Budgeting guide – part two: Different approaches to budgeting

With a recession now seemingly inevitable, our first piece in the budgeting best practice guide examined how to budget in uncertain times. That is, how often should budgets be put together, what data to include and how long a budget should take to prepare.

This second part looks at the most commonly used budgeting approaches. Your company’s budgeting needs may have changed recently. This could be due to developments around its size, corporate structure, geographical location/s, sector, business model and economic performance.

While turbulence and transformation create difficulty, it’s also an opportunity. Now is a good opportunity to revisit your budgeting processes with a fresh pair of eyes.

Every company is unique. So you will have different budgeting needs. You’ll also need to consider your approach based on where you are in your journey.

For example, newly formed companies are likely to take a zero-based approach due to holding minimal historical data. Whereas mature businesses may build out their budgets by updating actual figures from the previous year with an incremental budget.

Start with the master budget

You should start your budgeting for the year ahead with a master budget, irrespective of your approach. This is a projection of the fortunes of the overall company. It typically covers 12 months.

Large companies will likely split this out on a departmental basis to make line managers accountable for their divisions.

It is the most comprehensive type of budget. And it includes the three primary financial statements: the income statement, balance sheet and cash flow.

If you are putting your budget together on spreadsheets, link statements together on different tabs. This will make updates painless, as changes should feed through across all statements.

You should pay particular attention to cash flow. Negative cash balances should be treated seriously and may require external financing. Additionally, be mindful of breaching loan covenants that require cash balances to be maintained above specific levels.

Approaches to your master budget

Zero-based budget

A zero-based budget starts with the assumption that all figures are built from scratch.

This is suitable for new businesses that lack historic data. It’s also useful when finances are under severe pressure and spending needs to be kept to a minimum. If you are a venture-backed business with less than six months burn rate, you’ll need to do this to extend your runway to the next funding round.

In the current economic environment, it may be a good idea to lead with this strategy to force all employees to make a business case for spending. For example, marketing teams should not use their spend from the prior year as a given. Instead, they should tie planned expenditure against associated new sales.

A downside of zero-based budgeting is that it can be extremely time-consuming. So it’s a somewhat blunt (but effective) tool.

Incremental budget

A commonly used budget is the incremental budget. They are relatively easy to put together. And they are also simple to understand.

This approach takes last year’s actual performance figures. Then you add or subtract a certain percentage to the forthcoming 12 month period.

A common issue to look out for with incremental budgets is departments overstating the size of their budgets. Departmental leads may be tempted to do this to make it easier for their teams to perform within budget.

If your cost drivers have recently changed, you should be mindful of using the incremental approach. For example, if the cost of the raw components associated with your cost of sales increases, this will undermine the accuracy of budgets.

Rolling budget

Rolling budgets are maintained on an ongoing basis and are updated as each recent budget period is completed. Depending on your company’s size and nature, this could be monthly or quarterly.

For example, if you have a January-December annual period, prepare your initial budget January-December. When the January-March period passes, update the budget so that it runs from April to the following March.

Rolling budgets tend to be more accurate than annual budgets.  In a rolling budget, future periods are adjusted considering recent business performance.

However, they are more time-consuming to maintain. You should review your rolling budget frequently. Therefore, if this is an approach you are considering, ensure staff have sufficient bandwidth to update further iterations.

Static budgets 

Static budgets incorporate anticipated revenues and expenses over a specific period, and once they have been set are not adjusted. These are suitable if you have predictable inputs and outputs.

If your organisation is in the non-profit or educational sectors, static budgets may be appropriate as activity may be limited by restrictions related to donations and grants.

However, be aware that rising inflation means that it will be difficult to generate accurate static budgets due to costs being unpredictable

Flexible budgets

Flexible budgets take into account variations between static budgets and actual business performance. They will be relevant if you are in manufacturing or production.

Flexible budgets take into account recent activity levels (i.e. under or over-performance related to supply chain) and compare them to static budgets.

Variances are then used to update budgets to see what effect this will have on future output and/or sales. Flexible budgets don’t require fixed costs from static budgets to be updated, as they should remain constant.

Optimise with technology

Now armed with knowledge of the different budgeting approaches, it’s to put your plans into action. In the third part in our budgeting series, we’ll be looking at ways to use technology to streamline the creation of budgets, as well as tools to implement them effortlessly.