Budgeting is the process of creating a financial roadmap for your organization. It is essential for the effective management of a business. If you are planning a move into a managerial role, you will need to be well-versed in the different techniques that can be used for budgeting, as well as the advantages and disadvantages of each type.
The importance of good budgeting in business
Budgeting plays an important role in the success of an organization. The process involves a lot of decision-making, number crunching, and attention to detail, but there are many benefits to preparing a robust budget.
- Ensures that resources are available: Budgeting helps you assess where additional resources will be needed to deliver on business objectives. It will also indicate areas where resources can be scaled back.
- Supports internal goal setting: The budgeting process helps determine how much revenue the organization needs to generate in the coming financial period.
- Helps with prioritization of projects: Some budgeting techniques will require you to justify each line of expenditure with details of return on investment. This information is useful for prioritizing initiatives.
- Supports future financing: If investors can see actual performance against budgeted figures, with clear reasons for deviation from forecasts, it will give them assurance of the organization’s ability to manage finances, allocate funds and make adjustments where needed.
Key approaches to budgeting
All types of budgeting methods are designed to support the delivery of business objectives, but the approaches to achieving this goal vary considerably. There is no right or wrong budgeting methodology. Rather, it is usually a matter of working with the system that best fits the culture and management style of the organization.
Incremental budgeting takes figures from the previous accounting period and uses them with minor adjustments to prepare the budget for the next period. Actual or budgeted figures from one year are projected forward, with alterations to accommodate anticipated changes. For example, an increase of 5% may be applied across a range of departments to cover rising costs.
This type of budgeting is ideal where only minor changes are required from the previous accounting period because very little has changed, either within the business or in the external environment.
Care needs to be taken to ensure that percentage increases are reasonable.
Advantages of incremental budgeting:
- Very quick to prepare
- Simple to understand
Disadvantages of incremental budgeting:
- This may promote inefficiencies, as potential cost savings are not being actively sought
- It may overstate performance; it is easy for departments to stay within the budget if they have been allocated a percentage budget increase that is higher than needed.
- It may ignore general external economic factors, such as inflation
- It may not be sufficiently tailored to individual departments – for example, if one department is more significantly impacted than others by external factors
Activity-based budgeting uses cost-driver analysis for budget setting. Business activities are analyzed in detail to predict costs. This budgeting methodology has traditionally been used in the manufacturing sector but lends itself to use in many other industries. Some nonprofits also use activity-based budgeting.
The process starts with senior management determining the target amount of revenue the company needs to achieve. Once this figure has been decided, managers need to assess the scale of activities that need to be carried out to deliver the target revenue.
The basic process involves:
- Identifying activities and the related cost drivers
- Forecasting the number of units required within each cost driver
- Calculating the cost per unit of activity
The emphasis of activity-based budgeting is on revenue-driving activities rather than overheads and administration. However, all costs incurred by a business are examined to assess whether efficiencies can be delivered to reduce costs. Cost reduction may be achieved by lowering some activity levels or eliminating some.
Activity-based budgeting does not rely on historical costs when creating a budget. This makes it an ideal approach for start-up businesses that don’t have years of past data to work with.
Advantages of activity-based budgeting:
- It enables you to understand the exact costs associated with each operational activity
- You can drill down further within these costs to identify areas of unprofitability
- It can be used to inform evaluations of business units about one another
Disadvantages of activity-based budgeting:
- More costly and more time-consuming to use than some budgeting methodologies
- Accountants must have in-depth knowledge of the business processes if they prepare accurate budget calculations.
Zero-based budgeting is now a widely used budgeting methodology for businesses. It is particularly helpful when an organization is experiencing financial difficulties and costs must be rigorously contained to transform its financial position and enable it to survive. The budget for every department is reset to zero for the forecast for the new accounting period. Every expense added to the budget must be justified so that only necessary items are included.’
Evaluating every cost is a good way to ensure that managers prioritize effectively and focus on the important elements of the business.
A zero-based budgeting methodology requires significant input from every department of the organization. Suppose external consultants are brought in to support the preparation of budgets. In that case, they must familiarize themselves fully with the needs of the business so that they can develop accurate forecasting.
This type of budgeting can be ideal for measuring discretionary costs rather than planning essential operating expenses.
Advantages of zero-based budgeting:
- Comprehensive and highly disciplined approach to budget setting
- Can be expected to filter out unnecessary or unprofitable activity
- Helpful where costs need to be reduced to the absolute minimum for survival
Disadvantages of zero-based budgeting:
- Zero-based budgeting takes longer to prepare than some alternative budgeting methodologies because it involves a lot of work, with input required from all departments
- Inaccurate budgets may be scheduled if external consultants do not have an adequate understanding of the business
Value proposition budgeting
With value proposition budgeting, everything included in the budget is assessed in terms of value added to the business.
For every item, the following questions need to be asked:
- Why is the object included in the budget?
- Does the thing create value for stakeholders such as customers or staff?
- Does the item have a net positive value, i.e., does the deal outweigh its cost? If not, some other justification for the price needs to be specified.
Value proposition budgeting helps to ensure the organization is focused on what matters but is a little less demanding than zero-based budgeting.
Advantages of value proposition budgeting:
- Develops the mindset across the organization of delivering value for the business
- It helps to avoid unnecessary expenditure
- Demands less extensive input than zero-based budgeting
Disadvantages of value proposition budgeting:
- Requires broad input
Negotiated budgeting is a methodology whereby responsibility for budget setting is shared between senior management and their subordinates. More traditional budgeting methods favor a top-down approach with budgets set by senior management, whereas negotiated budgeting entails seeking input from lower levels of management to inform decisions on budgets by the department. Senior management will still be responsible for ensuring the organization is in a strong position overall.
The process begins with senior managers setting top-level department budgetary figures for the next financial period. These target figures will usually be primarily based on historical data. Senior managers then pass these targets to departmental-level managers for review. At this stage, the lower-level managers can put together suggested changes to the amounts included in the budget for projected revenue and costs based on their departmental expertise. Departmental forecasts may be higher or lower than the figures in the draft budget.
The next stage is to hold a meeting where senior and department managers can discuss the recommended changes to the budget. The conference’s goal is to negotiate until a consensus on the budget figures can be reached. Department managers can use this meeting to provide more detail on the realities of delivering against the proposed budget and justifications for recommended changes.
Advantages of negotiated budgeting:
- The combination of a top-down and bottom-up approach shares empowerment and responsibility across the organizational tiers
Disadvantages of negotiated budgeting:
- This approach can be more time-consuming because more management levels have input and need to reach an agreement
Participative budgeting applies some of the principles of negotiated budgeting but uses a bottom-up method. This roll-up budgeting approach has gained popularity with its empowerment of managers and department heads to determine their budgets.
The budgeting process starts from the bottom up, with managers preparing figures for the budget for their company area. These individual budgets are then amalgamated into a business-wide budget. This process of devolving ownership for budgets has the advantage of making managers more accountable since they have prepared the figures themselves.
Advantages of participative budgeting:
- Managers feel empowered because they have ownership of setting their budgets
- Accountability and an increased incentive to deliver on objectives within budget
- Relevant departmental expertise is used in developing the budget
Disadvantages of participative budgeting:
- It takes longer to prepare
- Managers may be tempted to build in slack to make it easier to deliver within budget.
Applying budgeting methodology
Using just one budgeting methodology is not always necessary when preparing your forecasts for the next accounting period. You can also combine budgeting processes to create a customized solution for your organization’s way of working.
For any career in management, it is important to understand budgeting techniques and how they are applied. If you are pursuing more senior roles in engineering, a master’s degree in engineering management from an institution such as the University of Ottawa will give you a good grounding in budgeting methodologies and many other essential management tools. Online learning has become an increasingly popular way to pursue further education and is an ideal study format for postgraduate degrees. Achieving an online master’s of engineering management enhances your knowledge and equips you with the qualifications and skills you’ll need to gain access to more senior roles.
Various types of software are available to support multiple budgeting methodologies. Whether a top-down or participative-style approach is followed, the process can be facilitated with the right software. For example, applications are available to support participative budgeting methods, with input from multiple levels within the organization. Whereas organizations used to rely on clunky spreadsheets for preparing budgets, software products such as Prophix, Mosaic Tech, and Cube can all be used to facilitate budgeting and monitoring within your organization.
The methodology used for budgeting in an organization will often reflect its overall management style and culture. In an organization where there tends to be less delegation of responsibility, you are more likely to find a top-down approach to budgeting being used. Organizations that generally adopt a more collaborative, devolved approach will lean towards a participative budgeting method. If senior management is looking to introduce a shift in management style to a less top-down style, changing how budgeting is done can be a good start since it can immediately move the focus toward empowerment and responsibility.
A good understanding of the different budgeting techniques used by businesses will prepare you for managerial roles in various engineering and science environments. A higher degree could be an ideal way to develop your skills in budgeting and other aspects of finance, project management, operations, and more.