7 TYPES OF BUDGETS: DETAIL EXPLANATION

Businesses prepare budgets for financial forecasts and performance evaluations. The Budget serves many purposes to any business including; Planning, Control, Performance measurement, motivation, and communication. Depending on the purpose and nature of the budget, it can be classified into different categories.

Management can take different approaches to the budget process. By nature or characteristics budgets can be divided into two categories:

Fixed budgets and Flexible budgets. By budgeting approach, a budget can be categorized into four broad categories:

  1. Incremental budgets
  2. Zero-based budgets
  3. Activity-based budgets
  4. rolling budgets

1) FIXED or STATIC BUDGETS:

In the traditional approach of budgeting, each activity of the business is supposed to remain static. Fixed budgets are allocated for each activity of business separately. As the name suggests fixed budgets are:

“Budgets that are supposed to remain the same regardless of the actual level of change in the activity”

This approach uses historic data and adjusts for expected inflation or deflation in the estimates. Once budgets are allocated, the management then makes sure to achieve the forecasted results. These types of budgets are most difficult to achieve as variances are bound to happen.

2) Flexible or Variable Budgets:

Flexible budgets are assigned to the activities by dividing them into fixed and variable costs. With this approach each activity can change the level of actual results; hence the budgeting can also be changed and adjusted.

In a rapidly changing business environment, variances are bound to happen. Flexible budgets allow adjusting at each activity level and help management achieve targets.

Flexible budgets also offer top management an overview of operating and planning variances, by comparing the revised budgets with the original and then with the actual results.

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Depending on the management style and hierarchy the budget types can be categorized as budgeting approaches.

3) Incremental Budgets:

In this approach, management starts with the previous year’s data, adds “increments” to previous budgets, and prepares the new budgets.

In this simple approach, the previous year’s performance is taken as a starting point and any variance adjustments are taken into account. This approach is suitable for a large business with a stable market share and static growth rates.

ADVANTAGESDISADVANTAGES
A traditional and easy method of budgeting doesn’t require complex skillDoes not challenge operational managers to achieve results beyond targets
Suitable for stable and uniform production facilities with a less changing environmentDoes not eliminate waste and idle activities
 Less useful for dynamic and rapidly changing business natures

4) Zero-based Budgeting:

This budgeting approach does not account for the previous activity level but rather takes each activity as the new one. In other words, it calls for the justification of each cost driver, and the level of activity is considered from zero. Zero-based budgeting takes form in stages from planning to allocation:

  • Each activity is defined individually at the management level
  • Each activity is then assigned costs and revenue attached to it
  • Activities are then evaluated and ranked for budget allocation priority
  • Based on the priority each activity is assigned budgets
ADVANTAGESDISADVANTAGES
Each activity cost needs to be justified, eliminating waste and reducing costsAssigning cost drivers to each activity requires special skills and time
Challenges staff to achieve operational efficiencies and achieve higher performance targetsOperational managers may not agree to the final performance appraisals
More responsive to external business environment than incremental budgetsIn stresses on short-term operational efficiencies
Resource allocations are more efficient 

5) Activity-Based Budgets:

Closely adapted from the activity-based costing method, which takes into account the variable overhead costs. It can be defined as “a budgeting method based on activity level and using cost drivers to identify variances”.

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Overhead costs form a large portion of the total unit cost of the product, cost drivers are the activities associated with these overhead costs.

Budgeting for activities in overheads can provide management with useful insights about the total costs and profitability of a product. This method of budgeting is particularly useful in manufacturing facilities with various products and levels of production.

ADVANTAGESDISADVANTAGES
Consistent with the activity-based costing method, emphasis on overhead costsOften considered a time-consuming practice
Stresses on cost “driver” rather than the activity itselfDifficult to identify each activity cost driver, as often cost drivers overlap
Offers better control of costs, hence improving favorable budget variancesLong-term or fixed overheads do not change frequently, hence do not account for any variances in the ABB method

6) Rolling Budgets:

Traditionally, budgets are prepared for one year or longer terms. A Fast-changing business environment demands quick responses to market changes. Often a seasonal demand or a new competitor’s entrant compels management to change the production levels.

A Rolling budget is kept continuously updated with each budgeting period expiring. This can often be “rolled” or updated as monthly or quarterly.

ADVANTAGESDISADVANTAGES
Offers continuous upgrades to the budgets hence keeping performance in checkIt is often time-consuming and requires special skills to update budgets so frequently
Provides more accurate and updated operational efficiency insightsOperational managers may not agree to the notion of an “on-demand” budgeting approach
Resources are allocated on-demand with varying needs that eliminate the uncertainty among lower management 

7) Beyond Budgeting Approach:

The modern approach to budgeting is to continuously change and adapt to the changes in the business environment with both internal and external factors.

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This approach calls for more flexibility, responsiveness, and a collective approach features often lacking in traditional budgeting.

This approach continuously updates budgets on a monthly or quarterly basis as in the rolling budget approach.

Key performance indicators and critical success factors eventually are monitored regularly, which provides robust performance and control measures to the management.

Some of the key factors differentiating beyond budgeting from traditional budgeting can be listed as:

Beyond BudgetingTraditional Budgeting
Continuous or rolling planning with monthly budget updatesFixed planning often budgets plans with yearly or longer terms
Decentralized controls towards the operational and lower managementCentralized controls towards the top-level management
Flexible planning, responding to market changes, and updated KPIsStatic or fixed planning focuses on achieving the set targets
Rolling nature of budgets means resource allocations are updated with demandsResource or budget allocations are fixed with yearly budgets