Back to Basics: Budgeting Methodologies

There are proponents of a myriad of budget methodologies and there are very legitimate arguments that can be made in support of their diverse opinions.* However, careful consideration should be given to the specific requirements of your organization and the level of resources available to manage the process.  The last thing you want to do is establish a complicated and difficult process without the organizational wherewithal to pull it off.  The chaos created under that scenario would do much more harm to the company (on many different levels) than any benefit that might be derived from the process.

1.            Zero Base budgeting, by definition, requires that each effort begin with a clean slate – at zero dollars.  The details for each line item are then built up based on the fundamentals associated with the specific requirements in support of an anticipated level of business.  There is no presumption that a service or function will be necessary for continuing operations.  Theoretically, any resources believed to be important in support of particular line items must be justified independently for each budget period.  Although it is expected that historical data or trends will not directly influence the current budget decisions, there are certain situations where allowances can be made for minimal operating requirements to be considered essential while still requiring the remaining portion of the line item be validated separately.

This approach is often used in governmental budgeting processes since it reduces the entitlement mentality when appropriations are being determined for the allocation of public funds.  It forces management for each program to re-justify the level of funding every budget year, and therefore, does not allow any inaccuracies of the past to directly affect the new budget.  At a minimum, it would appear to eliminate the “creep” that can occur in an incremental process when proper controls are not in place.

Although this approach is reasonable in the public arena because of the unique requirements of a political environment, it requires a substantial effort in researching and collecting data needed to complete the budget process.  The requirement for resources to support this effort seems to be quite onerous for any but the very largest private sector organizations.

2.            Activity Based budgeting is founded on the notion that certain cost drivers or major activities exist in any particular operation.  A driver could be anything that exists as a major activity in the business of the company (i.e. the processing of an order, a policy or a claim or, the presentation of a customer, a patient or a component for a certain service).  All of the costs associated with the specific drivers (direct materials, direct labor, administrative salaries, office expenses, telephone, any associated overhead, etc.) are compiled as a cost per unit of activity for the purpose of presenting the budget in terms of the company’s products or services being delivered at some expected level.  Each unit of activity would carry with it a specific and predetermined level of cost.

Depending on the number of individual drivers or the multiple variations resulting from unique characteristics in a specific driver (i.e. customers presenting for several different levels of service), you could have many smaller budgets developed somewhat independently.  The compilation of these various budgets would represent the total budget for the organization.  Once the information has been compiled, you must make certain that all cost components have been properly accounted for in the total and are representative of the company’s overall operating profile.

3.            Incremental budgeting assumes that a valid baseline exists in the line items of the company’s historical financial information.  Specific changes in conditions cause each respective line item to increase, decrease or possibly remain flat relative to the prior year(s).

This approach requires a disciplined effort of analysis in order to avoid any unjustified “creep” in the values associated with the prior years’ standards.  To make this process effective, each line item must be reviewed with the purpose of validating the underlying factors that make up the overall total.  For example, the application of some arbitrary “inflation factor” can grossly distort the results and seriously damage the potential of the organization through the pursuit of an improper target.

Although this method is most likely the least resource intensive to manage, without the proper controls there is the potential to allow errors from prior years to be perpetuated and anomalies in the numbers to be ignored going forward.  In order to avoid these problems, careful consideration must be given to the changes in the operating details of the company relative to the expected volume of business when developing the budget.

Only you can decide the most appropriate method for your business given the available resources and specific requirements of the organization.  Choose an effort that causes the organization to stretch a little and work to revise (improve) the process incrementally over time.  The point is to start at a level that does not cause unmanageable stress in the company.  If you persist in improving the process, you will continually reap benefits in the business. 

*The Profit Experts can help you sift through the method that works best for your business. Visit us to find out how.