Traditional budgets are the most common and oldest forms of budgets. Traditional budgets are budgets prepared by a business based on its prior period’s budget.
When a business wants to develop a traditional budget or update it, it takes the previous period’s budget as a base and alters it to obtain an updated budget. This updated budget is, then, used in the next period.
The traditional budget of a business is updated based on several factors such as inflation rates, market demand, environmental factors, etc.
Mostly, traditional budgets are only incremented according to the applicable inflation rates while other factors are not considered unless these factors have significantly changed.
This makes the preparation of traditional relatively easy as compared to the other types of budgets, such as zero-based budgets, where everything businesses prepare everything from scratch.
How are traditional budgets prepared?
The traditional budgeting process is simple and starts from projecting the sale or revenues of a business. The process commences by considering the previous period’s budget and, afterwards, considers any changes to the expected revenues.
The business can compare its budgeted revenues for the last period with its actual results to check how much the variance is. Once the variation is determined, the business can also adjust any expectations gap in the new budget.
A business must first estimate its revenues and, then, based on those revenues estimate its expenses and their behaviour. For example, production costs, mostly variable by their behaviour, are directly dependent on the revenues of the business.
Therefore, the business must alter these production costs in line with its revenues. On the other hand, fixed costs, such as rent, will remain fixed and will be carried over to the next period unchanged.
If a business expects these fixed costs to grow, then it will increase these costs accordingly.
Once both the revenues and expenses of a business are estimated, the profits of the business can be estimated. The business will subtract its estimated costs from its estimated revenues to calculate the profit.
The business will also need to make multiple budgets for every department separately. Similarly, the business may delegate the preparation of departmental budgets to their respective managers.
However, these budgets will have to be reviewed by senior managers for any possible errors by the department managers. After the departmental budgets are ready, the business aggregates those budgets to get a budget for the business as a whole.
Who should use traditional budgets?
Generally, traditional budgets are more suitable for established businesses that are also stable. It is because as soon as there are significant changes within the business or its environment, the traditional budget may produce inconsistent results.
Traditional budgets are also more suited to smaller businesses as compared to larger businesses. This is mainly because traditional budgets do not require any expertise to prepare and can be easier and cheaper to prepare as compared to other types of budget.
Traditional budgets, as discussed above, also rely on the previous period’s data and may, therefore, not be suitable for startups. Similarly, businesses going through unstable periods may also find that traditional budgets are not suitable for them and should use zero-based budgets or activity-based budgets instead.
However, once startups have a base budget or once unstable businesses stabilize, they can start using traditional budgets as intended.
Advantages of Traditional Budgets
There are many advantages to traditional budgets for business. These advantages are as below.
1) Easy to implement
Traditional budgets, as discussed above, are easier to prepare and implement as compared to other types of budgets. This is because these budgets use the previous period’s budget as a base.
The managers and employees of a business are likely to understand traditional budgets better and do not require any specific training to adjust to traditional budgets.
2) Promotes decentralization
As mentioned above, businesses may allow departmental managers to prepare a budget for their respective departments. This allows the departments within a business to have greater control over their budgets, thus, promoting decentralization within the business.
Similarly, if a business has many branches across a geographical location, each branch can make its budget.
3) Provides a framework of control
Traditional budgets create a reference point for the activities of the business. This helps the managers of different departments or activities within a business understand their roles better and understand what the business expects from them.
Similarly, in cases of uncertainty, the traditional budget can be used as a reference. This allows for a business to use traditional budgets as a framework to control its performance.
Disadvantages of Traditional Budgets
While traditional budgets can be advantageous for most businesses, they can also have some disadvantages. These disadvantages are listed below.
1) Can be inflexible
The traditional budgeting process is carried out only once before the start of every period. Businesses do not revisit the budgeting process when changes occur during the period, thus, forcing managers to follow the same old budget.
This makes traditional budgets rigid and inflexible as they do not consider any changes.
2) Can be manipulated
As mentioned above, some businesses allow the managers of departments to make a traditional budget for their department which gives them more control over the budget than they should have.
Therefore, managers can inflate their expenses to get favorable results in the future or to create a budget slack. If the business does not have a robust budget review system, it can encourage manipulative behavior by the managers.
3) Carry on errors
Due to the fact the traditional budgets use the previous period’s budgets as a base, they can carry over undetected errors to the next periods.
This means that traditional budgets can also pile up undetected errors which will get carried on to upcoming periods without getting detected. Until the time they come to notice, traditional budgets will create unrealistic standards for the business.
Traditional budgets are budgets made based on prior period’s budgets. Traditional budgets are one of the most commonly used budgets within businesses.
Traditional budgets are prepared by first estimating the revenues of a business, then estimating the expenses of the business based on the estimated revenues and behavior of the expense and, lastly, calculating the profit of the business.
Traditional budgets are mostly used by established and stable businesses that have prior data to base the budget on.