Budgeting Models, Types, pros & cons

Budgeting Models

One of the most significant aspects of financial management in an individual’s as well as that of an organization is budgeting. 

It will help the user utilize the available resources, measure their financial performance, and establish plans for further goals. 

Throughout time, numerous budgeting models have been established to suit a variety of requirements, environments, and financial objectives. 

This article will explore different budgeting models, types, advantages, and disadvantages of each, with a comparison chart to help determine the best fit for any particular situation.

Introduction to Budgeting Models

Budgeting models also provide structures which the financial resources are organized, managed, and controlled. 

When a budgeting model is carefully designed, this allows the organization to allocate all revenues and undertakings while aligning it with strategic goals and ensuring adequate allocation of everything. Other organizations use other budgeting models depending on their needs or constraints.

Types of Budgeting Models

This comes after categorizing different budgeting models according to how they are designed, flexible to use, or controlled. Other types include,

1. Incremental Budgeting
2. Zero-Based Budgeting
3. Flexible Budgeting
4. Activity-Based Budgeting
5. Value-Proposition Budgeting
6. Rolling Budgeting
7. Performance-Based Budgeting
8. Top-Down Budgeting
9. Bottom-Up Budgeting

Each model provides its own inherent characteristics, advantage, and limitations, which sets it apart based on the various contexts.

1. Incremental Budgeting

One of the most ancient and common forms is incremental budgeting. In that approach, an incremented base budget, derived from a previous period budget, is usually adopted. 

That increment could cover inflationary variation, introduction of new projects, or changes anticipated in revenues or expenses.

Pros

The model is quite appreciable in its simplicity: The process does not seem to be difficult and confusing; Continuity: the base on which it relies ensures stability and not being disjointed by change.

Time-Efficient: Less time and energy is needed in preparation as most items are rolled over.

Cons:

Lack of Innovation: It tends to promote inefficiency as it is a step-by-step improvement and fails to recognize changing priorities.

Promotes Expenditure: It encourages departments to spend the entire amount budgeted so that similar provisions are done the following year.

Does Not Question Existing Priorities: It does not question existing expenses or programs.

2. Zero-Based Budgeting (ZBB)

In Zero-Based Budgeting, every budget cycle begins at zero, meaning that no budget line is automatically continued from the past period. 

Each expense must be justified by its need and worth, regardless of any past spending habit.

Pros

Cost Efficiency: It forces managers to reconsider all expenses and eliminate inefficiencies.

Focus on Priorities: ZBB ensures resources are allocated to the most important areas, promoting a strategic approach.

Reduces Waste: It can save much cost by eliminating unnecessary or obsolete activities.

Cons

Time-Consuming: ZBB is time and effort consuming since it must justify every expense.

Complexity: It can be more complicated to administer than incremental budgeting, especially in large organizations.

Resource Intensive: This method requires much effort from all levels of management and can lead to budgeting fatigue.

3. Flexible Budget

The flexible budget adapts the budget by modifying with changed levels of activity or changes in actual revenues. 

The flexible budgets, unlike standard fixed-period budget, are altered by adjusting according to actual performance levels.

Pros

Adaptability: It helps flexibility by making room to adapt and modify in changed business conditions

Better Control: This way adjustments could be taken place on actual grounds with improvement over managerial decision.

Reflects Real Performance: This model provides better comparisons between budgeted and actual figures.

Cons:

Difficult to Prepare: It demands constant monitoring and updating of actual performance data.

Requires Accurate Forecasting: For this model to work effectively, businesses need to predict variables accurately, which can be challenging.

Not Suitable for All Industries: This will not suit some industries that lack flexibility in doing this on frequent times.

4. Activity-Based Budgeting (ABB)

Activity-Based Budgeting concentrates on the costs incurred for the activities that produce goods or services.

Pros

Costing Accurate: As this model emphasizes activities, ABB helps better identify and allocate overhead costs.

Costs Align with Activities: It links every activity to costs such that business organizations may understand their cost drivers.

Increased Transparency: Managers gain better insight into the relationship between costs and activities.

Cons:

Complexity: The model can be difficult to implement in organizations with many different activities and departments.

Requires Detailed Information: Successful implementation of ABB requires detailed and accurate data, which can be time-consuming to gather.

Not Flexible: Once the activities are identified and budgets are set, making adjustments can be difficult.

5. Value-Proposition Budgeting

Value-Proposition Budgeting focuses on ensuring that the amount allocated in a budget is tied to the value or benefit a specific program or project can deliver. 

It determines if an investment or cost is helping to achieve an organization’s objectives.

Pros

Strategic Alignment: Helps in the strategic allocation of funds towards activities with maximum value generation.

Performance-Oriented: Initiatives are prioritized on the basis of ROI or their effectiveness.

Clearly Defined Objectives: Helps define and track value-based objectives in an organization.

Cons

Accurate metrics: The concept heavily depends on having an accurate set of metrics that help to measure the value. Such a thing may not be defined in many places.

Time-Consuming: Value proposition analysis of every project or expense requires much time.

Complex Decisions: Value-based decisions may seem subjective and take considerable intangible effort to consider.

6. Rolling Budgeting

Rolling budgeting refers to a budget that is regularly updated for a specific period, usually a month or a quarter. 

A rolling budget, therefore, replaces the static annual budget with adjustments to changes and extended planning horizons on a periodic basis.

Pros:

Constant Reassessment: Because the budget is constantly updated, it provides a correct, up-to-date financial plan.

Forward-Looking: It enables businesses to make plans ahead of time by continuously adding new months or quarters.

Flexibility: The rolling nature makes it easier for businesses to react to unexpected events.

Cons

Resource Intensive: It requires constant effort to have a rolling budget, and thus is resource-intensive.

Complexity: This is especially true for large organizations; it becomes challenging to implement and monitor.

Risk of Over-Focus on Short-Term: The rolling budgets risk focusing more on short-term gains at the expense of long-term goals.

7. Performance-Based Budgeting

Performance-based budgeting is a method that relates appropriation of funds with some measurable output or performance results. 

The model is often utilized by government agencies with the intention of ensuring the utilization of funds for programs whose performance meets desired performance objectives.

Pros

High Accountability: Resources are channeled based on performance results.

Efficiency Orientation: Program managers are inclined towards resource use in order to have said outcomes.

Aligns with Long Term Objectives: It allows the organization to monitor program performance for a particular period.

Cons

Performance Measurement Complexity: Some programs, especially those in the public sector, are not measured by specific performance standards.

Short Term Orientation: Performance-based budgeting may cause organizations to focus more on short-term accomplishments and less on long-term strategic planning.

Opportunities for Misalignment: The performance measures selected may not align with the overall objectives of the organization.

8. Top-Down Budgeting

Top-down budgeting refers to a process in which senior management determines a total budget to be allocated downward to departments or units. 

It is typical in large organizations whereby top managers provide the financial guidance for the organization.

Advantages

Centralized Control: Senior management exercises control over the financial guidance of the organization.

Clear Direction: The budget clearly reflects the overall strategy and objectives of the organization.

Fast Process: As fewer numbers of people have to decide, thus faster.

Advantages:

Lower Involvement: Departments or low-level managers might be bypassed in decisions that lead to low morale and no ownership

Alienated from the ground reality: the top management feels out of the touch with departmental operational requirement

Not an Adaptive Process: Cannot be locally or departmentally attuned

9. Bottom-up Budgeting

In bottom-up budgeting, managers are involved at all levels of the organization. Lower-level managers are asked what their departments require, and then an aggregate budget is developed.

Pros

Employee Acceptance: Participation in budgeting can make the employees more committed.

Rich Information: The needs of department managers are better known, so they can better forecast their needs.

Motivation: This can boost motivation because employees are more empowered with decision-making authority.

Cons

Time-Consuming: Because input from many levels of the organization is needed, the process may take longer to complete.

Risk of Inefficiencies: Some departments might inflate their budgets or request more than what is needed, which would not be a priority for the organization.

Poor Strategic Direction: Without proper senior management guidance, the budgeting process may not align with company strategic goals.

Conclusion

The right budgeting model is mostly determined by the nature of the organization, the financial goals it has, and the operational environment. Each model has its specific advantages and disadvantages, and understanding them can help managers make better decisions.

For example, organizations concerned with efficiency and cost could apply Zero-Based Budgeting, while those needing flexibility might prefer a Rolling Budget. 

The same is true for performance-based budgets, which are applied best when there is a need to connect investments directly with outcomes. 

It will generally depend on the organization or individual’s own specific needs, culture, and financial goals that determine the best practice.

Knowing different budgeting models and their advantages and disadvantages with comparison charts would guide managers into strategic decisions compatible with the financial objectives of their organization as well as with their operational requirements.

Summary:

Budgeting models are guidelines that help an organization guide its resources and allocate them appropriately to manage the finances of an organization. 

Types of budgeting models include Incremental, Zero-Based, Flexible, Activity-Based, Value-Proposition, Rolling, Performance-Based, Top-Down, and Bottom-Up. 

Each of these has pros and cons; some are best suited for stable organizations, while others are best suited for flexible, performance-based, or activity-driven organizations. 

The right model depends on the goals, complexity, and operational needs of the organization.

Frequently Asked Questions

• What is Incremental Budgeting?

It is a budgeting technique that adds small changes from the previous year’s budget for the new cycle.

• What is Zero-Based Budgeting?

Zero-Based Budgeting necessitates that one starts the budget from scratch at the end of every cycle with a justification of every expense.

• What are the advantages of Flexible Budgeting?

It responds to changing circumstances and gives current financial information.

• What is Activity-Based Budgeting (ABB)?

ABB distributes costs based on the cost of activities to produce goods or services.

• What is Bottom-Up Budgeting?

Bottom-Up Budgeting requires lower-level managers to contribute input, hence making it very inclusive but also time-consuming.