What Are The Four 4 Main Types Of Budgeting Methods?

Introduction

Let’s talk about everyone’s favorite topic – Budgeting! (Just kidding, we know it’s not the most exciting) But hear us out, because budgeting is actually really important. At its most basic level, budgeting is the process of creating a plan to manage your money. It helps you make sure you’re not spending more than you’re earning and that you’re allocating your money in a way that aligns with your priorities.

Budgeting isn’t just important for individuals, it’s also important for businesses and organizations. It helps them make strategic decisions about how to allocate their resources and make sure they’re using their money effectively. There are a few basic principles that apply to all types of budgeting – you should have a clear understanding of your income and expenses, you should set realistic goals, and you should track your progress regularly.

Now that we’ve covered the basics, let’s dive into the four main types of budgeting methods!

Incremental Budgeting

Budgeting is an essential function for any organisations, irrespective of size. It is an act of planning and execution of financial resources to accomplish future goals. Budgeting is a crucial aspect to ensure that an organisation’s financial plans are in line with the market regulations and objectives defined by the organisation’s management. Let’s dive into the four main types of budgeting methods.

Incremental budgeting refers to a budgeting method wherein the previous year’s budget is used as the base year and incremental changes are made to it. This budgeting technique is prevalent, primarily because of its simplicity.

Advantages of Incremental Budgeting:
This method is easy to prepare and requires minimal time and effort. It is an intuitive method to implement when compared to other budgeting techniques; it is easy to review and understand.

Disadvantages of Incremental Budgeting:
One of the significant drawbacks is that it does not take into account any future changes in the scenario. It creates an assumption that the previous year’s expenditure was efficient, which may not always be the case.

Real-life examples:
Amazon uses the incremental budgeting method to allocate resources to its various departments. The company has a research and development team, and it uses incremental budgeting to allocate resources to the team every year.

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Activity-based Budgeting

Activity-based budgeting, also known as ABB, is a budgeting method that relies on activities instead of the previous year’s budget or revenue to determine the allocation of resources. This method focuses on the costs associated with each activity and is used by companies that have several products or services.

One of the primary advantages of activity-based budgeting is that it allows companies to assess the costs of each activity and eliminate unnecessary ones. This method also facilitates the identification of areas that need improvement, leading to better cost management. Additionally, it enables companies to allocate resources effectively and prioritize activities effectively.

However, ABB has some disadvantages. One downside is that it requires more resources to implement compared to other budgeting methods. It also needs comprehensive data, which can be challenging to obtain in some cases. ABB is also more complex than some other budgeting methods, which can make it challenging for some companies to understand.

Real-life examples of companies that use ABB include Proctor & Gamble and American Airlines. Proctor & Gamble used ABB to reduce the costs of running its plants, which led to significant savings. On the other hand, American Airlines implemented ABB to prioritize activities and reduce unnecessary costs.

In summary, activity-based budgeting is a budgeting method that relies on activities to determine the allocation of resources. This method has several advantages, including cost management, optimal allocation of resources and better prioritization of activities. However, it has some disadvantages, like the need for more data and resources, and complexity. Companies, such as Proctor & Gamble and American Airlines, have utilized this budgeting method to make significant cost savings and optimize resource allocation.

Zero-based Budgeting

Zero-based budgeting (ZBB) is a budgeting strategy where the organization’s budget starts from zero each year and the budget holders must justify all of their expenses. In other words, expenses are only considered if there is a valid business case. This budgeting method is quite different from the traditional methods that start with the previous year’s budget and add or subtract funds based on that.

Also Read This Article: Why Is It Important To Build An Emergency Fund?

Advantages:
ZBB has various advantages that make it appealing to organizations. For one, it ensures that every department or project within the organization is weighed equally. It provides a level playing field and eliminates the bias or favoritism often seen in traditional budgeting methods. Furthermore, by scrutinizing all expenses, it leads to a more efficient allocation of funds and encourages cost-cutting where possible. Lastly, since budgets start from scratch every year, it offers the opportunity to reassess objectives and processes critically.

Disadvantages:
However, ZBB also has its downsides. Since every expense requires justification, it can be a time-consuming process and can delay operations. There is a risk that essential expenses may go unmet if they are not justified and make it challenging to obtain funds. The process can also lead to disagreements and conflict, especially if budget holders require funds for initiatives that may not be deemed as critical by others. Lastly, it may not be suitable for all organizations since it requires frequent assessment and transfer of resources and can be costly.

Real Life Examples:
The U.S.: In the U.S., ZBB gained popularity in the 1970s when President Carter’s administration introduced it. Since then, it has come into use in some government agencies at different levels.

India: In India, the government has implemented ZBB programs for different ministries and organizations, including the Ministry of Finance.

If you think that justifying every expense sounds laborious and expense cutting unimaginative, you are not alone. However, with fiscal responsibility being a primary goal of most organizations, ZBB has become an increasingly relevant budgeting strategy. And let’s face it – there is no harm in reassessing and weighing expenditure with fresh eyes each year.

In conclusion, ZBB allows for a critical analysis of funds and promotes accountability. However, its implementation can be a tedious process, and it may not be suitable for all organizations. It is up to each organization to weigh the advantages and disadvantages carefully and assess if this method is the right fit for them.

Value Proposition Budgeting

If you’re looking for a budgeting method that focuses on creating value, Value Proposition Budgeting might be the one for you. Unlike Incremental, Activity-based, and Zero-based Budgeting, Value Proposition Budgeting doesn’t prioritize cost-cutting, but rather aims to maximize value for both the company and the customers.

In simple terms, Value Proposition Budgeting is a method where budgeting decisions are based on the organization’s overall strategy and the value that is created for the customers. This method helps companies to focus on creating more value for their customers instead of cutting costs.

One of the key advantages of Value Proposition Budgeting is that it helps organizations to align their resources with their strategies. By focusing on value creation, companies can better understand their customers’ needs and align their resources to deliver value, which can ultimately lead to increased customer satisfaction and loyalty.

Another advantage of this budgeting method is that it helps companies to prioritize their resources. By focusing on value creation, companies can prioritize their resources on high-value activities and allocate resources accordingly. This can help companies to be more efficient and effective in their operations.

However, there are also some disadvantages to Value Proposition Budgeting. One of the main disadvantages is that it can be challenging to measure the value that is created. Unlike traditional budgeting methods, Value Proposition Budgeting focuses on intangible factors such as customer satisfaction and loyalty, which can be challenging to measure.

Another disadvantage of this method is that it can take time to implement. Value Proposition Budgeting requires a significant amount of planning and analysis, which can be time-consuming and costly.

Real-life examples of Value Proposition Budgeting include Apple’s commitment to design and innovation, Zara’s focus on fast-fashion, and Southwest Airlines’ strategy of providing low-cost flights with no-frills amenities.

Overall, Value Proposition Budgeting is a budgeting method that prioritizes value creation. While it has its advantages and disadvantages, it can be a valuable tool for companies that want to create more value for their customers and align their resources with their overall strategy.

Conclusion

Choosing the right budgeting method is crucial as it can make or break a company’s financial health. Each method has its own advantages and disadvantages. Therefore, it’s important to align the method with the business objectives, size, and industry requirements.

Key Takeaways: Understand your business needs and match them with the right budgeting method. Choose a method that aligns with your strategic goals, analyze variance, and track metrics closely. Regularly update the budget as per the changes in the business environment.

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