Types of Budgets

What Is A Budget?

A budget is an estimate of revenue and costs for a certain future period that is generally created and re-evaluated regularly. Anyone who produces and spends money may make a budget, whether an individual, a group of people, a corporation, a government, or anything else. 

Budgeting is essential for managing monthly spending, preparing for life's unexpected occurrences, and affording big-ticket things without falling into debt.

Keeping track of how much you make and spend doesn't have to be a chore; it doesn't require you to be a math genius, and it does not mean you can't buy the items you want. Instead, it simply implies that you'll know where your funds are going and have more control over your budget.

In business, budgeting is estimating a company's expected earnings (the money the firm receives from selling goods and services) and expenditures (the money it spends on paying expenses and bills) over a certain period in the future. 

It enables a company to determine if it can continue functioning at its planned level with these forecasted earnings and expenses.

A budget is an estimate of revenue and costs for a certain future period that is generally created and re-evaluated regularly. It can be structured for various timeframes, including monthly, quarterly, or annually.

Using this budget, a company may evaluate how well they intend to do during the year and can compare their actual performance to the original projected plan.

Types of Budgets 

Budgeting is necessary for management and planning. This article dives further into the popular budget types and budget categories. Any of these combinations may include fixed and variable costs.

Some of the types are:

1. Master Budget 

A master budget is a collection of operating and financial budgets for a fiscal term. It is often used for the next calendar or fiscal year. These budgets are typically created for a fiscal term, which can vary in duration depending on the organization's needs, whether quarterly, annually, or otherwise.

The master budget format varies in size depending on the nature of the firm. Operating budgets are utilized in day-to-day operations and form the foundation for financial budgets.

Sales, production, direct labor, direct materials, overhead, operational expenditures, selling, cost of production, and cost of goods sold are included in operating budgets.

Financial budgets contain a budgeted revenue statement, a balance sheet, a cash budget, and a budget for capital expenditures.

2. Cash Budget 

A cash budget is a budget for projected cash inflows and outflows over a specified period. It is divided into four sections:

• Receipts: This section includes the initial cash balance and cash collections from customers and others
• Disbursements: This section displays all cash payments classified by purpose
• Cash Surplus or Deficit: This section represents the difference between cash receipts and cash disbursements as a surplus or a deficit
• Financing: This section examines the specifics of the company's planned borrowings and repayments for the period. Its purpose is to plan and manage predicted cash flow by projecting cash inflows and outflows over a specified period.

3. Static Budget

This budget is at the predicted capacity level, sometimes a fixed budget. Because it is fixed, businesses commonly use it to plan their expenses based on predicted capacity levels.

However, departments that benefit from fixed budgetary allocations, regardless of capacity fluctuations, may utilize this type of budget.

For example, general marketing and administrative departments do not rely on production and sales as much as procurement does. Instead, they are established by the department's management; consequently, they can employ a static budget.

4. Flexible Budget 

The flexible budget, often known as the expenditure budget, adjusts to different activity levels rather than being fixed at the actual capacity level.

Because this budget is dynamic, it is often employed by organizations. Flexible budgets are tailored to a company's real activities.

These budgets can be created using a computerized spreadsheet such as Excel, simplifying the process for many organizations.

First, the relevant activity range for the upcoming accounting period is calculated. The expenses estimated to be incurred across the relevant range are then assessed. Next, the expenses are classified according to their cost Behavior, which might be mixed, variable, or fixed.

Finally, various levels or activities within the relevant range establish a flexible budget for variable costs. For instance, there might be a correlation between utility prices and the number of operating machines.

5. Operating Budget

The operating budget is for income statement components such as revenue and costs. You may have numerous sub-budgets within this budget, such as

• Production Budget: This budget plans production for the budgeting period, from the number of units and costs to the types of goods, plant capacity, operating cycle, production or purchase policy, etc. Typically, this budget is dependent on the sales budget. But, again, the production manager is in charge of this
• Sales Budget: The amount and value of sales that are planned. The sales manager is responsible for forecasting sales for the budgeting period
• Purchase Budget: This budget accounts for each item purchased by each department. The purchasing manager must create this budget to ensure the proper functioning of the department
• Production Cost Budget: This covers the cost of raw materials, labor, direct expenditures, and factory overheads. It is also known as the manufacturing cost budget or work cost budget. It displays the manufacturing costs for the units budgeted for manufacture
• Overheads Budget: This section includes the manufacturing overheads budget, administrative overheads budget, selling and distribution budget, as well as additional budgets such as the plant utilization budget and R&D budget.

Budgeting Methods 

A budget becomes necessary for continuing growth, planning, and expansion as a firm expands and gets more complicated. Budgets are essentially corporate spending plans that estimate anticipated expenditures and available funds. A sound budget can help predict income.

Budgeting is important to the company's control systems because it offers management planning, coordination, and control mechanisms. However, the budgeting process can be challenging, often causing apprehension among those involved in budget planning.

Many firms perceive budgeting as a process of maintaining the status quo. Some use the current year's budget and year-to-date actuals as the starting point for the next year's budget.

While using the current year's budget and actuals as a basis for the next year's budget is a valid technique, it is just one of five major budgeting procedures available to company executives.

Put simply, one approach involves basing the budget for the following year on the actuals from the current year, though other factors may also be considered.

While nothing is wrong with this strategy, there are a few more budgeting procedures to be aware of before your next budget meeting.

There are various methods for business budgeting, with four of the most frequently used types being incremental, activity-based, value proposition, and zero-based.

These budgeting strategies each have their advantages and disadvantages, which we will discuss later in this article to enhance your understanding of budgeting methods.

Incremental budgeting 

Incremental budgeting is the traditional process of generating the budget by starting with the current period's budget or actual performance and then adding incremental amounts for the next budget period. 

The next stage is to adjust specific line items with predictable numbers or items with evident foreseeable changes. 

For example, the interest expenditure on an amortized loan will slowly rise over time as the principal amount of each payment decreases. However, lease payments are frequently consistent over time. 

Supervisors may be aware of spending categories that may fall substantially or disappear entirely in a few circumstances. After making these predictable adjustments, allocating a portion of the increase across different accounts or departments is a common practice. 

For example, if a company's leadership intends to launch a new product, it may allow for a higher-than-usual rise in marketing spending. That would imply an increase in the budget for that function across the board. 

When faced with the status quo, other departments may perceive a flat budget or an increase specifically meant to keep up with inflation.

Advantages

The advantages of incremental budgeting are:

• It is simple to prepare and understand. It is also easily assigned to more junior members of staff
• It is less time-consuming
• Preparation expenditures are reduced when preparation time is reduced
• The use of a uniform methodology throughout the organization, along with the incremental nature of the budgeting process, helps prevent friction among departmental managers
• Change may have an immediate impact. For instance, in a hypothetical scenario, a $138k increase in staff expenditures at a school could be attributed to hiring two new staff members and implementing a 5% pay raise while keeping other aspects of the staff wages budget unchanged

Disadvantages

The drawbacks of the Incremental Budgeting Method are:

• As this type of budget is frequently expanded by a specific percentage year after year, this technique could encourage unnecessary expenditure
• This may cause departments to feel obligated to spend the entire budget, even if there has been no change in current spending. Some sectors may not need more expenditure monies, but they will be granted under this approach
•  Incremental budgeting is commonly utilized in various business settings, although it is more prevalent in conservative environments where innovation is less prioritized. Because modifications are done slowly, there is little room for creative development in new budgets based on prior-year data

Activity-Based Budgeting 

Budgets for specific activities are known as activity-based budgets. All expenditures are allocated to cost centers and subsequently assigned to activities in activity-based budgeting. The cost of a product or client is assigned depending on the quantity of activity used.

Activity-based budgeting is ideal for organizations that lack historical data to generate the following period's budget, such as newly established businesses or those undergoing expansion.

Advantages

The advantages of Activity-Based Budgeting are:

• A forward-looking perspective allows managers to allocate costs based on where improvements may be made instead of only using what was done in the prior period
• More likely to uncover inefficiencies in procedures or areas that require more or less money in the upcoming budget
• Because the budget adopts a top-down strategy that allows resources to follow an outcome or objective, it aids businesses in keeping themselves goal-oriented
• It is easier to make modifications based on climate or current events, and it aids in identifying capacity concerns

Disadvantages

The drawbacks of Activity-Based Budgeting are:

• Activity-based budgeting is a time-consuming and labor-intensive procedure that can become tedious and counterproductive if too much time is spent evaluating
• Skilled individuals in budgeting and financial planning are needed to identify gaps or overlaps
• Activity-based budgeting can occasionally lead to goal-oriented thinking that is too focused on the short term, and the larger picture can get lost in the process
• This strategy relies on future predictions that might be untrustworthy if the end outcomes do not turn out as expected. Additionally, incomplete and inadequately thought-out budgets may lead to significant cash flow concerns

Value Proposition Budgeting 

The third method is value proposition budgeting, which looks at each line item or budget category and asks, "Why are we spending this money?" and "How does it benefit our customers, staff, or other stakeholders?" 

This strategy strikes a balance between incremental and zero-based budgeting, the latter of which calls for managers to justify virtually every line item in the budget. 

In contrast to the activity-based approach, value proposition budgeting aims to justify spending based on value rather than solely focusing on a direct relationship with strategic goals.

Advantages

The advantages of the Value Proposition Budgeting Method are:

• This strategy assists executives in identifying items that add the most value and eliminating those that add no value or do not benefit the business idea statement
• Aids in the creation of significant differentiation between you and your rivals by recognizing the company's main value elements and assisting in emphasizing them for the following period
• By concentrating on how they can offer value to their customers, stakeholders, and workers, value proposition budgeting helps firms stay more customer-focused
• Businesses can concentrate their marketing efforts on activities that will yield the best results
• Excellent for in-depth budget analysis and reducing needless expenditure

Disadvantages

The drawbacks of the Value Proposition Budgeting Method are:"

• It might be difficult to quantify "value"
• This might lead to focusing on the short rather than the long term. Sometimes, objects are more complex than just determining their worth, which can lead to the elimination of significant items that do not have an additional benefit
• Value perception is not always permanent and might shift due to cultural, societal, economic, or technical variables

Zero-Based Budgeting 

Zero-based budgeting (ZBB) starts from scratch. Managers must determine their budgetary requirements for the future year and justify each line item without respect to previous years' numbers using this technique. 

Past expenditures do not automatically justify future spending under the zero-based budgeting approach. Budget owners must explain practically every planned spending under the zero-based approach. 

In this regard, ZBB is an effective tool for reducing needless spending. It enables business executives to aggressively trim bloated budgets and control expenditures while minimizing any adverse impact on operations.

Consequently, ZBB necessitates businesses to prioritize and adopt a deliberate approach to cost management, focusing on areas that offer the highest value to the organization. 

ZBB typically leads to innovations, enabling organizations to operate more efficiently by compelling management to analyze their expenditures and the value they provide carefully.

Advantages

The benefits of Zero-Based Budgeting are:

• Zero-based budgeting is ideal for firms that want to be more inventive and efficient
• ZBB requires a bottom-up budgeting approach for implementation, potentially leading to increased employee motivation
• It questions the existing quo and pushes managers to think critically
• Assists businesses in reducing expenses while minimizing any negative impact on operations

Disadvantages

The drawbacks of Zero-Based Budgeting are:

• Departmental managers may lack the skills needed to develop decision packages, necessitating training, which incurs time and financial costs
• The volume of documentation created by ZBB will be unmanageable in a large organization due to the vast number of activities
• It compels managers to consider every dollar spent within a budgeting period
• This strategy may prioritize short-term objectives and broader perspectives over long-term planning. For instance, critical areas like research and development, essential for long-term growth, may receive inadequate funding in the short term

Researched and authored by Kavya Sharma | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• 2/10 Net 30
• Accelerated Depreciation
• Activity-Based Budgeting
• Budgeting Software
• Zero-Based Budgeting