What are the steps in the budgeting process?

By Sigma Conso

Abstract office desktop

What we’re going to talk about:

  • Budgeting is one of the most important operational and strategic activities for a company
  • There are 4 types of budgeting – incremental, zero-based, activity-based, and value proposition – each with its advantages and disadvantages
  • There are 4 basic steps to the budgeting process, but the process itself depends on the type of budgeting an organisation uses

It’s already well known that budgeting is one of the single most important activity for any company. In fact, a recent McKinsey surveyof 127 CFOs found that 43% of respondents were aiming to streamline their budgeting processes to help their businesses react more rapidly to shocks such as the Covid-19 pandemic. Your master budget is your organisation’s roadmap for the upcoming year, ensuring sufficient funds to operate effectively, tracking income and expenditure, and setting clear targets for growth (which can be measured against key performance indicators).

Budgeting also has value beyond the simply operational. Strategic budgeting, which looks several years beyond the regular annual budget, enables organisations to build a long-term vision: creating capacity to expand into new markets and areas, carry out R&D, or respond to the unexpected.

Are you interested in discovering how to streamline your budgeting process? We have a team of experts who will be happy to discuss your specific needs.

The different types of budgeting

There are four commonly used types of budgeting: incremental, activity-based, value proposition, and zero-based. Each has its advantages and disadvantages, and the method your company adopts will depend on its needs. For example, incremental budgeting is quicker and simpler, while zero-based budgeting demands a far more detailed approach.

Incremental

This method is probably the most widely used. The starting point is past performance - specifically, the previous year’s operating budget, which is modified to take in expected changes in the next year, such as a change in variable expenses or variable costs. The budget may allow for a percentage rise in certain departmental budgets if there is a need. For example, if new technology is being rolled out, the IT department may have its budget increased, while the budget for an HR department with no new personnel or functions will stay flat or have a small, standard percentage increase.

While incremental budgeting is simple, takes little time, and is applicable across a range of businesses where costs don’t vary wildly from year to year, it also has considerable disadvantages. It encourages a status quo approach, rather than a proactive, strategic approach. Department heads will not be motivated to make cost savings or come up with ideas to boost profit margins if every financial year brings a bigger budget. Automatic incremental rises also fail to take into account external factors which may drive up costs unexpectedly, such as the recent energy price rises.

Activity-based

Activity-based budgeting takes a far more analytical and target-driven approach than incremental budgeting. A CEO's first step will be to set a target and plan ahead – for example, a 50% increase in revenue in the coming year. What activities will be necessary in order to achieve that output? How much will those activities cost to carry out? The answers to these questions will be in the activity-based budget, which is created anew every financial year, rather than an adjusted version of the previous years.

This form of budgeting demands a regular and expert deep-dive into what your company actually does and what it wants to do. It can raise uncomfortable questions around what functions are necessary, and which ones can operate with fewer resources. Done well, and with buy-in from all levels of your company, it can help cut costs and drive efficiency, which in turn feeds into strategy, enabling an organisation to be more competitive and innovative.

Value proposition

This value-first method of budgeting sits somewhere between the low-analysis method of incremental budgeting and the intensive detail of activity-based or zero-based budgeting. The key question for this method is: how does this expense create value for the business?

If the expense creates value, and that value is more than the expense, then the expense is justifiable. However, for this form of budgeting to be effective, you must be able to define the different forms of value which your business owns and creates, both tangible and intangible – an essential strategic exercise in itself.

Zero-based

This approach is the polar opposite to incremental budgeting and resets the budget clock to 00:00 every financial year. Managers and department heads must justify all expenditure to top management in terms of how it contributes to the company’s success – there are no assumptions that money spent last year can be spent again this year.

This form of budgeting is on the rise: a 2018 Accenture Strategy studyof zero-based thinking in 85 of the world’s largest companies found that adoption of the method grew at a rate of 57% each year between 2013 and 2017. This method can save vast amounts of money: the Accenture study found that 91% of those companies which adopted zero-based budgeting went on to either fully meet or exceed their targets.

However, it also highlighted that change on this scale can be challenging to implement. Cultural buy-in was the hardest potential obstacle to overcome when implementing a zero-based budgeting strategy, and changes on this scale require complete buy-in from the C-suite.

The budgeting process

Every CFO is familiar with the four basic stages of the budgeting process: preparation, approval, execution, and evaluation. These further break down into the following important steps:

  • Consider the current financial climate
  • Examine your financial statements to see what funds are available
  • Consider costings and cash flow
  • Look at your sales forecast and sales budget, as well as current departmental budgets
  • Account for compensation, bonuses, and capital expenditures before you update your budget
  • Review budget for approval and distribution.

However, this process has numerous variables depending on whether your organisation takes a top-down or a bottom-up approach, and which of the budgeting approaches above it uses. With a top-down approach, key budgeting decisions are laid down by senior management. They set a budget’s financial goals and guidelines, leaving mid- and lower-level management teams to work out how their department will implement these budgetary guidelines.

The top-down approach allows for a high level of control from the top but can run into difficulties if senior management are not sufficiently aware of challenges on the ground, leaving lower management with the difficult task of implementing a budget which is not sufficient for their needs.

A bottom-up approach sees those lower and mid-level managers take a far more active role. Although they may follow general guidelines from the top, they are responsible for putting together their own budgets, which are then brought together to form the master budget.

This last approach gives less control to upper management and is also likely to result in higher spending targets. Individual managers may not have overall company objectives in mind, meaning their budgets are too individualised. However, it also allows for more flexibility, enabling managers on the ground to put together a budget from their own experience. The process can also improve communication and commitment, as employees feel more engaged and valued, and that their activities are taking the company in the right direction.

Simplifying your budgeting process

The budgeting process is both time and money-heavy: it’s not uncommon to have an entire department devoted to it. In order to get maximum value from the budgeting process, an increasing number of CFOs are taking a more strategic approach and investigating how the process might be simplified.

This might include the following questions: does our current method of budgeting create maximum value for the company? Do we use too many different manual processes and spreadsheets, which are time-consuming and error-prone? Do we take a top-down or bottom-up approach, and is this approach the best way? What are the pain points and how might they be resolved? How might a new approach enhance our strategic plan and our company's objectives?

Unlike financial consolidation and reporting, budgeting and planning leaves more room for creativity. However, a budget will only ever be as good as the information which feeds into it. Best practices require clean data which the finance department can gather quickly and regularly for analysis from numerous different departments. Budgeting software that enables collaboration, speed, and accuracy can be a game-changer.

A simplified budgeting process which runs smoothly will allow you the time and space to consider how a new budget package will add value and underpin strategy. This will enable you to create a culture where your budget works for the business – not the other way around.

Are you interested in discovering how to streamline your budgeting process? We have a team of experts who will be happy to discuss your specific needs.