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6 Budget Setting Techniques – Explained

The budget setting process is crucial for effective budgetary control. Budgets should accurately reflect the services being provided. There are several budget setting techniques that can be used for both expenditure and income budgets.

These techniques can be used independently or in combination, depending on the type of budget implemented.

The 6 widely used budget setting techniques are:

  1. Incremental budgeting
  2. Zero based budgeting
  3. Cash limited budgeting
  4. Resource restricted budgeting
  5. Activity based budgeting
  6. Contingency budgeting

1.     Incremental budgeting

The incremental budgeting technique uses historic income and expenditure data as a starting point. This data is usually acquired from the previous year’s budget, accounts, or a combination of the two. The historic data is used as the baseline to formulate the budget for the following year.

The budget can be set by implementing the following procedure:

  • Consider each budget heading separately
  • Add or subtract inflation factor to the historic data
  • Adjust for other known factors such as savings or approved growth

Advantages

  • Simple
  • Quick
  • Accurate – only if there is little change in activity

Disadvantages

  • Historic
  • Doesn’t consider any necessary future changes
  • Assumes the base is accurate
  • Compounds historic errors

 

Incremental budgeting should be used for expenditure that are unlikely to change. For example: when staff is constant, salaries can be budgeted for incrementally. Factors like increase in pay due to a bonus or annual inflation rate can be added.

2.     Zero Based Budgeting

The zero-based budgeting technique is the most recommended and popular technique, as it is linked to the business planning process. The zero-based budget assumes that all budgets are derived from first principles and that the organisation can start the budget anew – with a zero base.

The budget is then based on the objectives to be achieved in the time period, without necessarily referring to the past.

Advantages

  • Proactive and focused on business objective
  • Realistic and accurate
  • Links into business plans

Disadvantages

  • Time consuming
  • Requires clear objectives
  • Many organisations cannot begin with a zero base as they have previous commitments to uphold. This can include existing staff, buildings and contracts, which they are obliged to continue – at least in the short term

 

The advantages of zero based budgeting generally outweigh the disadvantages. Where possible, zero based principles should be adopted, even when an organisation cannot have a complete zero-base budget to begin with.

3.     Cash Limited Budgeting

The cash limited budgeting technique is appropriate when a limit is set on total net expenditure. The manager must determine what can be delivered within this cash limit and create a budget accordingly. This technique can be difficult to implement when the objectives of the business for that time period have been set without considering the cash limit.

The budget can be set by implementing the following procedure:

  • Identify fixed cost, i.e. those that cannot be reduced
  • Spread the balance of the budget across items which are flexible

Advantages

  • Clear parameters on expenditure
  • Quick
  • Provides incentive to increase savings

Disadvantages

  • Services may have to decrease quality, quantity, or both to stay within the cash limit
  • Not necessarily linked to business objectives, which may include a need for change or development
  • Presumes that there is enough flexibility in the budget to operate within the overall cash limit
  • Inflexible – It is not practical for demand led/statutory services

4.     Resource Restricted Budgeting

Resource restricted budgeting is useful when resources to be utilised by the business are restricted. Resource restriction will usually apply to:

  • Staff
  • Equipment
  • Property
  • Finance (cash limited budgetis a form of resource restricted budget)

There are many reasons for restricting resources.

For example: it may be beneficial for the whole organisation to restrict staff numbers. This may be required because recruiting an additional full-time staff is an on-going commitment that the organisation may not be able to fulfil. Hence, restricting staffing resource is a common budget setting approach.

Advantages

  • Clear parameters on expenditure
  • Quick
  • Organisation maintains strong control over its resources

Disadvantages

  • No consideration of the practical impact of restricting resources and the impact on services
  • Not linked to business objectives, which may include a need for change or development
  • Inflexible – It is not practical for demand led/statutory services

5.     Activity Based Budgeting

Activity based budgeting is based on the cost of providing an activity or service. When the budget needs to be reduced or adjusted, each activity will need to be examined. A decision will be required as to which activity should be ceased or reduced.

This method of budgeting is only possible if there are clear divisions between each activity, to indicate clearly where resources are allocated. When resources are shared (such as staff, premises, etc.) implementing the activity-based budget is difficult. Accurate resource allocation methods such as the time charged by staff, allocating square footage, and utility usage, etc. will be required.

Advantages

  • Resources are clearly matched to its service provision
  • Forms a base for unit costing
  • Highlights the most expensive activities

Disadvantages

  • Resource allocation may not be accurate
  • Detailed work needs to be undertaken to isolate each activity and the resources consumed
  • It is not practical for services where a flexible approach is required and/or where resources need to be moved between activities in response to demand

6.     Contingency Budgeting

The contingency budgeting technique uses a broad approach to budgeting. Limited effort is used to establish estimates for each budget heading. A contingency amount is provided to compensate for poor estimates, changes in demand, and insufficient resources.

The contingency budget can be used flexibly across any of the budget headings. The level of the contingency will depend on an estimation of the risk of error within the budget. If it is considered that the budget has been calculated to an accuracy level of 80%, then a 20% contingency may be added to the budget.

Advantages

  • Quick
  • Easy
  • Flexible

Disadvantages

  • Inaccurate – involves a lot of guess work
  • Insufficient thought given to linking service with finance
  • Difficult to monitor

What Next?

It is important to understand the different budgeting factors that need to be considered when setting the budget. These factors are the input element that determined the expenditure and income, and hence the budget. Understanding these factors enables budget holders to think creatively and implement effective control.

Using the correct budget setting techniques is crucial for setting realistic budgets. Learn more about all the important aspects required to set budgets from our book, Managing the Devolved Budget. This publication is a learning resource and contains examples and exercises that enable you to apply your theoretical knowledge in practice.

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