2 Different Types of Budgeting — Super Business Manager

The most widely used types of budgeting include:

Fixed Budgeting: Zero Budgeting and Incremental Budgeting
Flexible Budgeting

While budgets are not forecasting per se, they are indeed very often based on future sales forecasts. In fact, budgets are very clear, specific and measurable targets for different departments and divisions in the organization to achieve in the near future.

SMART Budgeting – How to Do It?

Two different approaches to budgeting in details

Let’s take a look at each of different types of budgeting in details. The way in which business budgets are created and used largely depends on the firm’s business objectives and its corporate culture.

1. Fixed Budgeting

Both Zero Budgeting and Incremental Budgeting belong to Fixed Budgeting. Fixed Budgeting assumes that the actual level of output always remains at the same level as the budgeted level of output. If actual output fell or rose above the budgeted level, then this would lead to variances – differences between the actual number and the budgeted number in the budget.

Example 1: The budgeted output is 1,000 units and the budget cost of raw materials is USD$200,000. It gives the budgeted average cost of raw materials of USD$200 per unit.

When the actual output is 800 units and the actual cost of raw materials is USD$180,000, this shows a Favorable Variance of USD$20,000 (USD$200,000-USD$180,000). The actual cost of raw materials is lower than the budgeted cost of raw materials. This should sound good right

However, Fixed Budgeting ignores the fact that the actual output of 800 units is 20% below budget. Producing 20% less products should lead to lower cost of raw materials by 20%, right? It is because when the actual output is 800 units, the actual cost of raw materials should be USD$160,000 (800 units x the budgeted average cost of raw materials of USD$200 per unit).

Unfortunately, the actual cost of raw materials was USD$180,000. This gives an Adverse Variance of USD$20,000 (USD$160,000-USD$180,000). The actual average cost of raw materials is now USD$225 per unit. It means that raw materials are used less efficiently or costing more per unit on average.

A. Zero Budgeting

Zero Budgeting sets budgets to zero each year.

All departments and budget holders must justify their whole budget each year by arguing their case to receive any finance. With Zero Budgeting, each budget holder must seek prior approval for any planned spending above USD$0.

When is Zero Budgeting used?

Zero Budgeting will be used by business organizations that have an authoritarian corporate culture as they adopt tightly controlled budgetary systems.

✔ Advantages of Zero Budgeting: Zero Budgeting ensures that budgets do not grow automatically each year. It forces all departments and all budget holders to justify their budgets from scratch every single year. Hence, Zero Budgeting provides added incentive for the managers to defend the work of their own section. The budget holders are held accountable for all variances no matter how small these might be. Zero Budgeting also helps the business organization to identify areas that require large amounts of essential expenditure and those that require less. This will provide an opportunity to reflect on changing situations in different budget levels each year.

✖ Disadvantages of Zero Budgeting: Zero Budgeting is very time-consuming as a fundamental review of the work and importance of each budget-holding section is needed every year. Also, targets might often be imposed upon budget holders without any discussion or negotiation.

B. Incremental Budgeting

Incremental Budgeting adds a certain percentage onto the previous year’s budget.

It uses last year’s budget as a basis and an increment is made for the coming year – usually linked with the inflation rate raising the firm’s costs and causing prices to grow.

When is Incremental Budgeting used?

Incremental Budgeting will be used by business organizations that operate in highly competitive markets as there may be plans to lower the costs and raise the sales revenue.

✔ Advantages of Incremental Budgeting: Incremental Budgeting saves time as it is using last year’s figures as a basis. Each year, each department and budget holder must justify only the increment in a budget, not the whole budget for the upcoming year like it was the case in Zero Budgeting.

✖ Disadvantages of Incremental Budgeting: Incremental Budgeting puts a lot of pressure on many employees to achieve higher productivity, boost prices and decrease business costs. This type of budgeting does not allow for any unforeseen events as increments are already set in stone.

2. Flexible Budgeting

Flexible Budgeting means that sales revenue and costs budgets for each year are allowed to vary, if the actual sales and costs vary from the budgeted levels. This flexibility allows the actual level of output to be different than the budgeted level of output. The new budgets will be set depending on the actual output level achieved. Flexible Budgeting shows a more realistic approach to budgeting as it allows for individual budgets to be adjusted in real times depending on the level of sales.

Example 2: The budgeted output is 1,000 units and the budget cost of raw materials is USD$200,000. It gives the budgeted average cost of raw materials of USD$200 per unit.

When the actual output is 800 units, then the actual cost of raw materials in a Flexible Budget will be USD$160,000 instead of USD$180,000. Producing 20% less products leads to lower cost of raw materials by 20%. When the actual output is 800 units, the actual cost of raw materials is USD$160,000 (800 units x the budgeted average cost of raw materials of USD$200 per unit).

By applying Flexible Budgeting, this shows a Favorable Variance of USD$20,000 (USD$180,000-USD$160,000) for the cost of raw materials.

When is Flexible Budgeting used?

Flexible Budgeting will be used by business organizations that have an open and entrusting culture as budgets are a form motivation for employees.

✔ Advantages of Flexible Budgeting: Flexible budgeting constantly gives employees more realistic targets. It accounts for changes in business conditions that may result in very different outcomes than those budgeted. This enables a business to adapt to changes in the business environment and also helps to make the change in a business happen. Flexible Budgeting will make it easier to produce valid Variance Analysis as changes in efficiency are highlighted, not changes in output. Therefore, this will be motivating for middle-managers and lower-level managers as they will not be criticized for Adverse Variances that might occur just because output was lower than budgeted.

✖ Disadvantages of Flexible Budgeting: Flexible Budgeting can make original long-term budgets very inaccurate, hence distort long-term planning of the firm.

In short, no matter which way to set budgets and which type of budgeting a business manager chooses, at the end of the day, smaller budgets are always put together to create the Master Budget for the whole firm.