What are the Best Types of Budgets for Your Business?

the Best Types of Budgets for Your Business

Creating a budget is a must to stay on track and keep expenses in control. Proper budgeting can help businesses spend less and derive the most value from each expense. A budget also enables you to predict uncertainties and prepare for any potential disruptions in the future. So – what type of budget should you prepare for your business?

Businesses use different types of budgets to allocate resources for the year, and how you create your budget has a direct impact on your business performance. 

So, a strategic budget can cut costs and give you a competitive advantage, while an ill-planned budget can result in waste and take a toll on your bottom line. There is no one-size-fits-all solution, and your circumstances will determine the best way ahead.

Let’s explore the common budgeting approaches available for your organization. You will also learn how to pick the right one for your needs.

Standard Budget Methods

Here are the common budgeting approaches you can adopt to create your budget:

Traditional Budget

This form of budget uses last year’s figures as the foundation. You then change the numbers to suit the conditions of the current year. Specifically, you look at the costs and revenues of last year and adjust them based on factors like market demand, inflation, change in prices, and so on.

The traditional budget takes less time to prepare, and only a few figures need justification. However, it can be a bit rigid and averse to change.

Incremental Budget

Incremental budgets are quite common and used by many businesses. You base your current budget on last year’s numbers and adjust them to account for your projected growth or decline.

Let’s say your organization has projected a decline of 5% for this year. So, you reduce your budget by 5% across your organization to account for the change.

Incremental budgeting is fast but not very accurate. You can spend money without deriving value as you aren’t justifying but only adjusting your expenses.

Zero-Based Budget

Zero-based budgeting takes zero as the starting point without any consideration for last year. Every department will get new resources based on the needs of the current year. You will need to justify each item in your budget, which can be time-consuming.

This is, however, the most accurate budget creation method.

Activity-Based Budget

An activity-based budget ensures your allocation of resources aligns with your business goals. This type of budget focuses on what you want to achieve in the current year.

Let’s say you want to increase your sales by 10%. So, you will need to determine the cost drivers you will require to boost sales by 10%. You can then create your budget, taking into account all those cost drivers.

What Types of Budgets are Best for Your Business?

You have multiple approaches for creating budgets available to your organization. But, how do you know which one will suit your needs best?

First, start by weighing the pros and cons of each method of budgeting. Along with that, consider the following:

  • Your business size
  • Areas where you operate
  • Your business objectives
  • Market competition
  • Available data for creating your budget

Analyzing each budgeting method based on the above factors will help you choose the right one for your needs.

Let’s say you want to cut production costs and waste across your department. You can choose the activity-based budget that aligns your budget with your business objectives.

Alternatively, if you are dealing with tough competition, zero-based budgeting can come in handy to justify each cost and explain the need.

You can also rely on an activity-based budget to gain a competitive edge in your industry.

Specific Types of Budgets

Once you have selected a method for preparing your budget, you will want to apply that method to the various budget categories across your company.

Operating Budget

An operating budget is a forecast of revenues and expenses a business will make in a fixed time. You can prepare an operating budget for the coming year to spend within plans. Operating budgets are also helpful to forecast your income and expenses for the future.

Generally, you will prepare this type of budget at the start of the year. However, you will also need to make regular updates periodically based on current situations.

An operating budget includes elements like:

  • Fixed and variable costs
  • Capital costs
  • Non-operating expenses

Cash Flow Budget

A cash budget is a prediction of cash flow your business can experience over a fixed time. You can create a cash budget for the next year, month, or even week.

Businesses need to estimate their payables and receivables to create a cash budget. It can help them determine if the business has enough liquid cash to carry on operations. A cash budget also enables you to predict surplus and allocate money wisely.

Moreover, you can make out the profits or losses you may earn based on your cash flow budget.

Direct Labor Budget

A business needs employees to work and produce goods. Employers need to account for their labor costs, especially since demand can change at any moment.

A direct labor budget lets you estimate the cost of your labor. You need to create monthly labor budgets that help you understand when you need to hire or lay off staff. In addition, a direct labor budget can help businesses make an idea of product expenses and calculate profit.

You will need first to determine your future demand to create a labor budget.

Financial Budget

A financial budget is a must to understand how much capital you will need in the short and long term. You can estimate crucial finances by preparing a financial budget like:

  • Capital expenses
  • Cash budget
  • Assets and liabilities

Financial budgets focus on the items in a balance sheet to determine your business’s financial health. In addition, the insights of this type of budget will also drive your strategic plan.

Therefore, businesses must prepare a financial budget to predict and determine future financial activities.

Master Budget

A master budget is the collection of lower-level budgets of your business. It includes all the predictions in your financial and operating budget and acts as a planning document. You can also include any budget based on unique functional areas your business serves.

Some common elements of master budgets are:

  • Sales budget
  • Labor and materials budget
  • Costs of goods sold budget
  • Administrative budget

Businesses can create yearly master budgets to plan their activities. You can also break down your budget into months and quarters.

First, prepare your operating budget, then your financial budget, and use the insights to create your master budget.

Static Budget

This type of budget can come in handy if you are a non-profit or in the education industry. A static budget lets you estimate your fixed expenses and revenues for a period of time. You can also use the line items of your budget as performance metrics, as your sales do not influence them.

Businesses need to predict their future expenses and revenues to prepare a static budget. However, you are not going to update this budget even if the figures don’t represent actual costs or revenues.

Final Thoughts

Your budget has a direct impact on your bottom line. As a result, you need to carefully pick out the best approach to prepare your budget. Focus on your business requirements and consider factors like competition to decide what is best for your needs. You may also want to consider your available resources, as methods like zero-based budget need time and labor.

Your unique business needs and operations will determine the budget categories needed for your business. However, some of the budgets like cash, operating, and financial budgets are crucial, no matter the size of your business or industry. Always prepare a well-documented budget so that you can avoid overspending.

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