There are basically four methods of budgeting, although most organisations are likely to prepare budgets using a combination of these methods. The four basic methods are:
- traditional historic budgeting
- zero-based budgeting
- priority-based budgeting
- activity-based budgeting.
Traditional historic budgeting
This is the most common method of budgeting and is used in most financial institutions. It is based on historical information and involves an incremental approach. In simple terms, the managers take last year's figures and adjust for growth and/or inflation, plus or minus any significant changes in expected results.
Most financial institutions have undertaken some form of cost reduction exercise within the last twelve months. In most instances, cost reduction initiatives consist of a directive from the Managing Director or the Finance Director stating that costs will be held at last year's levels (a cost reduction in line with inflation) or will be reduced by a fixed percentage. Those cost centre managers who have seen these kind of initiatives in the past will have padded their budgets to ensure reductions can be achieved without damaging the infrastructure of their departments. In this way, a traditional historic budget builds on unnecessary elements and encourages the vested interests of managers.
This type of budgeting can be performed in several ways, the two extremes are:
The bottom-up approach - unit managers prepare their own budgets and these are reviewed and consolidated by a central department. Changes are then suggested from the centre and eventually, after some negotiation, a budget is agreed.
The top-down approach - an initial budget is prepared by the centre, with targets for each unit. This is then expanded by unit managers to form a detailed budget.
In both circumstances, there is likely to be a planning gap between the performance levels considered achievable by unit managers and the expectations of senior management at the centre. The time taken to eliminate this gap through negotiation can be significant, but if this is not achieved and final budgets are imposed by central management then ownership of the budgets by unit managers will not be obtained.
Zero-based budgeting requires that expenditure above a zero base be justified and that costs be estimated for differing levels of output and service, i.e. that all expenditures be justified, not just additional expenditure. The major advantage of zero-based budgeting is that all proposed expenditure can be judged consistently and that optional and discretionary operations can be more closely scrutinised. It does, however, require significant management effort to evaluate each cost centre by service level and expenditure. The required level of data and number crunching can mean that the effort can obscure the purpose. Some organisations perform this type of budgeting for selected cost centres and profit centres as a separate cost reduction exercise, maintaining regular financial control using traditional budgeting methods.
Priority-based budgeting is designed to produce a competitively ranked listing of high to low priority discrete bids for resources which are called "decision packages". A method of budgeting whereby all activities are re-evaluated each time a budget is set. Discrete levels of each activity are valued from a minimum level of service upwards and an optimum combination chosen to match the level of resources available and the level of service required. The concept of ranking bids for capital expenditure is well known; priority-based budgeting applies a similar process to more routine expenditure. It is similar to zero-based budgeting but does not require a zero assumption.
Activity-based costing information can be used in financial institutions as the basis for a variety of tools that will assist senior managers in the management of the cost base. It can be used as the basis of a regular means of managing the cost base by activity throughout the organisation. It may include the need to set targets or budgets for activities and costs, but tends to focus on longer term improvements in the delivery of activities which enable the institution to move towards its corporate goals through the monitoring of productivity, capacity utilisation, efficiency and effectiveness. It may therefore be used as the basis of an activity-based budgeting system.
Activity-based budgeting differs from traditional budgeting in that it concentrates on the factors that drive the costs, not just on historical expenditure. The volume of activity, for example, will be a key driver of the costs within any operations function and the quality of customer service will have a significant effect on the costs associated with customer liaison. The strategic objectives can drive the budgetary targets and determine the volume of activities to be performed. The budgets are then derived from the activities using estimated cost rates.
Activity-based budgeting justifies expenditure on the basis of activities performed in relation to the predetermined drivers and places responsibility for cost control on the manager with responsibility for the control of the driver. Activity-based budgeting separates the analysis of cost/benefit and value of activities from the more mechanistic budgeting exercise, reducing the complexity of the budgetary process and concentrating attention on the management of the business not simply on the costs incurred.