What is Budgeting?
Budgeting refers to the process used by the companies in which the detailed projection of revenues and the expenses of the company for the future specific period of time are made considering the different internal as well as external factors prevailing at that time.
The budget is the plan which intends to figure out expected operations revenue and expenses of an organization for a future period. In other words, for business, entity budgeting is the process of preparing a detailed statement of financial results that are projected for a certain period. It is to estimate the future while taking the management inputs considering internal and external factors of the organization.
In every organization, the finance department plays a vital role in the preparation of the budget in consultation with higher management. It is a document, which is referred for the health check of the organization during the budgeted period.
The budget is prepared to carry out various functions like planning activities, developing projects, testing and implementing programs, etc. There are numerous such functions for which an entity prepares it. This can increase the chances of making profits within the given environment and help the decision-making process of management.
However, the approaches can be divided into two major points as below;
Top-Down Approach of Budgeting
In the top-down approach, the top management prepares the budget according to the objective of the organization and passes it on to the managers for implementations. The suggestion and inputs may have taken from the managers before it’s preparation, but consideration to their suggestions for such preparation is solely on management’s desecration.
Top-down budgeting begins with the estimation of costs at a higher level. The entire budget is divided into first-level tasks, and then below level task and then below level task.
- Management from previous trends and experiences estimates the cost and revenue while keeping internal as well as external influences in mind, such as an increase/decrease in salary cost, the economic condition of the country, etc.
- Experience and current market conditions are critical elements for budget preparation. Management is expected to be in knowledge of the current affairs of the market as well as the history of the organization.
- Management may take inputs from the managers at the initial preparation. This will help the management to acknowledge the feelings of the lower staff and expectations at the organization level.
- Management shall consider margin pressure, macroeconomic factors such as a change in tax legislation, as well as internal factors such as resource allocation.
- Management may also take a look over the peers and their budgets and profitability to compare the same with the organization. This will help to set targets for the organization and increase the margin or profitability and outperform in the market. The comparison with the peers may be at turnover level, cost level, or overall profitability level. This exercise helps management to find out the reasons for the gap between the organizations.
- Management posts their finalization of the budget may again put it for the manager’s inputs. Management may consider the inputs provided by the managers and finalize the same.
- Post finalization, management shall deploy the resources according to the target set by the budget and, if required, shall be intimated to every small business unit/department.
- It will have an overall corporate functional approach rather than a divisional approach since management’s concern will be the overall growth of the organization.
- It will be in the experienced hands, and management, if required, can take the help of an outsider.
- It will be fast and interdepartmental issues shall be ignored.
- It will be aggressive towards the growth of the organization.
- Managers / Lower management will be d-motivated as they don’t have ownership over the budget and tends to feel that management has set practically impossible targets.
- Top management may not have close information about the organization, and that may impact its budget.
- Interdepartmental communication will take a hit as they will have no idea how the management set targets for each of them.
- Management’s considerable time will go into this and may lose from the path of strategy.
- It is feared as less accurate as the top-level management cannot have the idea of unit wise expenditures.
ABC Limited prepares its budget through Top-down Approach. The management, to increase the overall profitability of the organization, sets a target for the sales team to sell 12000 units at a lower price for the year. However, the production unit cannot produce 12000 units in a year, and this may lead to a day to day clash between sales and production. If the management had taken inputs from the production unit too, this situation would not have arisen. On the other hand, the sales team has if achieved the target, they will expect a raise or incentive for their order book even though the same was not delivered due to lower production. The management may have to bear this cost without any addition in the top lineTop LineThe top line is the revenue earned by the business by selling goods or services, reported in the income statement for a defined period. .
Do have a look at this course on Financial Modeling, where you learn all about projecting Income statements, Balance sheets, and Cash flows along with its key business, revenue, and cost driversCost DriversA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity..
In the bottom-up approach, the managers shall prepare the department wise/business unit wise budget according to the information and past experiences and present the same to the management for their inputs and approval.
The bottom-up approach begins by identifying the different operations and tasks performed by the organization. Each unit of the organization shall disclose the resources and funds required by them in their budgets. The finance department then consolidates the funding requirement of the entire organization, and the HR department shall consolidate the resources needed. The combined budget shall be put up to the management for the approval.
- Managers from their past experiences and their involvement in the day to day business shall prepare a budget for the forthcoming period. The management has asked them to set their targets concerning revenue as well as cost.
- Managers are expected to take into account market conditions and margin pressures and help them to make it more realistic.
- Managers are expected to go beyond the internal environment and consider the external influencers as well.
- Managers then put the budget to the management for their review and approval. It shall have an explanation for every item, and if there is a significant variance from the previous period budget, that should be highlighted to the management with the explanation.
- Post their review and query resolution, it shall be finalized and implemented in every business unit.
- The managers shall be motivated as the ownership of the budget is in their hands.
- It will be more realistic as managers will have a better knowledge of the operations of the organization.
- Managers will be more committed to the organization and targets set by them as they are the owners of the same.
- Senior management will now only have to concentrate on the overall business strategy rather than a business unit wise.
- It can be quite accurate for the individual task, which leads to overall accuracy over the total budget.
- The budget may not be at par with the overall objective of the organization as it has been prepared by the managers on the business unit level.
- It may be slow, and disputes between inter-department may arise.
- Management may lose control over the organization’s forecasting.
- Managers may set targets that are easy to achieve to reduce pressure from them.
At a lower price, the sales team budgeted sale of 20000 units, and the same units budgeted by production too with the additional incentive to all the workers @ $1. Eventually, the sales team achieved the target at a lower price and production team also. Still, the overall profitability of the organization will take a hit as an incentive given to production, as well as a sales team, will sit into the cost. So the general aim of the organization to maximize the profit will not suffice even if the increase in sales and production.
Types of Budget
The approach towards budget depends on the organizations’ phase. A new startup will have incremental or a Zero Base budgeting, whereas a mature company may have Kaizen or Base Budgeting. Let us discuss the top 5 types of budgets –
#1 – Incremental Budgeting
This type of budgeting is also called as the traditional method whereby it is prepared by taking the current period’s budget as a benchmark, with incremental amounts then being added for the new period.
In Incremental Budgeting, the figures for each expenditure and income start with the previous year’s actual numbers and adjusted for inflation, overall market growth, and other factors management deem fit. For example, in an organization total salary paid to employees in a particular year is $500,000. When it is prepared for the next year, the management thing that they need five more new employees who will be paid $30,000 each and also an increment of 10 % to existing employees shall be given. Therefore, the budget for salary would be Rs. $700,000 ($500,000 + 10% raise to existing employees + ($30,000*5 new employees).
#2 – Zero Based Budgeting (ZBB)
In ZBB, all the numbers reset to zero and given a fresh thought over all the items of the budget. The new numbers of every item shall be justified with proper reasoning and shall not be ad hoc figures.
This type of budgeting helps the management to avoid traditional expenditures that are no longer required. As the base is zero, management can give a new thought to every item of expense and reassess the requirement or possible cost-saving.
#3 – Base Budgeting (BB)
This type of budget prepared to know how much expenditures will be there just to survive (going concern). However, any incremental spending over and above that level shall be justified on cost vis-a-vis benefit from the same.
It’s been generally prepared in companies running into a cash crunch. To cut costs, the management may just make a budget for the survival, and any expenditure over and above shall be cut off. For example – rent, electricity and primary staff are essential to run the company but training, picnic and celebration expenditures are not required for the survival of the company.
#4 – Activity Based Budgeting (ABB)
This type of budget is prepared with the intention to identify the operations which generate cost to the business and how can be the said cost reduced from the current level. This kind of budgeting is mostly used in a mature organization.
Activity-based budgetingActivity-based BudgetingActivity-based Budgeting is a budgeting process in which the firm first identifies, analyses, and researches the activities that determine the cost of the company and, based on the results, prepares the budget. is an extended exercise to find our cost of every activity in a large organization and assess the value addition of the same. This exercise also includes an alternative procedure to perform the same activity or reaching the same goal while reducing the cost. In almost every organization, directly or indirectly, this budgeting is prepared and performed. However, it depends on the management’s focus to enlarge it or reduce it to a certain level.
#5 – Kaizen Budgeting
“Kaizen” means continuous improvement, and this type of budget is designed for cost improvements and revenue maximizationRevenue MaximizationRevenue maximization is the method of maximizing a company's sales by employing methods such as advertising, sales promotion, demos and test samples, campaigns, references. It aims to capture a larger market share in an industry. Technically, revenue is maximized when MR (Marginal Revenue) equals zero..
Kaizen is a Japanese word that means continuous improvement of working practices, personal efficiencies, etc. Kaizen budgeting is all about innovative methods to improve the organization’s efficiency to deliver. Kaizen budgeting mostly uses by leading organizations, which has a long term approach, and short term cash outflow is not a big deal for them.
This article has been a guide to what is Budgeting and its meaning. Here we discuss the top 5 budgeting types along with its methods, advantages & disadvantages. You may learn more about financing from the following articles –