Types of Budgets: Which One is Right for You

Traditionally, most businesses approach budgeting utilizing many types of budgets as an adjustment to the status quo. The current year’s budget and year-to-date actuals usually serve as the starting point for next year’s budget. Although this is an entirely legitimate approach, it is only one of many types of budgeting processes that business leaders have at their disposal.

It’s important to understand the pros and cons of the different types of budgets before beginning your business budget process. There are several budgeting methods you may choose to use when developing your organization’s master budget, each with its own unique purpose. For example, you can create a static budget to measure your company’s financial health by comparing actual performance against forecast performance. At the same time, you can create a cash budget to track and plan cash inflows and outflows to avoid overspending and ensure your business always has sufficient funds for business operations. These are just two of the many budget types you can use when completing your financial planning and budgeting.

What is a Business Budget?

A budget is a financial plan that outlines an organization’s expected revenues, expenses, and resources over a specific period, usually a fiscal year. Businesses need budgets for a number of reasons, including:

• Business Planning: Budgets help businesses plan for future financial needs and ensure that they have sufficient funds to meet their goals and objectives.
• Resource Allocation: Budgets provide a framework for allocating resources efficiently, ensuring that money is spent where it is most needed and can generate the best returns.
• Performance Measurement: By comparing actual financial performance against the budget, businesses can measure their progress, identify areas where they are over or underperforming, and make necessary adjustments.
• Cost Control: Budgets help in monitoring and controlling costs, preventing overspending, and ensuring that expenses are kept in line with revenues.
• Strategic Planning: Budgets provide valuable information that aids in strategic decision-making, such as when to invest in new projects, expand operations, or cut costs.
• Risk Management: Budgets help businesses anticipate potential financial liabilities, plan for contingencies, and establish an emergency fund, thereby reducing the risk of unexpected financial shortfalls.
• Goal Setting: Budgets help set financial goals and targets, providing a benchmark for evaluating the success of short-term and long-term business strategies and initiatives.
• Funding and Investment: Budgets are essential for securing funding and investment, as they show investors and lenders that the business has a well-thought-out financial plan and can manage its finances effectively.

By projecting future financial performance, a business budget helps in planning for growth, controlling costs, allocating resources efficiently, and monitoring actual performance against the planned objectives.

What is the difference between a spending plan and a budget?

While both rely on your business balance sheet as a starting point, the main difference between a budget and a spending plan is intent. A budget is a detailed and structured financial plan focused on controlling spending and meeting specific financial goals. A spending plan is a more flexible and broad approach to managing money, focusing on aligning spending with priorities and goals without the rigidity of a traditional budget. Spending plans are often used to manage discretionary spending and can be adjusted as circumstances change. Budgets, on the other hand, are used for financial planning, control, and accountability, setting limits on spending in various categories.

What Type of Budget is Most Popular?

The most popular type of budget for businesses is the master budget, a comprehensive financial planning document that consolidates all the various individual budgets into one overarching budget. By including all budgeting data, including operating budget data, financial budget data, and capital expenditure budget data, the master budget provides business leaders with a holistic view of the organization’s health and performance. Executives can use the master budget to facilitate strategic planning, resource allocation, and performance evaluation across the organization.

In this article, we’ll explore all the methods of producing a budget, including the distinct advantages and disadvantages of each approach. We’ll also discuss the role of technology in facilitating a more efficient and thorough budgeting process for today’s organizations.

The 7 Main Types of Budgets

Budgeting is a critical financial tool used by organizations to allocate resources, plan for the future, and ensure financial stability. Among the various budgeting methods, seven main types stand out for their unique approaches and applications.

Each of these budgeting methods has its strengths and challenges, making them suitable for different organizational needs and financial strategies. By understanding these seven main types of budgets, businesses can choose the approach that best aligns with their goals and operational requirements.

Incremental Budgeting

The traditional approach referred to above is also known as  incremental budgeting. It generally starts with the previous year’s numbers as a baseline, often combining last year’s budget numbers with some year-to-date actuals and remaining projections. Those don’t necessarily become the budget per se; but they serve as a starting point from which you build the final budget.

The next step involves modifications to specific line items that involve predictable numbers, or line-items for which there are obvious, foreseeable changes. Interest expense on an amortized loan, for example, will steadily increase over time as the principal portion of each payment declines. Lease payments often remain steady over a period of years. In a few cases, managers may be aware of expense categories that will sharply decline or go away altogether.

After you make these more predictable changes, it’s common practice to apply a percentage of uplift across a range of accounts or departments. For example, if company leadership plans to roll out a new product, they may allow for a higher than normal increase in marketing expenditures. That would presumably call for an across-the-board uptick in budget for that department. Other departments, faced with status quo operations, might see a flat budget, or an increase intended only to keep up with inflation.

The primary advantage of incremental budgeting lies in its focus on what is changing. Broad-brush changes, such as increasing all personnel expenses by 3.1%, are relatively easy to make, and they don’t necessarily require a lot of thought or extensive discussion, which makes this method easier and less time-consuming.

The downside to this approach is that it tends to result in less discussion and debate. It doesn’t necessarily call upon business leaders to examine the details very closely. So, although you can accomplish incremental budgeting relatively quickly when compared to the other approaches in this article, it may be the least useful in terms of enforcing a highly disciplined approach to spending.

Advantages:

• Ease of Implementation: Incremental budgeting is relatively simple to apply, particularly in stable organizations where expenses don’t fluctuate dramatically year-over-year. The process is straightforward, as it builds on historical data and requires fewer resources compared to more complex budgeting methods.
• Stability and Predictability: This method offers stability, allowing departments to operate with a clear understanding of their financial boundaries. It’s particularly useful in sectors with steady growth or in organizations that value operational continuity.

Disadvantages:

• Risk of Entitlement and Inefficiency: One major downside of incremental budgeting is the potential for departments to view their budgets as entitlements, leading to complacency and a lack of scrutiny over spending. This can perpetuate inefficiencies, as there is no requirement to justify existing expenditures.
• Complacency and Lack of Innovation: The reliance on historical budgets can lead to complacency, as managers might not critically assess the necessity of each expense. This can stifle innovation, as there’s little incentive to explore cost-saving measures or new opportunities.

Activity-Based Budgeting

Activity-based budgeting (ABB) is a top-down approach that focuses on the key outcomes a business intends to achieve. It begins with the end in mind, then explores the question “What must we do as an organization to achieve our primary goals?” From there, ABB defines the necessary resources and activity levels required to support those objectives.

Consider an organization that has developed an innovative new technology, for example. It isn’t yet well-known in the marketplace, and its product requires a highly consultative sales process. If the organization’s goal is to produce $5 million in revenue in the coming year, it will need a direct sales force with the requisite technical experience and an outbound lead generation process to build an adequate funnel of prospective customers.

Working backward from the goal ($5 million in revenue), company leaders would establish the number of deals they need to close, the number of sales appointments they need to make, the size of the sales pipeline they need to generate, and so on. Each of those questions implies some amount of spending on staffing, services, technology, or other resources.

ABB tends to focus on strategic objectives and pays considerably less attention to expenditures that cannot be tied directly to high-level goals. As such, business leaders must be careful not to take the principles of ABB too far. You could discount or overlook departments that fail to produce specific, measurable outcomes in service of the company’s strategic objectives in the process. Nevertheless, ABB generally provides a higher level of strategic focus than the other approaches on this list.

Advantages:

• Accurate Cost Allocation: Activity-Based Budgeting (ABB) accurately assigns costs to the activities that drive expenses, providing a clearer understanding of what truly drives costs within the organization.
• Resource Optimization: By focusing on value-adding activities, ABB ensures resources are allocated more efficiently, helping organizations to streamline operations and reduce waste.

Disadvantages:

• Complex Implementation: ABB requires detailed tracking and analysis, making it complex and time-consuming to implement, especially for organizations not already familiar with this approach.
• High Resource Demands: The need for precise data and ongoing analysis means ABB can be resource-intensive, both in terms of time and cost, potentially requiring additional staffing and technology.

Value Proposition Budgeting

The third approach is value proposition budgeting, which examines each line-item or budget category to ask the questions: “Why are we spending this money?” and “What value does it provide to our customers, employees, or other stakeholders?” This approach is a happy medium, fitting between incremental budgeting (which, it can be argued, scrutinizes too little) and zero-based budgeting (which calls for managers to justify virtually every line item in the budget, as does the approach used below). Unlike the activity-based approach, value proposition budgeting seeks to justify expenses for the value they create, without requiring a direct link to strategic goals per se.

Advantages:

• Strategic Alignment: Value Proposition Budgeting ensures that every budgeted expense is directly tied to the organization’s value proposition, aligning spending with strategic goals and enhancing overall efficiency.
• Elimination of Non-Essential Costs: By justifying each expense based on its contribution to the value proposition, this method helps eliminate unnecessary costs, ensuring that resources are used where they add the most value.

Disadvantages:

• Subjectivity in Value Assessment: Determining the value contribution of certain expenses can be subjective, leading to potential disagreements or misalignment in budget allocation.
• Risk of Overemphasis on Short-Term Gains: The focus on immediate value may result in underfunding long-term investments that are critical for sustainable growth but may not have an immediate impact on the value proposition.

Zero-Based Budgeting

Zero-based budgeting (ZBB) starts with a blank slate. With this approach, managers must establish their budgetary requirements for the coming year and justify each line item without regard to prior years’ numbers. Just because the company spent money on a particular thing in the past doesn’t mean it should necessarily continue to do so in the future.

The zero-based approach requires that budget owners justify virtually every proposed expense. In this respect, ZBB is an excellent means of eliminating wasteful spending. It helps company leaders to aggressively streamline inflated budgets and to bring costs under control while minimizing any negative impact on operations.

In effect, ZBB forces companies to prioritize and take a more intentional approach to managing their costs, focusing on the areas that generate the highest value for the business. Because it forces managers to carefully consider what they are spending and how much value that spending produces, ZBB often results in new innovations, helping companies to run more efficiently.

Advantages:

• Cost Efficiency: Zero-Based Budgeting (ZBB) promotes cost efficiency by requiring all expenses to be justified from scratch each period, eliminating unnecessary or redundant expenditures.
• Focus on Current Needs: ZBB ensures that resources are allocated based on current business priorities and needs, rather than simply adjusting previous budgets, allowing for more dynamic and responsive financial planning.

Disadvantages:

• Time-Intensive: Implementing ZBB can be time-consuming and labor-intensive, as it requires a detailed justification of every expense, making it less suitable for organizations with limited resources or time constraints.
• Potential for Short-Term Focus: The intense scrutiny on justifying expenses may lead to an overemphasis on short-term cost savings at the expense of long-term strategic investments.

Driver-Based Budgeting

Driver-based budgeting (DBB) focuses primarily on the key variables that most dramatically impact business performance, and ties budget numbers to the physical resources necessary to achieve the company’s targets for each of those variables. These may include internal factors such as the total number of customers or subscribers, number of salespeople or distributors, or average revenue per customer. Variables might also include external factors such as total market size, commodity prices, or even weather conditions. DBB builds a budget based on key business objectives, baseline assumptions about external drivers, and a results-driven approach to internal business drivers.

If any of those input variables changes, you can adjust the budget relatively easily to suit those new conditions. For example, consider a ski resort business in which early-season and late-season business are especially dependent on weather conditions. An early onset of cold weather, especially if there’s an unseasonably large amount of snow early in the season, will undoubtedly affect revenue, as skiers flock to the slopes after a long off-season. That, in turn, impacts personnel requirements; not only for ski area operations, but also for lodging, restaurants, and other ancillary businesses that benefit from the good weather conditions. In this example, weather conditions constitute a key business driver that affects virtually everything else the company does.

DBB helps managers to identify the most important drivers that impact their business performance and to align budgeting and planning accordingly. It also ties business results very closely to outcomes as key drivers change. This results in greater accountability, and less room for managers to make excuses. DBB virtually eliminates the practice of “gaming the system” because it establishes a clear set of business rules in advance, which guides expectations and serves as a roadmap for performance as key variables affecting the organization change.

Advantages:

• Focus on Key Business Drivers: Driver-Based Budgeting emphasizes the most critical factors that impact business performance, allowing organizations to create more accurate and relevant budgets that align with key operational goals.
• Flexibility and Responsiveness: By linking budgets to specific business drivers (like sales volume or market conditions), this method allows for quicker adjustments in response to changes in the business environment, leading to more agile financial planning.

Disadvantages:

• Complexity in Identifying Drivers: Identifying and quantifying the key drivers that most significantly impact the business can be complex and requires in-depth analysis, which can be challenging for some organizations.
• Risk of Oversimplification: Over-reliance on a few key drivers may lead to oversimplification, potentially overlooking other important factors that also affect the business but are not captured by the identified drivers.

Flexible Budgeting

Flexible budgeting is a budgeting approach that adjusts budgeted expenditures based on levels of actual activity. Unlike a static budget, which remains fixed regardless of changes in activity levels, a flexible budget varies in response to changes in business conditions. It acknowledges that business activity can fluctuate, and the budget should reflect that.

There are two main components of a flexible budget: fixed costs, like employee salaries, and variable costs, like sales bonuses. While the fixed costs are constant, the variable costs change with activity level; the budget defines a rate per unit of activity (e.g., bonus paid per sale) which allows you to calculate the total variable cost for any given activity level.

Flexible budgets are designed to change in response to fluctuations in activity levels, allowing for a more accurate comparison of actual performance against budgeted performance. They rely heavily on scenario planning to create different budget forecasts for low, moderate, and high activity levels. This approach is more responsive and adaptive to changing business environments, helping businesses stay agile and better able to manage their resources in response to real-time changes.

Advantages:

• Adaptability to Changes: Flexible budgeting adjusts budget figures based on actual activity levels or business conditions, making it highly adaptable to fluctuations in revenue, production, or market demand. This flexibility helps organizations maintain accurate financial forecasts and better manage resources.
• Improved Cost Control: By allowing adjustments based on real-time data, flexible budgeting helps in controlling costs more effectively, as budgets can be recalibrated to reflect actual performance rather than fixed assumptions.

Disadvantages:

• Complexity in Management: Implementing and maintaining a flexible budget can be complex, as it requires continuous monitoring and updating of financial data, which can be resource-intensive and may require sophisticated financial software.
• Potential for Overadjustment: Frequent adjustments in response to short-term changes can lead to overreacting to minor fluctuations, which might detract from long-term strategic focus and stability.

Envelope Budgeting

Envelope budgeting is a simple, cash-based budgeting system that involves allocating physical cash into envelopes, each representing a specific spending category. While the traditional method uses physical envelopes and cash, some people use digital tools to replicate the envelope system. Budgeting apps can create virtual envelopes, each with a designated amount of money, and track spending within each category.

Envelope budgeting offers several benefits, such as spending control, increased awareness of spending habits, and better discipline by limiting expenditures to cash available in each envelope. This approach to budgeting is particularly useful for identifying areas of overspending and encouraging financial discipline. It does have its drawbacks, though; the envelope method is inherently inflexible and not ideal for highly variable incomes and expenses.

Envelope budgeting is primarily a personal finance method and may not be directly applicable to business applications due to its simplicity and cash-based nature; businesses often rely on credit cards, lines of credit, and digital payments. However, its core principles can be adapted for small businesses or specific business processes. While not using physical cash, a business could establish internal controls to restrict spending within predefined categories using dedicated accounts or project budgets.

The Role of Technology for Types of Budgets

Most companies default to using incremental budgeting, partly because it is familiar, but also because it has historically required considerably less effort than the other methods. That’s especially true if your organization is still using spreadsheets and email to manage the process. Even so, the process of producing an annual budget can be complicated, time consuming, and often cumbersome if you’re using old-fashioned methods.

Learn more about the challenges of spreadsheet-based budgeting with these resources from insightsoftware:

• Three Hidden Dangers of Spreadsheet Based Budgeting and Planning
• Hidden Dangers Lurking in Your Budgeting and Planning Process
• 3 Ways Bizview Solves Your Budgeting and Planning Challenges

Fortunately, technology is making planning and budgeting easier than ever before and is helping to avoid common budgeting problems. Regardless of which of these budgeting processes you choose, there are common requirements for collaboration and discussion, version control, and automated workflows that simply cannot be duplicated by passing spreadsheet files back and forth by email. And because spreadsheets generally aren’t updated with live data from your ERP system, budgets are typically built on old information or must be manually updated periodically.

Today’s global economy calls for business agility. Most companies today recognize that planning and budgeting should no longer be annual processes. Instead, business leaders must constantly monitor external conditions and make rapid adjustments to stay ahead of the competition.

If your organization wants to take planning and budgeting to the next level, insightsoftware can help. We offer a number of budgeting and planning solutions for your unique business needs. Featuring user-friendly web and Excel integrations, our budgeting software solutions empower you to plan frequently and accurately, and to build agility with rolling forecasts and scenario planning. Watch this webinar for a deep dive into the benefits of budgeting and planning software.

To learn more, read our whitepaper on how to select the right budgeting software for your needs or contact us to arrange a free demo.