Ugh, the budgeting season. It kicks off way too early yet we still in a rush to meet that year-end deadline.
But what if there’s a way to make the process less painful?
In this article, we’ll go through the pros and cons of three common budgeting methods businesses use:
- Incremental budgeting
- Zero-based budgeting
- Activity-based budgeting
By the end, you’ll be able to identify your organisation’s budgeting method and make suggestions on how to improve it.
Table of contents
Incremental budgeting
Incremental budgeting is the most common, traditional technique that uses a top-down approach.
The previous year’s figures are taken as a starting point and adjusted up or down by a fixed percentage (usually 1–10%). The adjustment is based on assumptions about the change in current costs, taking into account the expected inflation.
This approach is most appropriate in stable conditions where cost drivers remain mostly the same from year to year. That’s why it’s popular in large, established organisations with reliable historical data and stable costs.
Advantages of incremental budgeting
Simple
Such a budget is relatively easy to prepare. Since the previous year’s actuals are already available, it’s only a question of how much to adjust them.
Time-efficient
Because of its simplicity, the process is quick, freeing up resources for other tasks. Also, maintaining the budget and preparing associated reports requires less time and effort.
User-friendly
The technique is easily understood by non-finance staff as it doesn’t require much knowledge of finance or accounting.
Encourages collaboration
There are fewer conflicts between departments competing for funding because the same approach is used throughout the organisation.
Disadvantages of incremental budgeting
Perpetuates inefficiencies
Arguably, the most significant drawback — no one questions the previous year’s actuals (used as a foundation). The current spending is carried forward to the following year, even if it’s unnecessary.
Increases wasteful spending
If managers know the funding will stay or increase next year anyway, they’ll have little incentive to reduce costs. As a result, they’d tend to spend the allocated budget regardless of actual needs or goals.
Creates budgetary slack
At the same time, managers may be tempted to overstate the next year’s budget to avoid overspending, particularly if their compensation is tied to a specific budget target.
Discourages innovation
Since the focus is on maintaining the status quo over exploring new opportunities, there is little drive to innovate. It can negatively impact a business’s competitive position and ability to adapt to market conditions.
Limits the talent pool
Accordingly, a conservative culture can make the organisation less appealing to young talent seeking innovative workplaces.
Zero-based budgeting
Zero-based budgeting emerged in the 1960s as an alternative to incremental budgeting.
The process starts from scratch — a ‘zero base’ — without taking past results as a reference point. The goal is to keep only the necessary expenses and eliminate any that aren’t essential for operations.
What’s the catch?
Since all expenditures in the budget should be justified, someone has to review each expense category thoroughly. And this is challenging in practice.
The process consists of three stages:
- Managers identify activities and prepare a ‘decision package’ for each one. These packages include cost breakdowns, performance measures, alternative ways of performing the activity, and consequences if it’s discontinued.
- The decision packages are ranked in order of decreasing benefits to the organisation.
- The resources are allocated based on the priority of the decision packages until spending reaches a predetermined level.
In practice, managers don’t start budgeting from zero. Rather, they begin with their current spending level and then conduct a cost-benefit analysis for each activity to determine whether it should be removed from the budget.
Advantages of zero-based budgeting
Responsive to changes
The method is useful when there’s an urgent need to reduce costs. It allows responding quickly to internal factors, like restructuring, and external ones, such as a slowdown in the economy.
Reduces inefficiencies
It helps to cut inefficient activities and legacy processes, which otherwise would be assumed to continue under incremental budgeting.
Promotes innovation
Since the status quo is challenged, managers are more likely to generate new ideas and innovative solutions.
Ensures transparency
The thorough research of each expense group makes it easy to understand and track where resources are allocated.
Boosts motivation
As it’s a bottom-up approach, employees are encouraged to participate. This reflects favourably on their commitment and promotes a positive organisational culture.
Disadvantages of zero-based budgeting
Time-consuming
As mentioned, it takes much time to drill down to each expense type and analyse it in detail. This process may result in many decision packages and much paperwork (more likely, Excel work), particularly in large and complex organisations.
Difficult to prepare
The management team needs to receive additional training to construct decision packages properly. If the number of identified activities is high, the ranking process isn’t easy — many could appear equally important.
Can omit necessary expenses
Managers may overlook certain expenses, particularly those that are qualitative in nature (like supporting customer experience), and end up not including them in the budget.
Not practical for essential costs
The technique is less effective for businesses with a high share of necessary expenses. What’s the point of analysing costs that will be incurred anyway?
Activity-based budgeting
Activity-based budgeting is a top-down method that analyses cost drivers to determine how they contribute to generating value.
It’s more rigorous than incremental budgeting, which merely adds a percentage to the actuals.
The process breaks down into three stages:
- Required outputs are defined — as a number of goods or services needed to achieve a particular revenue target.
- Activities are identified to produce the required outputs.
- The costs of these activities — both direct and indirect — are included in the budget.
Essentially, it’s activity-based costing in reverse.
And similarly to zero-based budgeting, all costs must be analysed and justified before including in the budget.
Advantages of activity-based budgeting
Helps to scrutinise costs
Activity-based budgeting aligns value-adding activities with objectives, thus revealing how the business spends money to generate revenue.
Improves processes
While reducing wasteful activities, there’s an opportunity to optimise business processes, resulting in more efficient use of resources.
Facilitates KPI development
The process can be used along with developing KPIs to measure the progress towards achieving goals.
Disadvantages activity-based budgeting
Time-consuming
It can be a tedious process. The tricky part is to identify how indirect costs (overheads) contribute to value creation.
Requires technical skills
Again, allocating overheads to value-generating activities can be complex, requiring accounting skills and an understanding of business processes.
Sensitive to assumptions
Activity-based budgeting relies heavily on forecasts. If the assumptions are wrong, the resulting budget will also be incorrect. Garbage in, garbage out.
Which budgeting method is best for your organisation?
Like everything else: it depends.
Incremental budgeting is more suitable for established businesses with reliable historical figures and stable costs over the long term. It’s also a practical option if there are limited resources for budgeting.
On the other hand, zero-based budgeting is excellent for startups and small businesses because it’s easier to implement in a simpler organisational structure. In addition, it’s useful for controlling discretionary spending and changing established practices.
Activity-based budgeting is worth considering for new businesses that lack historical data. Further, it’s a good choice for companies with many product lines, where products have considerably different cost drivers.
And remember, it’s possible to combine these methods.
For example, you may use incremental budgeting for necessary costs like rent, utilities, legal and accounting, and zero-based budgeting for justifying investments in new projects or initiatives.
Alternatively, opt for activity-based budgeting as standard and supplement it with zero-based budgeting every 3–5 years.
Final thoughts
Clearly, each of the three budgeting approaches has its pros and cons.
Transitioning to another budgeting method will likely encounter resistance from employees who are much used to the current process, but keep in mind the end goal — budgeting should help to manage finances effectively and, ultimately, drive business decisions aligned with your long-term plan.
