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Budgeting for business plays an important role in management control system. It gives a brief understanding of what are budgets, what are budgeting and its different methods i.e. zero-based, incremental, traditional and activity-based budgeting.
Before we understand the different types of budgeting methods, let us understand the meaning of budget.
What is a Budget?
A budget is a written estimation of the financial performance of a particular department, a specific project, a business unit or an organization. There are different budgeting methods in accounting.
What is Budgeting?
Primarily, the activity of preparing a budget is called budgeting. In many organizations, it is a separate department taking care of only preparation and implementation of budgets. The comparison of budgeted performance with actual performance provides an indication if something is going wrong and requires immediate attention.
The purpose of this article is to highlight different budgeting methods and procedures.
Types of Budgeting Methods
Listed below are the most popular types of business budgeting methods.
- Activity Based
What is Zero-Based Budgeting Method?
Zero-based budgeting is a commonly used method. In ZBB, current year’s budget is prepared from the scratch, without considering the budget of the previous year. For every financial period, a fresh budget is prepared taking the base as zero and resources allocated to each department is justified according to the expenses of that particular period. The ranking for allocation of resources is on the basis of priority of all the activities of the business. Though this method is time-consuming, it gives accurate results.
To have a detailed understanding of the method and its pros and cons visit – Zero Based Budgeting
What is Incremental Budgeting Method?
Incremental budgeting is a method where current year’s budget is prepared by making changes in the past year’s budget. The changes are in the form of addition or reduction of expenses to last year’s budget. In Incremental budgeting, the starting point for preparing a budget is prior period’s budget. The budgeting technique gives no priority to vital activities of a business. We simply adjust last year’s budget considering the inflation factor. This is a quick and easy method of preparing budgets.
For a detailed understanding of the advantages and disadvantages visit – Incremental Budgeting,
What is Traditional Budgeting Method?
Traditional budgeting is a budget preparation method which considers last year’s budget as the base. Current year’s budget is prepared by making changes to previous year’s budget by adjusting the expenses based on the inflation rate, consumer demand, market situation etc. Current year’s budget is prepared on the basis of the past year’s revenues and costs. Only those items in traditional budgets need to be justified which are over and above the last year’s budget. This technique is easy to prepare and implement barring some amount of rigidity as budgets once prepared, cannot change.
To have a detailed understanding of the method and its advantages and disadvantages visit – Traditional Budgeting.
What is Activity Based Budgeting Method?
Activity-based budgeting is a method where a budget is prepared after considering the cost drivers. It does not take into account last year’s budget. This method does an in-depth analysis of all the activities that incur the cost. The outcome of the research determines the allocation of resources to an activity. This method aligns the business activities with business goals. This helps in increasing the efficiency and profitability of a business.
To have a detailed understanding of the method and its advantages and disadvantages visit – Activity Based Budgeting.
Choosing a Method of Budgeting
These methodologies are suitable for every kind of business, but you need to compare and meticulously choose which budgeting technique fits right into your organization. The decision to select a particular method depends on a lot of factors like size of business, operations of a business, the focus of the business, competition in business, market situation, etc.
Like for example, zero-based and activity-based budgeting can be used in the businesses where there is stiff competition. Zero-based justifies and gives an explanation of each item of cost. Similarly, in activity-based, all the business functions are aligned with the business goals. This leads to the elimination of all the wasteful activities, resulting in cost savings. So in order to cut the cost of production and surviving the competition, zero-based budgeting and activity-based budgeting are the best choices.
Incremental and traditional budgeting methods can be used where there is limited fluctuation in the market price, consumer demand, etc. Since these methods of budgeting consider taking previous year’s budget as a base and doing only incremental changes like an adjustment for the inflation rate, consumer demand, market situation etc., these changes can be made in the market where the organization will not be much affected by the change in environment.
Same way, large-scale organizations generally do not opt for zero-based and activity-based budgeting, because these methods are costly and consume a lot of resources. Also here manager’s main focus is to prepare a good budget and because of that, the core activities of the business gets ignored.
In a nutshell, there are different methods of preparing budgets and there is no best method which fits all. Choice of method depends upon the type of business requirements.