Planning is an integral part of business and budgeting is a critical component of it. Budgeting is the process of creating a business plan setting goals, planning the means, resources, and roadmap to achieve the forecasted milestones, and thereafter measuring the performance against the forecasts. Many organizations consider the budget as their operational and financial guideline for the budget period.
In other words, a budget is a projection of anticipated revenue and expenses, cash flow, and financial position over a specified budget period in the future, mostly 1-2 years in the case of operating budgets and 3-5 years for capital budgets. Businesses, not-for-profit organizations, local bodies, governments, households, and other entities use budgeting as a planning and control tool in running their affairs. We will focus here on corporate budgeting, a financial control tool, which provides a plan of action for managers as well as acts as a point of performance comparison and analysis.
Types and Methods of Budgeting
A typical corporate budget has a master budget at the top that rolls up data from operating budgets, capital expenditure budgets, and cash budgets. Corporate budgets can be classified into several types depending on the criteria you use.
Types of budgets
The following are the common types of budgets in a corporate environment:
- Operating budget: Sales revenues and related expenses in the operations are forecasted in the form of an income statement. This could also include a sales budget, production budget, materials budget, and labor budget, among others.
- Capital budget: Capital budgets are meant for allocating funds for capital assets whose benefits are beyond one year, after evaluating the feasibility of investment.
- Cash budget: Cash budgets that are linked to operating and capital budgets help make decisions on the capital requirements and the sources for raising money, or where to allocate funds if there are excess internal funds.
Methods of budgeting
There are four popular methods of budgeting that companies adopt:
- Incremental: The previous period’s budget or actual is taken as the base and an anticipated percentage of change is either added or deducted to formulate the current budget. The adjustments are made for the change in the level of operations, inflation, overall market changes, price movements, and other relevant factors. It is the simplest budgeting method.
- Activity-based: Rather than depending on the historical data, operations or activities that drive revenues and related costs are identified and forecasted. This top-down approach is ideal for organizations that don’t have sufficient historical data or that are undergoing material changes that make historical data irrelevant.
- Value proposition: In this method, via media between incremental and zero-based methods, each cost is related to justify the value they propose for the business.
- Zero-based: Budgeting under this method starts from zero. It looks at each year’s budget as new, without getting influenced by past data.
The above types of budgets and methods of budgeting are not exhaustive lists. There are many different classifications based on different purposes and criteria.
What does Zero-Based Budgeting Mean?
Zero-based budgeting (ZBB) credits its origin to former Texas Instruments manager Peter Pyhrr who developed the concept in 1960. Harvard Business Review (HBR) ran his article on ZBB and later Jimmy Carter, the then-governor of Georgia, implemented it in the state in the 1970s. As the name suggests, a zero-based budget refers to planning and preparing the budget from scratch or zero bases every year or budgeting period, analyzing and justifying each revenue and cost component of the company, instead of making changes to the historical data as done in traditional budgeting,
The ZBB allows for a strategic, top-down approach that involves the review and justification of each and every component in the business that drives revenue and related costs. Simply put, it is a method for preparing a budget with zero bases without considering the current or previous business model and cost structure. ZBB prompts the decision-makers to look deep into the business as if they are budgeting for the first time. This eliminates prejudices and influences from past performance and data while forecasting the activities and functions for the upcoming period, thus making every budget a new budget from scratch.
How Zero-Based Budgeting (ZBB) Works?
In business, zero-based budgeting facilitates setting up high-level strategic objectives by correlating the goals to each functional activity of the organization. The goal for a budget period, typically the next year, is to decide and forecast the revenue, profit, and cash flow the company will make in the upcoming year. This is followed by identifying the elements and resources that will be needed for the business to achieve the goals set.
In this method, you are not basing your forecast and assumptions on past budgets or actuals. The review of variable expenses is pertinent, but what is more important is the need to revisit the fixed expenses and their changes on different capacity levels. For example, fixed expenses are fixed only up to a certain level and after that, they needed to be increased like the rent for a godown which will remain the same up to a certain capacity but will increase for a bigger one. Zero-based budgeting can help save costs, but It is an elaborate and resource-consuming process than traditional budgeting.
Traditional budgeting is typically done by increasing (sometimes decreasing) the revenue and associated expenses on previous budgets or actuals. It is done as a % of the increase in revenue and expenses. There is no justification for the arrived amounts. On the other hand, ZBB starts from zero and seeks explanations to justify the need for each expense element.
Example of Zero-Based Budgeting
Imagine that a company that is following a zero-based budgeting process observes that the cost of certain tasks that form part of the final project increases by 5% every year. In traditional budgeting, you will keep increasing the cost of the task component by 5% every year, but under zero-based budgeting that looks at it fresh every year, many solutions will be considered to address this. It can include evaluating the benefit of performing these tasks in-house, looking for alternative sources, and factoring it into the project pricing, among others.
Positives and Negatives of Zero-Based Budgeting
Zero-based budgeting offers many advantages including cost savings, flexibility, focus on business drivers, and strategic decisions. This method brings activities into focus by considering the most income-generating or profitable operations on the one hand and cost savings on the other hand. One major disadvantage is that it is time consuming and expensive to make. Examples of the minuses include the allocation of funds for operations with the best revenue, which is a short-term perspective, while not allocating funds for areas such as research and development that have a long-term objective.
Zero-based budgeting identifies alternative and efficient methods of allocating and utilizing resources. It can help reduce the cost and at the same time can affect the company and its culture. For example, the corporate culture of a company will suffer if all the expenses required for maintaining vibrant, collaborative, and positive employee relations in the company are curtailed due to a zero-based budgeting process. This can impact attrition rates and corporate brand perception.
A study by Accenture reported that only about 50% of companies can sustain cost savings for more than one to two years, and in such cases, traditional budgeting becomes ineffective. Zero-based budgeting can be successful if it is practiced in a collaborative and consensus-based approach within the company by considering the pluses and minuses of the method. As zero-based budgeting does not do budgeting by increasing or decreasing past results or budgets, insightful financial data would help make a useful budget that can guide the company in its financial management in the budget period.
Paci.ai, a unified finance management platform for SMBs, looks forward to tackling the backward-looking nature of accounting with its insights and predictor modules.
The insights module works on the concept of proactive messaging on trends (Income, expenses, cash flow, customers, and key notifications providing a small business with actionable insights at the right time.
The predictor module ( Coming soon), leverages historical data to simulate key but the day – to day decision-making on hiring, buying capital equipment, and planning promotions among others.