Budgeting is an essential part of any business, and understanding the different types of budgeting methods is key to success. There are four main types of budgeting: incremental budgeting, activity-based budgeting, zero-based budgeting, and value proposition budgeting. Each type of budgeting has its own advantages and disadvantages, and it's important to understand which one is best for your company. Incremental budgeting is an excellent method to use if your costs are more predictable and tend to be similar year after year.
This type of method is best used if a company has minimal changes year after year and you are confident that spending will remain stable. The main reason many companies use the incremental budgeting method is because of its simple and straightforward approach. Activity-based budgeting is ideal for companies that may not have enough historical information to create the budget for the next period, for example, newer companies that are growing. This type of model is more difficult to prepare than a static budget model, but it tends to generate a budget that is reasonably comparable to actual results.
Zero-based budgeting is, as the name suggests, a zero starting point or blank slate. This means that all expenses must be justified for each new period. Zero-based budgeting is ideal for companies that are innovative and seek to function more efficiently. On the other hand, some critics argue that the benefits of zero-based budgeting don't justify its time cost.
The value proposition budgeting method is a midpoint between incremental budgeting and zero-based budgeting. This type of budget takes into account both historical data and current trends in order to create a more accurate picture of future costs. Incremental budgeting may not sufficiently analyze each item or category of the budget, while zero-based budgeting may overanalyze each item or category. That's why the value proposition budgeting method is somewhere in between.
The value proposition budget is not for all companies, but when executed correctly, it can generate profits, generate value for your brand and build customer loyalty, leading to success. In order to create a successful budget, use the inputs from the financial statements, the cash forecast and the financial plan. Management teams use master budgets to plan the activities they need to achieve their business goals. In larger organizations, senior management is responsible for creating several iterations of the master budget before it is finalized. Once it has been reviewed for the last time, funds can be allocated for specific business activities. Smaller companies often use spreadsheets to create their master budgets, but replacing spreadsheets with efficient budgeting software usually reduces errors.
An operating budget shows the projected revenues of a company and the expenses associated with it over a period of time. It's very similar to a profit and loss report and includes fixed cost, variable cost, capital costs and non-operating expenses. While this budget is a high-level summary report, each item is backed up with relevant details. This information is useful to check if the company spends according to its plans. A cash flow budget gives you an estimate of the money that comes in or out of a company during a specific period of time.
Organizations create cash budgets using inferences from sales and production forecasts, and estimating accounts payable and receivable. For any company that plans to hire employees to achieve its goals, it will be important to have a work budget. It helps you determine the workforce you'll need to achieve your goals, so you can plan payroll for all those employees. In addition to planning for regular staffing, it also helps you allocate expenses to seasonal workers. As the name suggests, this budget is an estimate of income and expenses that will remain fixed throughout the year. The items in this budget can be used as objectives to be met, regardless of any increase or decrease in sales.
Static budgets are usually prepared by non-profit organizations, educational institutions or government agencies that have been allocated a fixed amount to be used in their activities in each area. A master budget refers to a set of financial and operating budgets for a specific accounting period. It is usually used for the next calendar year or fiscal year. These budgets are prepared quarterly or annually. The format of the master budget varies depending on the size of the company. Operating budgets are used in daily operations and serve as the basis for financial budgets.
Operating budgets include sales, production, direct labor, direct materials, overhead, administrative expenses, sales, the cost of manufactured goods, and the cost of goods sold. Financial budgets include a budgeted income statement along with a balance sheet, a cash budget, and a capital expenditure budget. The budgeted income statement and budgeted balance sheets are also known as pro forma financial statements. Understanding the types of budgets and their classifications is crucial for successful operations and profitability. However, as you can see, this type of method can create other challenges such as overspending and oversight as well as being surprised by unforeseen changes.