Each company plans differently for the upcoming fiscal year

Budgeting is an important plan of action for a company. A budget provides a vision. Guidance. Plan of attack. Even though things might turn out differently.

There are two options for how to implement a budget: top-down or bottom-up. Each type has its advantages and disadvantage: how much time does the company need to invest? How detailed is the budget? How many feedback iterations are necessary?

In the end, all budgets have similar goals. With budgets, companies want to have clear goals and define milestones. Besides, it helps firms communicate plans and ideas. And it should motivate employees to perform as well as possible.

In this article, I analyze different types of budgets and the corresponding pros and cons of each.

Incremental budgeting

Under this method, a firm determines next year’s budget by increasing or decreasing the financials of the current year. This way of planning is quick and easy and suitable for companies in a stable environment. But it is not useful for companies in a dynamic environment or fast-growing firms. Besides, it builds in inefficiencies. Let’s assume there have been one-off topics this year. For example, a lawsuit. This lawsuit was unique to this fiscal year. If the planning method assumes a general increase of 5% of all cost items, this lawsuit would be part of next year’s budget. So then, the planning would need adjusted figures. Also, activities are not challenged in depth. This means, that it is not always defined why the firm allocates resources to a certain activity.

Zero-based budgeting

In a zero-based budgeting process, a firm plans each item from scratch. This is to avoid incorporating inefficiencies or slack as in incremental budgeting. Under zero-based budgeting, a firm reviews each activity and deems it necessary or not. The firm avoids using current financials for its projection. Instead, the firm takes a completely new planning approach to set up the budget. Planning everything from scratch is time-consuming. But it avoids budgetary slack and supports efficient behavior. However, companies need to define how to evaluate whether a certain activity should be incorporated into the company’s business plan.

Rolling budgets

When a firm applies a rolling budget, it updates its budget throughout the fiscal year. As one period (i.e. month or quarter) ends, the firm adds a new period. That way, the rolling budget always reflects 12 months. This budgeting method is particularly useful in dynamic situations. These situations do not allow a firm to stick to the original budget for the whole year. This could include a pandemic, high-growth, crisis, inflation, or changes within a company’s structure. One advantage of this method is the ability to react to changes. Besides, budgeting is not seen as a “one-time thing of the year”. Instead, the firm includes it into the organization. This way, it removes uncertainty from the process. Downsides include the continuous effort to update the budget. Also the value of having a budget if the firm updates it frequently. Note that a rolling budget is not useful for companies in a steady environment.

Activity-based budgeting

Under activity-based budgeting, the company’s budget is based on activities. It mainly relates to cost-planning. Hence, a company needs to define the activities for the upcoming year. Subsequently, the firm needs to identify the cost drivers for each activity. This might be time-consuming but it ensures that all activities follow the company’s strategy.

Key aspects

1. Budgets can be incremental or planned from scratch.
2. Budgets can be planned based on activities and cost drivers need to be allocated.

Budgeting can be done on a continuous basis, i.e. each month or quarter a new month or quarter is added to ensure a 12-month planning horizon.

Final thoughts

This article illustrates the different types of budgeting methods. Note that a firm can take different approaches. E.g. if one business unit is stable while another one is dynamic. Or how to approach sales vs. cost planning. Ultimately, the firm needs to decide which methods are best for each area.

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