Eight budgeting processes and their pros and cons

Budgeting is a critical component of financial planning and one of the cornerstones of any successful business strategy. Budgets arm decision-makers with a robust foundation of fiscal insights, enabling leaders to make informed choices, whether it is about launching a new product, entering a new market, or making crucial operational changes.

By offering a tangible financial roadmap, budgeting facilitates proactive management, anticipating challenges and seizing opportunities. But is more than just allocating resources; it’s a strategic tool that, when used effectively, can propel a business to new heights.

With various budgeting methods available, how can an organisation determine the most appropriate one for its unique needs?

Here’s an overview of the 8 major budgeting types, the pros and cons of each as well as when to consider each method:

1. Traditional/Incremental Budgeting: A method that builds on the previous period’s budget (usually by adding incremental changes) to set the new budget. Its predictability is its strength.

• Pros:

1. Familiar and straightforward. It’s a tried and tested process.
2. Builds upon previous years’ budgets, making it relatively easy to prepare.

• Cons:

1. Can perpetuate inefficiencies from past budgets.
2. May not adapt well to rapidly changing business or market environments.

When to Consider: If the business environment is stable, and the company prefers a tried-and-tested method.

2. Zero-Based Budgeting (ZBB): A budgeting process where every expense must be justified for each new period, starting from a “zero base”. In this budget, every penny counts.

• Pros:

1. Encourages scrutiny of all expenses, potentially revealing inefficiencies.
2. Aligns spending with organisational objectives.

• Cons:

1. Time-consuming and resource intensive.
2. Can be difficult to implement, especially in larger organisations.

When to Consider: When an organisation is looking for a comprehensive financial review or is in a phase of restructuring.

3. Activity-Based Budgeting (ABB): A method that budgets based on the cost of activities required to produce a product or service, or with operational outputs.

• Pros:

1. Helps in strategic resource allocation and prioritisation.
2. Can provide a granular view of resource allocation.

• Cons:

1. Can be complex and time-consuming, which can deter its adoption.
2. Requires detailed analysis and understanding of processes and activities.

When to Consider: Useful for businesses keen on aligning their financial plans with operational activities or deliverables.

4. Value Proposition Budgeting: Budgeting that prioritises spending based on the expected return on investment (ROI) and value generation for the business.

• Pros:

1. Focuses on activities that add value to the business.
2. Prioritises spending based on the high return on investment activities.

• Cons:

1. Determining “value” can be subjective.
2. Might overlook necessary functions that don’t have immediate, tangible ROI.

When to Consider: For businesses looking to align budgeting closely with strategic objectives and value generation.

5. Rolling Forecasts (Continuous Budgeting): A dynamic or fluid budgeting approach that continuously updates by adding new periods (e.g., months or quarters) as the most recent period is completed.

• Pros:

1. Offers more flexibility as well as strategic alignment.
2. Allows businesses to rapidly adapt to changing conditions.

• Cons:

1. Requires regular updates, which can be resource intensive.
2. Might lead to short-term thinking.

When to Consider: In rapidly changing business environments where a fixed, annual budget might quickly become obsolete.

6. Project-Based Budgeting: Budgeting tailored to specific projects, detailing the income and expenses expected for each project. This approach is excellent for businesses running multiple projects simultaneously.

• Pros:

1. Ensures project-specific financial alignment.
2. Helps in allocating resources to individual projects effectively.

• Cons:

1. Not a holistic approach for the entire organisation.
2. Needs constant updates as project requirements change.

When to Consider: For businesses involved in numerous distinct projects, like construction firms or project-based tech companies.

7. Participatory Budgeting (or Bottom-Up Budgeting): A budgeting process where individual departments or teams contribute to the budget’s development. This approach promotes consensus across the business.

• Pros:

1. Engages different departments/teams, leading to more and diverse insights.
2. Increases ownership and commitment to the budget.

• Cons:

1. Can be a prolonged, time-consuming process.
2. Risks of inflated budget requests.

When to Consider: When you want to boost internal engagement in the budgeting process and tap into the insights of different employees.

8. Flexible Budgeting: A budget that adjusts based on actual levels of activity during a period, allowing for comparison with the budgeted performance.

• Pros:

1. Adjusts based on actual operational levels and provides real-time financial clarity.
2. Helps in a direct comparison of actual vs. budgeted performance.

• Cons:

1. Requires more sophisticated financial systems.
2. Might be more complex to prepare initially.

When to Consider: For industries with varying operational levels or periodic demand changes, like seasonal businesses

By understanding different budgeting methods, businesses can pick or combine approaches that align seamlessly with their objectives, ensuring not just fiscal discretion but also strategic clarity.

Five hybrid budgeting approaches to consider.

As business conditions and strategies evolve, leaders may also reassess and adapt their budgeting methods to stay aligned with their objectives. The combination approach aims to leverage the strengths of multiple methods while mitigating their respective weaknesses. Some budgeting approaches naturally complement each other.

Five examples of hybrid approaches to consider:

1. Traditional/Incremental with Zero-Based Budgeting (ZBB):

A hybrid approach could involve applying ZBB at specific intervals (e.g., every few years) while using incremental adjustments in the interim. This combines the thoroughness of ZBB with the efficiency of traditional budgeting.