, planned expenditures, etc.
- Draw up a Draft Budget: use your projected income and expenditure and all other information you have to hand to create a rough budget. This may be done with the assistance of your management team or other employees.
- Finalise: complete your budget when you’re satisfied with its accuracy and put it into action.
Review: track your income and expenditure and how they compare with the projections put forth in your budget. Pay attention to where your estimates proved incorrect, why, and how you can improve your next budget.
What to Consider When Deciding on a Budget?
Here are a few things to consider when selecting a budget management method:
- Goals as a Business: different budgeting techniques lend themselves well to a company’s varied objectives. Some, like incremental budgeting, are great for maintaining the status quo. In contrast, methods like zero-based budgeting are best employed if you’re trying to shake things up and create significant change.
- Organisational Structure: how your business is structured should influence your choice of budgeting method. For instance, participative and negotiated budgeting can prove tricky and time-consuming if you have several management layers or many departments.
- How Long you’ve been in Operation: incremental and value proposition budgeting draws on previous budgets, requiring a company to have a track record. Conversely, others are suitable for newer businesses.
- Will you seek input from others? collaborative methods like participative and negotiated budgets require input from departmental managers, so they’re a good choice if you’re relying on their help. Similarly, some budgeting methods are best employed with the expertise of a professional accountant.
What are the Different Budgeting Methods?
Here’s an overview of the six different budgeting methods we’ll be exploring in this post:
- Incremental Budgeting: a traditional budgeting method where incremental changes are applied to the previous budget to create the current one.
- Zero-Based Budgeting: this sees all budget items reset to zero so each can be re-evaluated and justified.
- Activity-Based Budgeting: this method sees a company determine which activities incur costs and seek to reduce them.
- Participative Budgeting: a method whereby senior management enlists the help of departmental managers to formulate a budget.
- Negotiated Budgeting: this method sees senior management pass down targets to each departmental manager from which they create a draft budget before they convene to negotiate a final budget.
- Value Proposition Budgeting: every budget item is evaluated and justified based on the value it generates.
Briefly Describe Incremental Budgeting
Incremental budgeting is a technique in which a new budget is created by making small amendments to the previous budget. More specifically, a set amount is added, or taken away, from each figure, or line item, in the existing budget to calculate the figures in the next budget.
Incremental budgeting is widely considered the simplest and most conservative budget management.
How Does Incremental Budgeting Work?
For incremental budgeting, a company’s management and/or financial department will take their existing budget and apply an incremental assumption to each figure. There’s no set formula for determining the incremental assumption, so the amount by which the budget is adjusted is at the company’s discretion.
Typically, the incremental assumption takes the company’s performance, projected revenue, and financial performance into account, as well as the state of the industry and the economy as a whole. However, the amount by which the budget is adjusted doesn’t have to be positive – making it a decrement, and individual figures, e.g., department budgets, will be adjusted downwards. This occurs when a company fails to meet projected revenue expectations, there’s market contraction, or the economy is sluggish.
What Are The Advantages And Disadvantages Of Incremental Budgeting?
Advantages of Incremental Budgeting
- Simplicity: it only requires making minimal changes to a previous budget.
- Stability: departments or business units can expect to receive a similar budget each period, allowing them to plan ahead more confidently.
- Reduces Departmental Rivalry: the incremental changes to budgets are usually equal, so departments don’t have to compete with each other to obtain a larger slice of funding.
Disadvantages of Incremental Budgeting
- Encourages Unnecessary Spending: departments typically spend their entire budget allocation to receive more in the next budgeting period – regardless of whether they need it. This can result in unnecessary, and even wasteful, expenditure.
- Reduces the Incentive to Reduce Costs: by the same token, as managers can expect a similar budget regardless of performance, there’s no reason for them to review their expenditure to reduce it.
What Is The Ideal Use of Incremental Budgeting?
Incremental budgeting is a good method if your company’s budget doesn’t change much each year and you don’t believe it will change much for the next period. It’s a simple and effective way of tracking the cost of multi-year projects that require consistent funding. The incremental budget technique also lends itself to established, typically larger, businesses with an established record of financial performance and creating and following budgets.
Briefly Describe Zero-Based Budgeting
Zero-based budgeting is an approach that sees each budget created from scratch – or zero. Consequently, each line item, or expense, must be analysed and justified, so each budget is built around the company’s most important needs and objectives for the next period.
How Does Zero-Based Budgeting Work?
Creating a zero-based budget typically begins with the company’s senior management and stakeholders meeting to review the last period’s financial performance and determine priorities and goals for the coming period. Senior management will then confer with the managers of each department to discuss their budgetary requirements and to attempt to align their expectations. Funding will then be allocated accordingly.
Each department, or business function, will receive a budget in line with the value they add to the business. So, the most profitable departments can easily justify their costs and have a better chance of securing more funding. Conversely, if a department is struggling or the company no longer sees its activity as value-adding, it may cut its budget – or reallocate it entirely.
Similarly, a company may allocate funding according to its overall objectives. If, for example, the company’s priority is to increase brand awareness, it’ll have to allocate a good slice of its budget to its marketing department. Alternatively, if the company’s priority is to increase its rate of digital innovation, it’ll have to spend more on IT. If achieving those goals requires hiring more employees, HR will need additional funding to recruit and train them.
What Are The Advantages And Disadvantages Of Zero-Based Budgeting?
Advantages of Zero-Based Budgeting
- Strategic Focus: because management has to build a budget from scratch every period, they’re forced to think strategically about the overarching needs of the company.
- Cost Reduction: as departments have to justify their costs to be allocated the budget to cover them, it’s in their best interest to reduce costs as much as possible.
- Flexibility: as the budget is created from scratch, it’s less rigid than techniques like incremental budgeting, which uses previous budgets.
Disadvantages of Zero-Based Budgeting
- Time-Consuming: the need to justify every budget item and include different levels of management makes zero-based budgeting one of the most time-intensive methods.
- Emphasis on Short-Term Rewards: itcan cause management to allocate more funding to activities that will yield the most revenue in the next budgeting period, as opposed to more lucrative, long-term opportunities. Consequently, longer-term investments or research and development can go underfunding and hamper the company’s future potential.
Manager Manipulation: more experienced, savvy, well-connected, or assertive managers can secure more resources for their departments than their counterparts who lack those attributes. This can lead to department rivalry, resentment, and reduced cooperation between business units.
What Is The Ideal Use Of Zero-Based Budgeting?
The main reason to use zero-based budgeting is to get your company’s expenses under control. By starting from zero, you’re forced to evaluate every expense individually and will gain a firmer understanding of how your business spends money. A zero-based budget is especially good for evaluating discretionary costs, such as purchasing equipment, funding projects or initiatives, training needs, attending conferences, etc.
Additionally, the zero-based budgeting approach is ideal when a company needs to “shake things up” – like when it’s looking to restructure. That said, as it doesn’t need to draw on previous budgets, it’s equally viable for new businesses without a financial track record.
What Is Activity-Based Budgeting?
With activity-based budgeting, a business creates a budget based on the anticipated revenue from each operational activity and the projected costs of generating said revenue. Activity-based budgeting highlights the costs required to generate particular revenue streams and assists the company in reducing overheads and increasing profitability.
How Does Activity-Based Budgeting Work?
The activity-based budgeting process works as follows:
- Estimate a particular revenue driver’s production or sales volume, i.e., a product or service.
- Identify the cost drivers for that activity, i.e., how much does it cost to deliver said product or service? Calculate the cost per unit for the activity.
- Multiply the cost per unit by the activity level.
Or, to arrange the above into a formula:
Activity-Based Budgeting Formula
Cost per unit x Activity Level = Allocated Budget
To better illustrate activity-based budgeting, let’s look at the example below:
- A company projects selling 50,000 units of product A in the next period. Each product costs $2, broken down into $1.50 in labour costs and $.50 in raw materials.
- The activity-based budget for product A is:
50,000 (units) x 2 (cost per unit) = $100,000 budget.
What Is The Ideal Use Of Activity-Based Budgeting?
Activity-based budgeting is ideal for any company that wants more insight into and control over its expenses. By understanding the costs that drive revenue, the company’s management can take the appropriate steps to reduce overheads. This could include renegotiating better terms with existing suppliers, sourcing new ones, and redesigning their wage structure to motivate staff to greater productivity.
What Is Participative Budgeting?
The participative budgeting method sees a company’s senior management involve departmental managers and other “front-line” employees in creating a budget.
Participative budgeting tends to result in realistic budgets as the business’ upper management can marry their strategic insights with information gathered by managers during the company’s day-to-day operations that they may not have been aware of.
How Does Participative Budgeting Work?
The first step in the participative budgeting process is for the manager of each department or business unit to create a budget draft. This will be based on the performance of their department in the last period, their projected performance in the next period, market forces, and other information gained from daily operations.
Once they’ve developed their draft, each department head will submit it to their manager for review. If there are several layers of management, the budget will be reviewed at each level until it reaches senior management for final review. After being queried and amended, the budget will go back down to each level of management.
Upon receiving their budget back, the manager can accept any changes made or meet with superiors to challenge any amendments and communicate the reasoning for their proposed budget. If the departmental manager can’t agree, it’s ultimately up to senior management to decide on the finalised budget.
What Are The Advantages And Disadvantages Of Participative Budgeting?
Advantages of Participative Budgeting
- Realistic Budgets: a participative process tends to produce more achievable budgets as departmental employees get to fill the gaps in upper management’s knowledge.
- Information Transfer: similarly, departmental-level managers benefit from senior management’s strategic insight and mindset. They learn how to better balance the needs of their department with those of the business.
- Increased Employee Motivation: involving departmental management in the budgeting process gives them a greater sense of ownership in the company’s decisions and future direction. This boosts their morale and gives them more motivation to accomplish the goals that they helped create.
Disadvantages of Participative Budgeting
- Time-consuming: as it has to pass from multiple levels of management before being finalised, a participative budget process takes longer than one devised solely by senior management, i.e., an imposed budget. The more layers of management a company has, the longer it will take.
Budget manipulation: managers may purposely overestimate expenses and/or underestimate income projections to manipulate their budget to their benefit. If their budget is easy to meet, they’ll be seen as exceeding expectations and looked upon favourably.
What Is The Ideal Use Of Participative Budgeting?
Companies that want to draw on as much information as possible when putting together a budget will find participative budgeting an ideal method. It’s especially beneficial for smaller businesses with flatter, simpler organisation structures, as the budget doesn’t have to pass through multiple layers of management, prolonging the process.
Also, as it relies on negotiation instead of previous budgets like other budget management techniques, participative budgeting lends itself well to newer businesses without an established financial track record.
What Is Negotiated Budgeting?
Like, participative budgeting, creating a negotiated budget involves collaboration between a company’s upper and lower-level management. Where negotiated budgeting differs, however, is that senior management first sets overall targets or objectives for the business, which are passed down to the different department heads to help them create their budget.
How Does Negotiated Budgeting Work?
A negotiated budget process typically involves the following four stages:
Senior Management Sets Targets: the company’s upper management will determine targets for the next budgeting period. These are usually based on the business’ recent performance and the company’s overall objectives. It’s not uncommon for senior management to seek the advice of departmental managers to devise targets. Once set, the targets are passed down to heads of department.
Departmental Managers Outline Action Plans: department heads receive the targets and create a plan for how to achieve them. Most importantly, the plan will include the department’s projected revenue, which can be higher or lower than their given target, and the associated costs.
Senior Management Meets With Department Heads To Discuss Their Action Plans: senior management convenes with each department head to discuss their action plan and proposed budget. This is an opportunity for each departmental manager to put the case for their budget across and educate upper management on operational issues and realities they may not be fully aware of. Conversely, senior management can present their views of departmental targets and budgets from a holistic standpoint that considers the company’s long-term objectives.
Budget Approval: the managers will negotiate the budget until they reach a consensus. If they can’t wholly agree, senior management will have final approval. Once finalised, it is sent to the finance department for funding.
What Are the Advantages and Disadvantages of Negotiated Budgeting?
Advantages of Negotiated Budgeting
- Realistic Budgets: negotiation between managers tends to produce more achievable budgets as departmental employees get to fill the gaps in upper management’s knowledge.
- Increased Employee Motivation: allowing departmental managers to negotiate their budgeting endows them with a greater sense of ownership in the company’s decisions and future direction. This boosts their morale and motivates them to meet their budgets – or improve on them.
Disadvantages of Negotiated Budgeting
- Time-Consuming: as the budget has to be negotiated by several managers before final approval, the process takes longer than if left to senior management. As with participative budgeting, the more managers required to approve a budget, the longer it will take.
- Budget Manipulation: managers may purposely negotiate a budget they can easily meet for an easier win at the end of the accounting period.
What Is the Ideal Use of Negotiated Budgeting?
The circumstances that make participative budgeting ideal also apply to a negotiated budgeting process. Namely, if a business wants to create as accurate a budget as possible by capitalising on the experience and perspectives of departmental managers. Again, a negotiated budget process works well in smaller businesses because budgets are likely to go back and forth between management before being finalised. Not to say, as with participative budgeting, that a negotiated process can’t work in a larger organisation – as it could, but it would just take longer.
Value Proposition Budgeting
What Is Value Proposition Budgeting?
Value proposition budgeting, or priority-based budgeting, is an approach that attempts to ensure everything within a budget creates value for the company. It aims to cut unnecessary costs by determining whether an expense is justified by the amount of value it ultimately delivers. Like incremental budgeting, value proposition budgeting requires an existing budget to work from. Subsequently, it’s seen as sitting somewhere between incremental and zero-based budgeting.
How Does Value Proposition Budgeting Work?
A value proposition budgeting process revolves around the following three questions:
- Why is this line item (figure) in the budget?
- Does the item create value for the company in some way? Whether it’s to customers, staff, or stakeholders?
- Is the value generated by the item greater than its cost? If not, is the cost justified for another reason?
The last question is crucial, as the company may be spending money on something that doesn’t generate value immediately. Capital expenditure on a new manufacturing facility could be an example, as could research and development costs.
What Are The Advantages And Disadvantages Of Value Proposition Budgeting?
Advantages of Value Proposition Budgeting
Value Focus: this budgeting method helps companies hone in on which activities bring the most value while cutting down on those that offer little. A company can consistently improve its products and services by focusing on its strengths.
Increases Efficiency: by systematically reducing activities that don’t generate value, companies will become more efficient. Also, constantly measuring cost against value created forces businesses to become more aware of their expenditure and potential ways to reduce it.
Disadvantages of Value Proposition Budgeting
Not Always Simple to Quantify Value
While budgeting according to the value generated by activities is a sound idea in theory, it’s not always straightforward to quantify value. Sure, you could go by monetary value, but then you risk undervaluing activities designed to pay off in the future, e.g. investments, research, professional development, etc.
On a similar note, though an activity evidently has value, it may be intangible and difficult to measure. A great example is expenditure on staff perks like parties, team-building exercises, meals, and other treats. While staff perks unquestionably boost morale, improve company culture, and help to reduce employee turnover, how do you determine how much that’s worth?
What Is the Ideal Use of Value Proposition Budgeting
Value proposition budgeting is an appropriate method for companies who want to align their budget with their performance. Subsequently, as consumer sovereignty, i.e., what customers purchase, drives the performance, honing in on what their customers want and focusing on the expenses relating to that is a sound strategy. Value proposition budgeting allows companies to increase their awareness of their expenses and reduce, or eliminate, costs that don’t result in value.
However, as this method requires drawing on previous budgets, it best suits businesses with a track record and an understanding of their customer’s preferences.
Budgeting Tips For Business Owners
To round this post off, here are some essential tips for effectively managing your company’s budget.
Track Your Expenses
Consistently recording your expenditure is vital to maintaining an accurate picture of your financial position as a company and how your business is faring overall. Most importantly, tracking your costs allows you to assess where to cut costs. You’ll become aware of areas within your business where you’re overspending and devise ways to increase your efficiency. This could include negotiating better supplier terms, sourcing new suppliers, trying new production methods, etc.
Additionally, ensure you and your employees keep all expense receipts, as they will not make it far easier to track expenditures but will allow you to claim more deductions come tax season.
Analyse Your Income
As well as meticulously recording your revenue, carefully analyse it for its source. This could inspire you to devise better ways to market your best-selling items to sell more of them or to develop new products and services that will appeal to your target audience. By knowing which products and services bring in the most money, you’ll learn where to focus your efforts as a company and gain a better understanding of your customer base.
Analysing your income also allows you to determine the return on investment against expenditures such as new equipment, marketing campaigns, and staff hiring. By understanding which activities most drive revenue, you can repeat them in the hope of generating additional revenue.
Maintain Consistent Cash Flow
A crucial part of effective budgeting is ensuring your business has a steady cash flow. Without it, you may not be able to meet your financial commitments on time and, at worst, won’t be able to maintain your ongoing operations. An effective method of maintaining positive cash flow is always keeping a “buffer” of at least one month’s expenses to account for unforeseen circumstances. It’s also essential to understand the company’s cash flow cycle: when you typically have the most income during the month and when the bulk of your bills are due.
Claim your Tax Savings
One of the most important aspects of budgeting is ensuring your taxes are in order. This includes ensuring you have enough to cover your tax bill at the end of the financial period and minimising your tax burden. Claiming all the tax breaks your company is eligible for aids your budgeting efforts as it allows for increased profitability and the amount of cash you have on hand.
As mentioned above, keeping all your receipts allows you to prove your business’ expenses and claim more deductions. Better still, a professional accounting firm will get to know your business inside out and guarantee your tax bill isn’t a cent more than it should be.
Review Your Budgets Frequently
It’s not enough to create a budget for a financial period and forget about it; you need to review it regularly to assess how accurate your projections are and that you remain on course to achieve or surpass them. Reviewing your budget also causes you to take greater stock of internal or external factors that you didn’t account for when creating your budget and need to consider in the future.
- A budget is a financial plan for a fixed period for which a business estimates its income and expenditure.
- Six budgeting methods:
- Incremental Budgeting
- Zero-Based Budgeting
- Activity-Based Budgeting
- Participative Budgeting
- Negotiated Budgeting
- Value Proposition Budgeting
- Budgeting tips for business owners
- Track your expenses
- Analyse your income
- Maintain consistent cash flow
- Claim your tax savings
- Review your budgets frequently
Do you need some help creating a consistent budgeting process for your company? Would you like more insight into which budget management method is best for your business? To discuss budgeting or any other aspect of your company’s finances or taxes, contact us, and we’ll be thrilled to help you in any way we can.