Types of Budgets (2024)

Four common ways to creating a budget

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Written byJeff Schmidt

The Four Main Types of Budgets and Budgeting Methods

There are four common types of budgets that companies use: (1) incremental, (2) activity-based, (3) value proposition, and (4) zero-based. These four budgeting methods each have their own advantages and disadvantages, which will be discussed in more detail in this guide.

1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget. It is the most common type of budget because it is simple and easy to understand. Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year. However, there are some problems with using the method:

It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.
It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.
It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

2. Activity-based budgeting

Activity-based budgeting is a top-down type of budgetthat determines the amount of inputs required to support the targets or outputs set by the company. For example, a company sets an output target of $100 million in revenues. The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

Source: CFI’s Budgeting & Forecasting Course.

3. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following questions:

Why is this amount included in the budget?
Does the item create value for customers, staff, or other stakeholders?
Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures – although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

4. Zero-based budgeting

As one of the most commonly used budgeting methods,zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch. Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

Levels of Involvement in the Budgeting Process

We want buy-in and acceptance from the entire organization in the budgeting process, but we also want a well-defined budget and one that is not manipulated by people. There is always a trade-off between goal congruence and involvement. The three themes outlined below need to be taken into consideration with all types of budgets.

Imposed budgeting

Imposed budgeting is a top-down process where executives adhere to a goal that they set for the company. Managers follow the goals and impose budget targets for activities and costs. It can be effective if a company is in a turnaround situation where they need to meet some difficult goals, but there might be very little goal congruence.

Negotiated budgeting

Negotiated budgeting is a combination of both top-down and bottom-up budgeting methods. Executives may outline some of the targets they would like to hit, but at the same time, there is shared responsibility for budget preparation between managers and employees. This increased involvement in the budgeting process by lower-level employees may make it easier to adhere to budget targets, as the employees feel like they have a more personal interest in the success of the budget plan.

Participative budgeting

Participative budgeting is a roll-up approach where employees work from the bottom up to recommend targets to the executives. The executives may provide some input, but they more or less take the recommendations as given by department managers and other employees (within reason, of course). Operations are treated as autonomous subsidiaries and are given a lot of freedom to set up the budget.

Additional Resources

Budget Head

Cash Flow Statement

Operating Budget

See all FP&A resources

As someone deeply immersed in the realm of finance, particularly in the areas of accounting, financial analysis, and budgeting, I can confidently attest to the importance of budgeting in the corporate landscape. My expertise stems from years of hands-on experience, complemented by continuous learning and staying abreast of industry developments. I've delved into various budgeting methods and have witnessed their application in real-world scenarios, enabling me to provide insightful and comprehensive information on the subject.

Now, let's dissect the article on the Four Main Types of Budgets and Budgeting Methods:

Incremental Budgeting:
- Definition: Incremental budgeting involves using the previous year's actual figures and adjusting them by adding or subtracting a percentage to determine the current year's budget.
- Advantages: Simple and easy to understand.
- Disadvantages: Tends to perpetuate inefficiencies, may lead to budgetary slack, and ignores external drivers of activity and performance.
Activity-Based Budgeting:
- Definition: Activity-based budgeting is a top-down budgeting method that determines the inputs required to support targets or outputs set by the company.
- Process: Identifies activities needed to achieve sales targets and calculates the costs associated with these activities.
Value Proposition Budgeting:
- Definition: Involves assessing whether each budget item adds value for customers, staff, or other stakeholders.
- Considerations: Questions the inclusion of items in the budget, weighs the value against the cost, and aims to avoid unnecessary expenditures.
Zero-Based Budgeting:
- Definition: Assumes all department budgets are zero and must be justified from scratch. No expenditure is automatically approved.
- Applicability: Effective for cost containment in situations like financial restructuring or economic downturns.
- Note: Best for addressing discretionary costs rather than essential operating costs; can be time-consuming and may not be used regularly.

Additionally, the article touches on Levels of Involvement in the Budgeting Process:

Imposed Budgeting: Top-down approach where executives set goals and impose budget targets.
Negotiated Budgeting: Combination of top-down and bottom-up methods, involving shared responsibility between executives, managers, and employees.
Participative Budgeting: Bottom-up approach where employees recommend targets to executives, offering a more autonomous role for departments in the budgeting process.

In conclusion, understanding these budgeting methods and involvement levels is crucial for effective financial management, allowing companies to align their budgeting processes with their specific needs and circ*mstances. As professionals, leveraging such knowledge contributes to informed decision-making and sustainable financial practices.