Types of Budgeting
When setting your budget, there are two main techniques that you can use:
1. Incremental budgeting
Incremental budgeting involves taking last year’s figure and adding a bit on for inflation or whatever, or even taking a bit off, due to perhaps, downsizing.
Example: Incremental budgeting
Jane is planning a night out with friends. Last month they went out and visited two pubs and a nightclub. Jane took £40, but ran out of money and had to walk home.
This time they are planning to go to the same places, so Jane decides to take £50 to be sure of being able to afford a cab home.
What do you think of Jane’s budgeting intentions? On the face of it, it seems quite sensible. But it doesn’t take into account the fact that Jane bought a couple of extra rounds, due to induced generosity, or that she gave a £10 note in the pub but got change from £5 - or even that she lost £5 or £10.
So, if Jane is more careful with her money this time, she could come home with £15 still in her pocket. That £15 had to come from somewhere, so at some point she has made a false economy in order to provide the cash for the night out.
Conversely, if one or two of her friends bought an extra round last time, or she paid for a round of drinks with £5 and received change from £10, she could still run out of cash!
The incremental approach to budgeting is still quite common, and indeed may be the one you choose. If you do use this method, however, bear in mind the potential problems as illustrated above.
2. Zero-base budgeting
With zero-base budgeting, you begin with no preconceptions. In principal, zero-base budgeting begins with the assumption that the function for which the budget is being prepared does not exist. In practice, however, it is generally based on the ‘survival’ level of expenditure as identified by (say) the department manager. This is the benchmark. Any requested expenditure above this level must be justified.
Example: Zero-base budgeting
Jane is preparing the budget for the administration team that she runs. She identifies her ‘survival’ level as herself plus two staff, each of whom will need a computer and an amount of stationery.
Jane is aware, however, of planned activity within the company that will impact upon her area. Consequently she requests an additional member of staff, computer and stationery allowance.
Once she has calculated the cost of this, she must justify the additional expense. This is done by describing the planned activity and estimating the impact it will have on her area.
This activity will be justified not only in Jane’s budget, but also in the budget of the manager whose intent it is to boost activity. If it is refused in his budget then, since they are dependent on one another, it will be refused in Jane’s, too. The converse is also true; if the activity goes ahead, Jane will get her extra resource.
Without such justification it is possible that one area’s request would be granted whilst the other was refused, resulting in either frantic activity or over-manning. Zero-base budgeting makes it easier to see the full cost of planned changes across the board.
So, with zero-base budgeting, units of cost are compared with units of benefit. It is possible that a need will exist for alternative budgets to be prepared, to compare the effects of alternative courses of action that may be followed - for example, do you continue to finance your own marketing, or do you contract it out? Do you employ a staff trainer directly, or do you buy in external training?
A major benefit of zero-base budgeting is that previous inaccuracies are not carried forward (as in the incremental budgeting example) but all costs are challenged and justified.