Business Budgeting

5 Business Budgeting Methods: How to choose the right one?

Author

Paula Kehoe

Senior Writer, Red Rock Communications

If you want to stay on top of your cash flow and make a healthy profit, you need a business budget. 📝 Running a business without a budget is like traveling overseas without a map. You might get to where you need with help from strangers and sheer luck — but it’s not likely. There are different types of business budgeting methods, and in this article, we’ll help you choose the right one.💡

But first — what are the exact benefits of having a budget?

Why your business needs a budget

A budget is a plan that guides your spending throughout the year. It lets you track your cash and shows you where you want it to go. A budget can help you eliminate wasteful spending. 💰 And it can help you make important financial decisions, like increasing marketing and advertising spending, hiring staff or buying equipment.

In particular, a well-planned business budget will help you:

  • Forecast earnings and expenses

  • Set achievable financial goals

  • Predict fluctuations and keep you profitable

When you can prove you have a handle on your cash flow, you also increase your chances of winning over investors or obtaining a bank loan.

Budgets may seem like table stakes, but not every business owner thinks they’re necessary. One industry survey found half of the small businesses didn’t create a formal budget in 2020. By skipping one, you may create more challenges for yourself, like missed revenue targets, unforeseen expenses or limited access to capital, which can hurt your business.

The better you can “read” where your dollars and cents end up each month, the more likely you are to succeed. 📈

Here, we’ve broken down the five most common types of budgets in business and their pros and cons. Read on to learn which one is best for your business.

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5 business budgeting methods

The most commonly used business budgeting methods are:

  1. Incremental budgeting

  2. Activity-based budgeting

  3. Zero-based budgeting

  4. Value proposition budgeting

  5. Envelope budgeting

Each has its pros and cons, which we’ll discuss in more detail.

1. Incremental budgeting

The incremental budgeting method is perhaps the most commonly used. It’s simple and can be used for almost anything — departmental budgets, project budgets, salaries — as long as that activity has been performed in the past.

Incremental budgeting involves adding to or deducting from the previous year’s actuals by an increment or percentage to create the new or current year’s budget. ↕️

Incremental budgeting example

Let’s walk through an example: The total salary bill for five gardeners at ABC Landscaping in 2021 was $150,000. In 2021, ABC Landscaping had more work than it could handle, and its revenues were 20% above budget. ABC Landscaping now wants to prepare a salary budget for 2022. Given the increased revenue, the company plans to raise its salary spending by the same percentage. It’ll do this by hiring an additional, part-time gardener at $22,500/year and giving all the current gardeners incremental raises of $1,500. These moves will raise the total salary budget by 20%, or $30,000.

What are the advantages and disadvantages of incremental budgeting?

An incremental budget is most helpful if your business is established and you’re confident the budget will remain stable in the long term, with only slight changes. 🔭

Are you a start-up in a fairly new industry looking to create or disrupt a category? Then you may want to consider another budgeting model, as your costs may fluctuate annually while you find the fit between the market and your product.

Incremental budgeting pros:

  • Requires no complex calculations. Uses current numbers and adjusts them to account for inflation or revenue growth.

  • Saves time because of how simple it is to create and calculate.

  • The budget can remain fairly consistent over time.

  • Helps with funding stability because expenses are easy to predict annually.

  • Fewer internal challenges between departments, as the budget usually assigns equal incremental changes across the board.

Incremental budgeting cons:

  • This can lead to overspending versus being cash efficient.

  • Doesn’t account for unforeseen changes or external factors.

  • This could discourage management from looking deeper into expenses and savings.

2. Activity-based budgeting

Activity-based budgeting identifies, analyzes, records and forecasts business activities that cost money. Every activity that incurs a cost is examined for possible ways to create efficiencies and enhance profitability. A business can do this by cutting back on activities, eliminating unnecessary activities, or reducing costs for relevant cost-drivers.

Activity-based budgeting example:

Here’s an example: Let’s say ABC Landscaping is expanding into interior painting, a new service that’ll require extensive marketing.

ABC Landscaping’s goal is to generate $400,000 in revenue from this new service in the coming year. To do so, they’ll require a dedicated marketing person to generate business. They’ll also need trained and experienced painters to provide the new service.

Because there’s no historical data on this service, the activity-based budget will use a top-down approach. It will work backwards from the revenue goal of $400,000.

ABC Landscaping management will have to determine how many painting contracts they need to complete, how many sales pitches they need to make to get that many contracts, and what other marketing activities they can do to drum up business. 🤔

Basically, what will it take to make their revenue goal of $400,000? Budget items will include the cost of staffing, training, equipment and supplies, advertising and other key resources.

What are the advantages and disadvantages of activity-based budgeting?

If you’re a new company or start-up, activity-based budgeting could be a great choice since you don’t have the historical data required for other methods, like incremental budgeting.

However, established companies that don’t have significant changes in their business activity each year may prefer traditional budgeting as it requires less time, effort, money and is often easier to calculate than activity-based budgeting. 😌

Apart from newer companies, activity-based budgeting is also suitable for companies undergoing material operational changes. These could include changes to the customer base or business lines, a big shift in the locations of prominent exporters and importers, or expansion in a new business line.

Activity-based budgeting pros:

  • Better insights into operational costs.

  • Focuses on value-added activities.

  • Eliminates unnecessary activities to save costs.

  • Better decision-making, as costs will be more defined.

  • Stays goal-focused due to a top-down approach that assigns resources based on a final result or goal.

Activity-based budgeting cons:

  • A lengthy and time-consuming process where too much time can be spent on analysis.

  • Requires experts in budgeting and fiscal planning to find gaps and/or overlaps.

  • This may lead to short-term thinking, leaving the overall big picture lost in the process.

  • Forecasting may be unreliable if the results aren’t as planned. This can lead to serious cash flow issues if the budget isn’t well thought out.

3. Zero-based budgeting

Zero-based budgeting is starting your budget with a clean slate each year. With this budgeting approach, managers must generate their budget categories and items and justify each expense without reference to the previous year’s numbers. 📃

Zero-based budgeting example

Let’s say last year, ABC Landscaping purchased plant material wholesale from a supplier for $40,000.

While listing expenses for the upcoming year, management realizes they can grow their plant material for cheaper than the supplier’s price. Making their products will save them $31,000.

When creating its zero-based budget, ABC Landscaping would only mark $9,000 ($40,000 – $31,000) as the expense budget for the plant material.

The company also realizes it can cut back on ads. Instead of spending $8,000 in this example of zero-based budgeting, they only need to spend $3,000. They would mark $3,000 for ads.

What are the advantages and disadvantages of zero-based budgeting?

Zero-based budgeting is time-consuming because budget owners must explain every single proposed expense. For example, if an IT department wants to spend $25,000 on software for the year, they have to explain what software they plan to buy and why they need it. 💬

But it’s a great way to remove unnecessary costs and determine key expenses that the company needs. Companies can also use zero-based budgeting when they urgently have to contain costs. For example, your business is going through a financial restructuring that requires you to dramatically reduce the budget.

Zero-based budgeting pros:

  • An excellent way to remove wasteful spending.

  • Holds managers accountable for costs and aggressively streamlines inflated budgets.

  • Helps bring costs under control while minimizing any negative impact on operations.

Zero-based budgeting cons:

  • A time-consuming method that requires time, resources and review.

  • Rewards short-term thinking rather than long-term, big-picture thinking.

  • Some managers may try to squeeze more resources into their departments.

4. Value proposition budgeting

Also called priority-based budgeting, this method aims to ensure that everything that’s included in the budget delivers value for the business and avoids unnecessary expenses.

It’s done through three steps:

1. Determine the company’s vision or preferred results

2. Identify the programs and services

3. Allocate resources to the programs

Value proposition budgeting example:

Here’s an example: ABC Landscaping has to prioritize which of its services are most profitable for the company. ⚖️ With a priority-based budget, management can see that mowing and mulching are the company’s two least lucrative services—and may actually be unprofitable.

Let’s look at the cost of mowing five lawns in a day.

ABC Landscaping charges $30 for each property, so mowing five lawns generates $150 in revenue. By the time ABC Landscaping pays its employee $105 for seven hours of labor, $25 for lawn mower gas, and $20 to cover gas mileage, the balance is $0.

Depending on the company’s vision, ABC Landscaping may then decide to allocate resources to increase profitability of existing services, axe unprofitable services or introduce new ones.

Whatever the course of action, the high-level vision will be set first and will dictate the budgeting decisions.

What are the advantages and disadvantages of value proposition budgeting?

The value proposition budgeting method works well for businesses or organizations that are more conscious of their budget. They want to eliminate unproductive expenses and focus on creating what customers want most.

Value proposition budgeting is commonly seen in government spending. For instance, a city government may use this approach to decide which city services are most valuable for the community. 🏙️ It’ll then decide to continue funding those services while reducing other lower-value services.

Value proposition budgeting pros:

  • Helps leaders identify items that bring the most value and the ones that don’t.

  • Helps to differentiate your business from your competitors by focusing on your company’s key value points.

  • Helps your business stay more customer-centered by showing how you can add value to your customers, employees and other stakeholders.

  • Concentrate your efforts on the activities that’ll deliver the best results.

Value proposition budgeting cons:

  • Value can be difficult to quantify. This can lead to potentially important items being cut.

  • Can lead to thinking more short-term rather than long-term.

  • The perceived value may not always be stable and can change based on social, cultural or economic factors.

5. Envelope budgeting

Envelope budgeting is more like a spending-control method than an actual budgeting method. First, you use whichever method you prefer to prepare your budget. Then, you use the envelope method to keep control of your spending and stay within that budget. ☑️

We don’t mean using actual, physical envelopes in the business context, as people often did with their household budgets. (One envelope for grocery money, one for rent, one for pocket money, etc.)

Instead, it means creating separate accounts or “envelopes” for major line items. ✉️

With envelope budgeting, you get a very clear picture of your cash position, and how each major line item is performing against the plan, in real-time. You can digitize and automate this process with tools like the Relay money management platform. (More on that below.)

Envelope budgeting pros:

  • It’s very easy to see where your money is going.

  • Because you have to review each “envelope” every time you need to spend, you can spot problems quickly and move to nip them in the bud.

  • You can often isolate problem areas and prevent issues in one department from affecting another.

Envelope budgeting cons:

  • You can focus too closely on one problem area, without seeing the bigger picture.

  • There isn’t a lot of room for creativity or innovation.

  • How to choose a budgeting method

How to choose a budgeting method

With so many budgeting methods at your disposal, which one should you use? While each method has its pros and cons, your choice will depend on the unique needs of your business, and your goals for each budget period.

Also, no rule says you must use only one budgeting method. This year, you may not anticipate much change and can use the incremental budgeting method. Next year, you may launch a new product and ramp up marketing spending. In that case, the activity-based budgeting method is more ideal for that period. 🧠

Creating a budget is an involved process. The more time you put into it, the more accurate and beneficial the budget will be. And that means the better the chances are that your business will stay on track for success.

The role of bookkeeping and technology in budgeting

Today, many businesses look to harness technology, especially automation, to develop smarter ways to budget and forecast.

An online bookkeeper, like Bench, and a banking and money management platform, like Relay, can help by simplifying this entire process.

The only way to get accurate financial data is through reliable bookkeeping. If your business is growing and you don’t have time to learn bookkeeping essentials, try Bench. As North America’s largest bookkeeping service, they’ll do your books for you, all online. 📒

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In addition to compiling your business transactions for you, they’ll also give you easy-to-use software to produce financial statements, track expenses, and help make tax time a breeze.

Bench Dashboard

Relay makes your business spending more transparent by letting you create up to 20 individual checking accounts. The accounts have the same purpose as old-fashioned housekeeping envelopes, but they’re assigned to business items instead of household spending. Want a dedicated account for taxes? Done. Perhaps you want to allocate your budget per account. Do that, too. Want an account for payroll? All possible on Relay.

Relay can also auto-sync your banking data with your accounts payable software to make paying bills and reconciling accounts fast, easy, and reliable.

A solid budget can help boost your business success

Today’s business practices have come a long way from the days of ledgers and adding machines. Today, a solid, well-crafted business budget can put you firmly on the road to business success. And powerful, versatile digital tools like online money management platforms and bookkeeping services will help your business stay on that road.