There's no single right way to budget a business—there are five common methods, and the best one depends on how stable your costs are and what you're planning this year. This guide breaks down each method with an example and its pros and cons, so you can pick the one that fits.
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 helps you make important financial decisions, like increasing marketing spend, 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 treats them as necessary. One industry survey found half of small businesses didn't create a formal budget in 2020. Skipping one can create challenges like missed revenue targets, unforeseen expenses, or limited access to cash.
The better you can read where your dollars end up each month, the more likely you are to succeed. Here are the five most common types of business budgets and their pros and cons.
5 business budgeting methods
The most commonly used business budgeting methods are:
Here's how they compare at a glance:
Method | Best for | Key tradeoff |
|---|---|---|
Incremental | Established businesses with stable, predictable costs | Fast and simple, but can carry forward waste |
Activity-based | New businesses or those making big operational changes | Precise and goal-driven, but time-consuming |
Zero-based | Cost-cutting or financial restructuring | Removes waste, but labor-intensive every cycle |
Value proposition | Organizations prioritizing customer/stakeholder value | Focuses spending on value, but value is hard to quantify |
Envelope | Controlling spending on top of any other method | Clear real-time visibility, less room for flexibility |
Each has its pros and cons, which we'll discuss in more detail.
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 year's budget.
Incremental budgeting example
The total salary bill for five gardeners at ABC Landscaping was $150,000. That year, ABC Landscaping had more work than it could handle, and its revenues were 20% above budget. The company now wants to prepare a salary budget for next year. Given the increased revenue, it plans to raise its salary spending by the same percentage—hiring an additional part-time gardener at $22,500/year and giving the current gardeners incremental raises of $1,500. These moves 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, 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 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 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:
Can lead to overspending versus being cash efficient.
Doesn't account for unforeseen changes or external factors.
Could discourage management from looking deeper into expenses and savings.
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—by cutting back on activities, eliminating unnecessary ones, or reducing costs for relevant cost-drivers.
Activity-based budgeting example
Let's say ABC Landscaping is expanding into interior painting, a new service that requires 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 need a dedicated marketing person to generate business, plus trained and experienced painters to provide the service.
Because there's no historical data on this service, the activity-based budget uses a top-down approach, working backwards from the revenue goal of $400,000.
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 can drum up business. Budget items 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 can be a great choice since you don't have the historical data required for methods like incremental budgeting.
Established companies without significant changes in their business activity each year may prefer traditional budgeting, as it requires less time, effort, and money and is often easier to calculate. Activity-based budgeting also suits companies undergoing material operational changes—shifts in the customer base or business lines, big changes in the locations of key partners, or expansion into a new 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, assigning resources based on a final result.
Activity-based budgeting cons:
A lengthy, time-consuming process where too much time can be spent on analysis.
Requires experts in budgeting and fiscal planning to find gaps and overlaps.
May lead to short-term thinking, leaving the big picture lost in the process.
Forecasting may be unreliable if results aren't as planned, which can cause cash flow issues if the budget isn't well thought out.
Zero-based budgeting
Zero-based budgeting starts your budget with a clean slate each year. 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, saving $31,000. When creating its zero-based budget, ABC Landscaping would mark only $9,000 ($40,000 − $31,000) as the expense budget for plant material.
The company also realizes it can cut back on ads. Instead of spending $8,000, they only need $3,000, so they 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 proposed expense. If an IT department wants to spend $25,000 on software for the year, they have to explain what they plan to buy and why.
But it's a great way to remove unnecessary costs and identify key expenses the company needs. Companies can also use zero-based budgeting when they urgently need to contain costs—for example, a financial restructuring that requires dramatically reducing the budget.
Zero-based budgeting pros:
An excellent way to remove wasteful spending.
Holds managers accountable for costs and streamlines inflated budgets.
Helps bring costs under control while minimizing 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.
Value proposition budgeting (VPB)
Also called priority-based budgeting, this method aims to ensure that everything included in the budget delivers value for the business and avoids unnecessary expenses.
> Get an in-depth look at value proposition budgeting here.
Value proposition budgeting involves three steps:
Determine the company's vision or preferred results
Identify the programs and services
Allocate resources to the programs
Value proposition budgeting example:
ABC Landscaping has to prioritize which of its services are most profitable. 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.
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 decide to allocate resources to increase the profitability of existing services, cut unprofitable ones, or introduce new ones. Whatever the course of action, the high-level vision is set first and dictates the budgeting decisions.
What are the advantages and disadvantages of value proposition budgeting?
Value proposition budgeting 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.
It's commonly seen in government spending. A city government may use this approach to decide which city services are most valuable for the community, then continue funding those while reducing lower-value services.
Value proposition budgeting pros:
Helps leaders identify the items that bring the most value and the ones that don't.
Helps differentiate your business by focusing on your key value points.
Keeps your business customer-centered by showing how you add value to customers, employees, and other stakeholders.
Concentrates your efforts on the activities that deliver the best results.
Value proposition budgeting cons:
Value can be difficult to quantify, which can lead to important items being cut.
Can lead to short-term rather than long-term thinking.
Perceived value may not be stable and can change with social, cultural, or economic factors.
Envelope budgeting
Envelope budgeting is more of a spending-control method than a 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 it.
> Tip: Get an in-depth overview of the envelope budgeting system here.
We don't mean using actual, physical envelopes in a business context, as people often did with household budgets (one envelope for groceries, one for rent, one for pocket money). 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 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 review each "envelope" every time you need to spend, you can spot problems quickly.
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
With so many budgeting methods available, which one should you use? Each has its pros and cons, and your choice depends on the unique needs of your business and your goals for each budget period.
No rule says you must use only one budgeting method. This year, you may not anticipate much change and can use incremental budgeting. Next year, you may launch a new product and ramp up marketing spend—in which case activity-based budgeting 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 the better the chances your business stays on track.
The role of bookkeeping and technology in budgeting
Many businesses use technology, especially automation, to budget and forecast more accurately. Two tools do most of the heavy lifting: reliable bookkeeping and a banking platform that shows you where your money is.
The only way to get accurate financial data is through reliable bookkeeping—whether you do it in-house or hire an online bookkeeping service. Accurate books produce the financial statements, expense tracking, and clean records that make budgeting (and tax time) far easier.
Relay makes your business spending more transparent by letting you create up to 20 individual checking accounts. The accounts serve the same purpose as old-fashioned envelopes, but they're assigned to business line items instead of household spending. Want a dedicated account for taxes? Done. Want to allocate your budget per account, or run a separate 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 and reliable.
A solid budget can help boost your business success
Today's business practices have come a long way from ledgers and adding machines. A solid, well-crafted business budget can put you firmly on the road to success—and versatile digital tools like online money management platforms and bookkeeping services help you stay on it.
Frequently asked questions
What are the 5 business budgeting methods?
The five most common business budgeting methods are incremental budgeting, activity-based budgeting, zero-based budgeting, value proposition (priority-based) budgeting, and envelope budgeting. The first four build the budget; envelope budgeting is a spending-control method you layer on top.
Which budgeting method is best for a small business?
It depends on your stability and plans. Incremental budgeting suits an established business with predictable costs. Activity-based or zero-based budgeting suits a new business, a big operational change, or a cost-cutting push. Envelope budgeting works alongside any of them to keep day-to-day spending in check.
What is the difference between incremental and zero-based budgeting?
Incremental budgeting starts from last year's numbers and adjusts them up or down. Zero-based budgeting starts from a blank slate and requires you to justify every expense from scratch. Incremental is faster; zero-based is more thorough at removing waste.
Can you use more than one budgeting method?
Yes. Many businesses switch methods year to year as circumstances change, and layer envelope budgeting on top of whichever method they use to control day-to-day spending.
