Building a budget takes time, flexibility, resources and money to complete. With the right guidance, a strong budget strategy can help avoid departmental conflicts, rigidity and other obstacles that can reduce productivity and create inaccurate projections down the line. One of the first steps is asking yourself: how much time, money and financial acumen do I need and/or have to create this budget? The budgeting method you choose will reflect how quickly you need to complete your plan and the information required to get there.
Different budgets and budgeting styles each call for their own strategic approach. The following budgeting methods will form the foundation for your strategy.
Types of budgets and what they mean for your business
A budget offers insights into how much the company plans to spend and earn in a given time period. This allows for proper planning and execution of business initiatives.
Before you can start budgeting, you’ll need to consider the projections your budget will be making to determine the leadership and departmental knowledge you’ll need in their creation.
- Master budget: A master budget is a projection for the overall company, taking into account the budgets from each department. It gives upper management a chance to make projections for major financial statements.
- Operating budget: This budget reflects revenues and expenses associated with everyday business operations, such as sales, administrative and overhead, interest on business loans and cost of goods sold.
- Cash flow budget: Also called capital budgeting, this kind of budget estimates cash inflows and outflows and often helps with planning major projects, investments or borrowing.
Whether your company wants to strictly manage its spending to cushion against unexpected expenses, or you want to have room to adapt, there are two options: static or flexible.
- The static budget, used for businesses with relatively unchanging and predictable expenses and revenues, keeps its calculated figures for each department the same regardless of deviations from the original assumptions. This kind of budget is usually determined using different forecasting methods.
- The flexible budget changes its figures based on changes in revenue or other external factors. For example, a specific department may see increased investment if a project is bringing exceptional success. This allows a company to adapt to what is or isn’t working.
Top 4 budgeting methods to consider
Once you identify the time, resources, flexibility and company/industry data that your budget requires, you can choose a method that best achieves your goals.
The two primary budgeting methods are the top-down and bottom-up methods, each with its own unique advantages and disadvantages.
With the top-down approach, upper management determines the budget themselves. After they have the budget determined, they send it on to the different department heads. The individual managers might make suggestions for budget edits. But they won’t determine the overall budget. They’ll merely implement it.
This method is valuable for allocating resources, saving time for lower management and making the overall process faster. However, in this case, lower management also tends to have less ownership over the budgeting process and, therefore, the end results. Since departments themselves aren’t involved in the process, the budget may be plagued by inaccuracies if leadership is not keenly aware of the company’s day-to-day operations.
One example of a top-down budget approach is activity-based budgeting. With activity-based budgeting, the company will set a target — i.e., total revenue — and management will produce a budget to meet that target. For example, if a company wants to earn $200 million in revenues in the coming year, first they’ll need to figure out what activities are needed to meet that revenue goal. Then, they’ll decide what costs will be required to implement their strategy.
On the other hand, bottom-up budgeting can be a great way to involve those who are ingrained in the day-to-day functions of the business. In this instance, lower-level managers and employees determine their own needs and submit them for approval to management. This method can give upper management great insights into how the different departments are functioning.
Zero-based budgeting is a form of bottom-up budgeting in which all departments’ budgets start at zero. Individual departments then submit their budgetary requests. However, every expense must be justified and requires buy-in from the top as well. Nothing is automatically given the “okay.” This is a good method for containing costs when a company is restructuring financially or if there’s been a market downturn, but it does take more time than other traditional approaches.
Additional budgeting methods
Two other types of budgeting methods are incremental budgeting and value proposition budgeting.
Incremental budgeting uses the current budget as a baseline to plan next year’s budget. It is a more traditional approach that also takes much less time to complete. An incremental percentage is added on to the existing budget each year in order to account for assumed revenue growth, added expenses or economic conditions. However, this method can perpetuate inefficiencies, leave budgetary slack and even ignore external cost drivers.
Value proposition budgeting is more about mindset than method and can be used in conjunction with other methods. It asks questions like: Why is this included in the budget? Does this item create value for our stakeholders? What activities have the highest impact on our goals? It might even ask if values outweigh costs, such as expenses associated with team culture.
Whichever method (or combination thereof) is used to build a company’s budget really depends on the end goal of that particular budget. For this reason, it’s important for managers to understand—in addition to types of budgets and budgeting methods—budget strategy.
Budget strategy requires industry expertise
Regardless of what type of budget you’re building or the method you’re using to build that budget, you always want to make sure the system itself is streamlined. Too much slack in the budgeting process can lead to inefficiencies, oversights and poor allocation of resources. These kinds of problems, of course, can hurt the business.
In order to accomplish the budgeting task effectively, the budget should be put together by a financial analyst who has knowledge of the industry they’re working in, how that industry might change and what’s needed to predict the company’s budgetary needs.
An expert financial analyst should be seasoned at setting the right guardrails and continuously monitoring them for immediate needs or opportunities to improve. A Paro fractional expert can offer the directional support you need as your business plans and finalizes its budget at the end of each year.