Whether your company is just starting out or facing a critical period of change, working with an established budget can help you minimize needless spending and maximize your profits.
In this post, we review the four most common budgeting methods and weigh their relative strengths and shortcomings to help your business find the process that best meets your needs.
Let's dive in.
How to size up the four standard budgeting methods and decide which is right for your team.
According to one survey, only about half of all small businesses operate with a fixed budget in place—but among those that do, few end up overspending. That means a little formal planning can go a long way when it comes to corporate finances.
There are many ways to put a budget together, and the strategy you choose will ultimately depend on factors like your company’s age, stage, size, industry, operational rhythms, and leadership style. Still, knowing what options are available to you and what they have to offer can help you identify the optimal path forward.
Method 1: Incremental budgeting
Incremental budgeting involves looking at your company’s historical financial data and adding or subtracting a set amount to the budget for the next fiscal period. That means the funds you assign each department or expense channel will depend on their past performance and anticipated needs, as well as foreseeable economic measures like inflation.
For example, if your manufacturing company spent more than expected on your steel supply last year, you’d adjust your numbers accordingly and budget more for raw materials this year.
- Pros: Incremental budgeting is quick and easy since you don’t have to come up with elaborate algorithms or do anything more than arithmetic to create a new budget.
- Cons: This method can be limiting, as it doesn’t ask why any discrepancies occurred, consider external factors like supply chain issues, or work to cut costs. It may even encourage bad behavior since departments could overspend just to secure the same or higher budget next year.
- The bottom line: Incremental budgeting is a simple, effective method if your costs don’t change much year over year. That makes it a good choice for established companies with a stable history of expenditures and predictable financial and operational patterns.
Method 2: Zero-based budgeting (ZBB)
Unlike an incremental system, zero-based budgeting wipes the slate clean with each new fiscal period and rebuilds departmental budgets from the ground up. As the name implies, each department starts at zero and must justify every projected cost to build up its resources.
For instance, if your marketing department wants a budget for digital ad spend, they’d need to break their expenses down line by line and show how paying distribution channels like Facebook and Google help your company succeed.
- Pros: Zero-based budgeting is thorough and granular, easily rooting out discretionary expenses that are not essential to your business’s operations or supporting its growth.
- Cons: Since department managers have to start from scratch every time to defend their budgets, this process can get tedious and time-consuming, eating away at their productivity and morale.
- The bottom line: Zero-based budgeting is direct and efficient when it comes to cutting costs—but it takes a lot of effort. It’s best used intermittently if/when you’re facing a major market shift, significant expansion, or corporate reorganization and need to tighten your belt.
Method 3: Value-proposition budgeting
Also called priority-based budgeting, this method strikes a balance between the incremental and zero-based processes outlined above. With a value-led approach, you consider each expense individually and assess whether its overall value to your business warrants its overall cost.
For example, you might scrutinize the cost of staffing and maintaining a customer service line in order to gauge the value it offers clients and the competitive edge it offers your business. In the end, you may find it’s a top-performing program and decide to continue or even increase its annual budget.
- Pros: Value-proposition budgeting helps you recognize the most (and least) productive elements of your business and allocate resources to match, ensuring you’re spending on the things that matter and contribute the most.
- Cons: “Value” isn’t always easy to quantify. You’ll need to align your team around what it means for your business and then apply that standard consistently. You’ll also need to have a solid long-term vision, so you’re not just prioritizing programs that yield immediate results.
- The bottom line: Budgeting based on value is a good solution if you need to take holistic stock of your business, have one or more strategic, high-level goals in mind, and want to become more intentional with your spending to meet them.
Method 4: Activity-based budgeting (ABB)
Activity-based budgeting means carefully analyzing your operational activities to predict and reduce future costs. It involves identifying the cost drivers (like staffing, work hours, and materials) behind each activity, evaluating how many units of each you need to meet your goals, and then calculating the total cost per unit.
For instance, if you’re in sales, you may expect 10,000 orders for a given period. If you find it takes $10 in labor and materials to fill each order, then you would need a 10,000 x $10 = $100,000 budget to meet your product needs.
- Pros: Activity-based budgeting takes a forward- rather than backward-looking or historical view. It breaks transactions down in precise, digestible terms, allows you to see where every dollar is spent and why, and makes it easy to cut costs in a practical way.
- Cons: ABB includes extensive research and analysis and can get quite laborious and costly. You’ll need an expert team of accountants you can rely on who understand the ins and outs of your business operations and industry.
- The bottom line: Because it’s a large, specialized, and expensive undertaking, activity-based budgeting is generally best for companies truly looking to overhaul their finances. But if you’re in a lucrative, well-established industry like manufacturing and have significant revenue to manage, it can give you the detailed insights you need to propel your business forward.
Tailoring budgeting methods to your needs
Just because one of these processes is right for your company right now doesn’t mean you’re stuck with it forever. As you scale and evolve, so will how you set and manage your budget. You may even find that your business falls into seasonal rhythms, with different operational and material costs at different times of the year, requiring you to adjust your methods as needs arise.
Taking a flexible approach to budgeting can help your team stay agile, easily adapt to market shifts, and respond to sudden challenges without harming your finances. Of course, you’ll also face a lot of trial and error and need the right support to roll with the punches.
Integrating with capable expense management solutions can help you gain greater visibility into company-wide costs, set relevant and achievable goals, and take control of your spending. When it comes to something as important as your finances, you want to know you’re not only using the best budgeting method but that you have the right tools in place to implement it effectively.
How Rho can help
Rho offers integrated budgeting tools as part of an all-in-one spend management platform, helping modern businesses track and analyze costs across vendors, expense channels, and departments.
Reach out to one of our specialists to learn what a tech-forward solution can do for your business.
Get in touch