Budgetary Systems and Types of Budget

Budgetary systems which are tools of planning and control occur at various levels in the performance hierarchy and to different degrees. Plans made at the higher level provide a guideline for the plans at the lower levels. Plans made at the lower level essentially carry out the plans made at the higher level.

Strategic Level (Corporate Plans/ Strategic Plans)

• Focus on the overall performance
• Sets plans and targets for each department
• Can be qualitative

Lower Management Level (Tactical Plans)

• Less than 12 months
• Individual departmental plans with guidelines set by senior management
• Many include non-financial budgets
• Overall budget is expressed in financial terms with accompanying financial statements
• Links strategic plans at senior level and operational level
• Budget target should be in line with strategic objectives
• Approved by senior management

Junior Level (Operational Plans)

• Based on objectives about what to achieve
• Specific
• Targets are listed quantitatively
• Detailed specs of targets and standards
• Short term
• Operational plans are prepared with goal of reaching budget targets

Budget

A budget is a written projection of a particular department’s financial performance, a specific project, a business unit, or an organization for the period under consideration. Usually, budgets for businesses or departments created for an accounting period, i.e., for one year. However, the period could be less or more than a year. Complete flexibility is there as the method remains the same, and the business can make or plan a budget for the period they want.

There are different types of budgets and, thus, budgeting methodologies.

Budgeting

Primarily, the activity of preparing a budget is called budgeting. In many organizations, it is a separate department taking care of only the preparation and implementation of budgets.

Importance of Budgeting

In the business world, we can not afford to overstate the importance of a budget. At every stage of decision making, planning, and coordination budgets or plans are the essential tools for Management Control.

It gives a direction to the entire organization internally where it needs to run and reach on the one hand and will help management in communication and guiding the team with full clarity. On the other hand, this document is useful to the outside world also. It shows what the business is trying to achieve and whether the path and direction are right or has a flaw. Whether the objective and targets or aligned with the market realities. Whether the budget is only a dream on paper or it has a clear cut and well-defined plan of action to achieve those dreams.

Types of Budgets

1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget.  It is the most common method of budgeting because it is simple and easy to understand.  Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year.  However, there are some problems with using the method:

It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.

It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.

It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs.  Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

2. Activity-based budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.  For example, a company sets an output target of $100 million in revenues.  The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

3. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following questions:

• Why is this amount included in the budget?
• Does the item create value for customers, staff, or other stakeholders?
• Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

4. Zero-based budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch.  Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs. However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.

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Budgeting introduction