What is Budgeting | Types, Examples, Advantages, Disadvantages – In the competitive world, budget plays a crucial role to organization’s survival and growth. Budget is majorly performed to control the cost and maximizing the profit of the organization. Further it also helps organization to prepare itself for the upcoming future and funding requirements. In this article on Budgeting, we discuss the following –
- What is Budgeting?
- Major Approaches of Budgeting
- Top – Down Approach of Budgeting
- Bottom – up Approach of Budgeting
- Other Approaches to Budgeting
What is Budgeting?
The budget is the plan which intends to figure out expected operations revenue and expenses of an organization for a future time period. In other words for a business entity budgeting is the process of preparing detailed statement of financial results that are projected for a certain period of time. Budgeting is to estimate the future while taking the management inputs considering internal and external factors of the organization.
In every organization, finance department plays a key role in preparation of budget in consultation with higher management. Budget is a document, which is referred for the health check of the organization during the budgeted period.
Budget is prepared to carry out various functions like planning activities, developing projects, testing and implementing programs etc. There are various such functions for which an entity prepare budget. Budgeting can increase the chances of making profits within the given environment and help decision making process of management.
The approach towards budget depends on the organizations phase. A new startup will have incremental budgeting or a Zero Base budgeting whereas a mature company may have Kaizen Budgeting or Base Budgeting. However the approaches can be divided into two major points as below;
Major Approaches of Budgeting
The above two budgeting approaches are major one and more and less either one is found in every organization. Both the approaches have their advantages and disadvantages. We can summaries these approaches towards budgeting as below;
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Top – Down Approach of Budgeting
In 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 for budget and inputs may have taken from the managers before it’s preparation but consideration to their suggestions for budget preparation is solely on management’s desecration.
Top – down budgeting begins with estimation of costs at higher level. The entire budget is divided in to 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 increase / decrease in salary cost, economic condition of the country etc.
- Past experience and current market conditions are key elements for the budget preparation. Management is expected to be in knowledge of current affairs of the market as well as past history of the organization.
- Management may take inputs from the managers at the initial preparation of budget. This will help the management to acknowledge the feelings of the lower staff and expectations at the organization level.
- Management while preparing the budget shall consider margin pressure, macroeconomic factors such as 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 of gap between the organizations.
- Management post their finalization of budget may again put the budget for managers inputs. Management may consider the inputs provided by the managers in the budget and finalise the same.
- Post finalization, management shall deploy the resources according to the target set by the budget and if required the budget shall be intimated to every small business unit / department.
Advantages of Top – Down Budgeting Approach
- Budget will have an overall corporate functional approach rather than divisional approach since management’s concern will be overall growth of the organization.
- Budget will be in the experienced hands and management if required can take help of outsider.
- Budget preparation will be fast and inter departmental issues shall be ignored.
- Budget will be aggressive towards the growth of the organization.
Disadvantage of Top- Down Budgeting Approach
- Managers / Lower management will be d-motivated as they don’t have ownership over the budget and tends to feel that management have set targets which are practically impossible.
- Top management may not have close information about the organization and that may impact their budget.
- Inter departmental 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.
- Budget shall be feared less accurate as the top level management cannot have idea of unit wise expenditures.
Top down Approach Budgeting Example
ABC Limited prepares their budget through Top- down Approach. The management, to increase the overall profitability of the organization sets a target for sales team to sell 12000 units at a lower price for the year. However the production unit does not have the capacity to produce 12000 units in a year and this may leads to a day to day clash between sales and production. If the management would have taken inputs from the production unit too this situation would not have been arise. On the other hand 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 line.
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In 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.
Bottom – up approach begins with 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 individual budgets. The finance department then consolidates the funding requirement of the entire organization and HR department shall consolidate resource required. 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 budget for the forthcoming period. They have been asked by the management for setting their own targets with regards to revenue as well as cost.
- Managers are expected to take in account market conditions and margin pressures while preparing budgets and help it to make more realistic.
- Managers are expected to go beyond the internal environment and prepare budget considering the external influencers as well.
- Managers than put the budget to the management for their review and approval. The budget shall have explanation for each and every item of the budget and if there is major variance from the previous period budget, that should be highlighted to the management with the explanation.
- Post their review and query resolution, the budget shall be finalized and implemented on every business unit.
Advantages of Bottom – Up Budgeting Approach
- The managers shall be motivated as the ownership of budget is in their hands.
- The budget will be more realistic as managers will have a better knowledge of the operations of the organization.
- Managers will be more committed towards 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.
- The budget can be quite accurate for the individual task which leads to overall accuracy over the total budget.
Disadvantage of Bottom – Up Budgeting Approach
- Budget may not be at par with the overall objective of the organization as it was been prepared by the managers on the business unit level.
- Budget preparation will be slow and dispute between inter department may arise.
- Management may lose the control over the organization’s forecasting.
- Managers may set targets which are easy to achieve to reduce pressure from them.
Bottom-up Approach Budgeting Example
At a lower price 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 too, but the overall profitability of the organization will take a hit as incentive given to production as well as sales team will sit into the cost. So the overall objective of the organization to maximize the profit will not suffice even if increase in sales and production.
Apart from the above there is some sub – approaches towards the budgets are also there. They are as below;
#1 – Incremental Budgeting
It is also called traditional method of budgeting whereby the budget is prepared by taking the current period’s budget as a benchmark, with incremental amounts then being added for the new budget period.
In Incremental Budgeting the figures of each expenditures and income starts with previous years actual numbers and adjusted for inflation, overall market growth and other factors management deems fit. For example in an organization total salary paid to employees in a particular year is $500,000. When the budget 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, in incremental budgeting 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 budget. The new numbers of every item shall be justified with proper reasoning and shall not be ad hoc figures.
This kind of budgeting helps the management to avoid traditional expenditures which are no longer required. As the base is zero, management can actually give a new thought to each and every item of expense and reassess the requirement or possible cost saving.
#3 – Base Budgeting (BB)
In BB, budget prepared to know how much expenditures will be there for 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 cash crunch. To cut costs the management may just prepare a budget for the survival and any expenditure over and above shall be cut off. For example – rent, electricity and basic staff are essential to run the company but training, picnic and celebration expenditures are not required for survival of the company.
#4 – Activity Based Budgeting (ABB)
In ABB, budget prepared with the intention to indentify 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 matured organization.
Activity based budgeting is a long exercise to find our cost of each and every activity in a large organization and assess the value addition of the same. This exercise also includes alternative procedure to perform the same activity or reaching to the same goal while reducing the cost. In almost every organization, directly or indirectly this budgeting is been prepared and performed. However it depends on the management’s focus to enlarge it or reduce to certain level.
#5 – Kaizen Budgeting
“Kaizen” means continuous improvement. A Kaizen Budget is designed for cost improvements and revenue maximization.
Kaizen is Japanese word which means continuous improvement of working practices, personal efficiencies etc. Kaizen budgeting is all about innovative methods to improve the organisation’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.