Budgeting Basics: 4 Approaches to Business Budgets - Brink's Money
Budgeting Basics: 4 Approaches to Business Budgets
08 Apr 2021
You won’t find a perfect business budgeting process. No single model makes sense for every business, or even a single category of business.
The right model for your budget depends on answers to questions like:
- How much time do you have to spend?
- What’s your level of financial expertise?
- How predictable is your company’s growth?
- How tight are your finances?
We’ll walk you through four common models to help you choose the right one.
1. Incremental budgeting: What most people think of
Incremental or “traditional” budgeting is the simplest form of business budgeting. You start by looking backward, usually over the past year. Total the revenue and expenditures. Then, based on how much you expect to grow, increase each budget by a certain percentage.
Say, for example, that you expect revenue to grow by 10% this year. if your marketing budget was $50,000 last year, you increase it by 10%, up to $55,000. Other department budgets also get that same 10% boost. (On the flip side, if you expect a difficult year, you could reduce across-the-board budgets by the same amount.)
Incremental budgeting is the fastest, easiest way to set a budget. Speed and simplicity have real advantages. You don’t have to spend days making complex calculations, and teams get predictable funding to plan their spending.
Simplicity is great—but it’s not free.
Simplicity, of course, also has its costs. How accurately can you predict next year’s revenue? If you’re a relatively new business or in a fast-growing industry, you may struggle to come up with a revenue number that’s anything beyond a guess.
If the year turns out to be more successful than you expect, an incremental budgeting process may underfund your team—and hamper growth. If you don’t meet your projections, you may have to cut programs or personnel as the year goes on. (If the last year has taught us anything, it’s that some changes—with a huge impact on business—are impossible to predict.)
Incremental budgeting struggles to account for isolated changes. For example, the price of essential machinery or transportation of goods may rise at a faster rate than other costs. As a result, some departments may need a greater budget increase than others.
Incremental budgets are also vulnerable to manipulation. If managers know they’ll get a steady budget increase—whether they need it or not—they may be unmotivated to cut costs. Additionally, managers may limit their growth projections to align with the budget increase.
If you’re starting to feel that the risks of incremental budgeting outweigh the rewards, you have other options, albeit more complex ones. To use them effectively, you’ll need more detailed knowledge about your business and a willingness to dedicate more time to calculations.
2. Activity-based budgeting
A better name for activity-based budgeting might be “goal-based budgeting.” You start by picking a growth target (e.g., $2 million in annual revenue), then work backward to establish the inputs you need to reach that goal.
Whether activity-based budgeting works depends on how effectively you can:
- Set a goal;
- Measure the value of your inputs (e.g., marketing campaigns, new sales staff, etc.).
Say each current sales rep brings in $300,000 of revenue a year. But if you hire two more, would they bring in as many sales? Could you supply them with enough quality leads? Would you run out of market opportunities?
The more uncertainty you have about such calculations, the more challenging it is to make activity-based budgeting work. (For this reason, incremental budgeting is considered more “conservative”—its estimates are based on past data, not just hypothetical goals.)
Even as an exercise, however, it can be useful. For example, if you have—or were given—a wildly ambitious growth target, activity-based budgeting can help show that a goal is unattainable.
Activity-based budgeting can also be helpful for short-term projects. A product launch may include a one-month sales goal. Activity-based budgeting can help you understand how to shift resources to reach that goal. Because a product launch requires only a portion of your budget for a limited period of time, you avoid some of the typical challenges.
Rather than assessing historical performance or forward-looking goals, the last two methods focus on increased scrutiny and decreased expenditures.
3. Value proposition (or priority-based) budgeting
Value proposition or priority-based budgeting can be used as a stand-alone method or as part of the activity-based budgeting process.
For this budgeting method, you list all your expenses (or have managers list expenses for their departments), then assess the value of each activity. Is it essential to keep the business running? Does it fill your sales funnel? Do customers rave about it?
Once you’ve estimated the relative value of activities, you create a rank-order list of the most impactful efforts. If you’re using activity-based budgeting, you can use this list (sometimes called a “decision package”) to identify the activities that give you the best chance to reach your goal.
The challenge is that the value of some activities is difficult to quantify. What’s the value of sponsoring a family night at a minor league baseball game? Or of extending customer service hours to include weekends?
For value proposition budgeting to work, you need to trust that you or your team can reasonably estimate the importance—if not the dollar value—of all activities. That ability is even more critical if you decide to use zero-based budgeting.
4. Zero-based budgeting
Zero-based budgeting is the most aggressive budgeting method to cut costs. Whether you do it annually, quarterly, or even monthly, zero-based budgeting assumes that the required budget for every department is zero—until proven otherwise.
From there, every expense must be justified by the value it provides, not dissimilar from the process for value proposition budgeting. (Zero-based budgeting could be considered an extreme form of value proposition budgeting.)
Zero-based budgeting asks hard questions:
- “If we stopped doing this, would it matter?”
- “How can we do this process with less money?”
- “Are we sure that this effort is creating value?”
Because the starting point is always zero, zero-based budgeting is a great way to cut costs. Nothing is taken for granted—the opposite of incremental budgeting, which assumes that everything is necessary.
Some experts critique zero-based budgeting for its hardline approach, but its aggressiveness depends on your goals. If you use zero-based budgeting to keep expenses in check but don’t face hard times, you can approve a higher percentage of expenditures.
By contrast, if you’re facing a financial crisis, you can cut spending down to the bone. The consistent aspect is to review everything, not to reject most requests.
As with other methods, if you cut activities because you can’t prove their value—but they do, in fact, provide value—you could unintentionally cut worthwhile spending. Wanting to stop unnecessary spending and figuring out exactly what’s unnecessary are two different tasks. As alluring as the former sounds, it doesn’t work unless you excel at the latter.
So if you find that you like—and dislike—bits and pieces of various methods, you’re not alone.
It’s not one size fits all—or even one size fits one
Here’s an idea: Use incremental budgeting as your baseline process but conduct zero-based budgeting every three years to identify wasteful spending. Fold in activity-based budgeting for short-term campaigns to support seasonal efforts or one-off projects.
Or, use zero-based budgeting only in departments where you feel confident about the value of inputs, letting other departments stick with incremental budgeting.
That kind of mix-and-match flexibility should be encouraging, not overwhelming. If you’re still feeling uncertain, you can always come back to the two central questions for business budgets:
- What is the right cadence for reviewing your budget? Monthly? Quarterly? Annually? Shorter intervals help you account for change, but it takes more time and can disrupt long-term projects.
- What is the right level of scrutiny for your spending? Less oversight usually means more spending, but tighter oversight takes more effort—and accurate knowledge about what really works.
What’s right for your organization today may not be right next year. But with an understanding of all possible approaches, you’ll know how to adapt—just as you do for every other aspect of your business.
Want to make the financial management of your business more efficient? Learn how Brink’s Money can help.
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