The 5 most effective budgeting models explained
The past few years have been full of disruption and change, and during these times, budgeting and financial planning have become a critical components of an organization’s growth strategy. Forecasting, planning for the future, and aligning resources and goals across the whole organization should be a top priority. A solid budget highlights an organization’s ambitions and exposes its limitations. Your profit margins or service provision depends on excellence in project execution and keeping a sharp eye on your budget.
Here, we take a look at some of the different models and approaches you can use to manage your budget and plan for the future.
Incremental Budgeting
This traditional approach to budgeting generally starts with the previous year’s actual numbers and budget numbers, along with some year-to-date actuals and projections. Then modifications are made to specific line-items with predictable numbers or foreseeable changes. It’s then common to apply a percentage of uplift across a range of accounts or departments.
The main advantage of an incremental budgeting model is its focus on changes. Widespread changes, such as increasing staffing costs, are relatively easy to make, and they don’t necessarily need much thought or discussion, which makes this budgeting method stable, quick and easy. And due to its predictability, it’s a good choice for organizations that like to plan for future year budgets.
The main disadvantage is that it tends to result in less discussion and debate. It doesn’t necessarily need the leaders in your organization to examine the details very closely. Although you can execute incremental budgeting pretty quickly when compared to some of the other approaches, it may be the least useful for professional service organizations if you are trying to implement a disciplined approach to spending or service provision. And it can be difficult for your business leaders to see where costs are coming from and how those costs contribute to revenue and value creation.
Activity-Based Budgeting
Activity-based budgeting is a top-down financial planning approach that focuses on key outcomes that your business wants to achieve. It begins with the end in mind then considers what must be done to achieve the organization’s goals. Resources and activity levels needed to achieve those goals can then be worked out.
The main advantage of this budgeting method is that resources can be strategically aligned with organizational goals. Working backward from the goals means you can determine the amount of revenue or resource you need to generate and, therefore, what budgets you will need to allow a pipeline large enough to be created. This will include considering staffing, marketing, services, technology, and other resources. This approach usually allows a higher level of strategic focus than most others.
The main disadvantage is that it can sometimes focus too much on strategic objectives and not pay enough attention to costs that are not directly related to the wider business goals. Make sure you don’t discount or overlook departments that don’t generate specific, measurable outcomes in the achievement of the company’s strategic goals. And make sure you consider indirect costs such as security, insurance, and depreciation.
Value Proposition Budgeting
This approach to budgeting looks at each line-item or budget category to find out why money is being spent in certain areas and what value it provides to customers, employees, or other stakeholders. This budgeting model is kind of a happy medium; it scrutinizes spending and involves far more discussion than incremental budgeting but much more so than zero-based budgeting. And unlike activity-based budgeting, value proposition budgeting looks to justify spending according to the value it generates rather than directly tying spending to strategic goals.
The main advantage of this strategy is that the detail makes sure that everything included in the budget delivers value for the business and aims to avoid unnecessary spending.
The main disadvantage of value proposition budgeting is that value can often be hard to quantify, and this can lead to short-term thinking rather than long-term thinking. The perceived value of any spending may not always be stable and can change based on cultural, social, economic, or technological factors.
Zero-Based Budgeting
This approach starts with a blank slate. The organization needs to determine their spending necessities for the coming year and then justify each line-item with no links to the previous years’ numbers. If the organization spent money on certain things last year, that doesn’t mean it should do the same this year. For people-focused businesses, this means justifying almost every single proposed expense, which is great for eliminating wasteful spending but not so great for the time it takes.
The main advantage of this approach is that it helps to aggressively streamline inflated budgets, stops money wastage, and brings costs under complete control while minimizing any negative impact on operations. It forces organizations to prioritize and be more intentional when managing costs, focusing only on the areas that generate value for the organization. And because of this careful management, this approach can often result in new innovations and improved efficiency.
The main disadvantage is the time and debate that is needed to start from scratch and to justify every single cost.
Driver-Based Budgeting
This approach focuses on the variables that most dramatically impact the performance of people-focused professional services organizations. It links budget numbers to the actual resources needed to achieve the company’s targets for each of those variables. These could include internal elements such as customer numbers, staffing levels, or the average value of each customer. It could also include external elements such as total market size, utility prices, or even weather conditions. This approach builds a budget based on key objectives, baseline predictions about external drivers, and a results-driven approach to internal organizational drivers. If any of those variables change, you adjust the budget relatively easily to suit the new conditions.
The main advantage of this approach is that it helps to identify the most important drivers that impact business performance and aligns budgeting and planning accordingly. It also links business results very closely to outcomes as key drivers change. This results in greater accountability and virtually eliminates any bending of the rules as it sets out clear rules in advance, which then helps to manage expectations and serves as a roadmap for performance as key variables affecting the organization change.
The main disadvantage is that it can be complicated to set up as it needs a very clear line of sight and access to the right data. Because this approach relies on large amounts of data to gain visibility into your drivers, you’ll need to access that data in a way that allows you to develop clear insights on past, current, and future performance. The right technology will help you automate the process and give you the data you need, but this approach can mean that you narrow your focus down to too few drivers, which could impact overall organizational success.
How do you decide which budgeting method is best for your organization?
Think about where your organization is currently and what your business values are, and then decide how much time and effort you are willing and need to spend on financial planning and budgeting. Compare all approaches and consider all manual and digital options. This will help you to determine what is going to be the right approach.. We would also suggest that you start to build a contingency fund. We all know that unexpected costs can land on us at any time, and often just when the budget is tight. Having an emergency fund is a must if your business relies on equipment or services that must be replaced immediately in a crisis. So, it’s a good idea to use any surplus income during healthier months to boost your contingency fund rather than being tempted to splash out on ‘nice to have’ extras that aren’t a necessity.
How technology can help
Most professional services companies default to using an incremental budgeting method. This is partly because it is routine and habitual, but also because it requires considerably less effort than the other approaches, certainly if your organization is still using spreadsheets and email to manage the process. Producing an annual budget can be complicated, time-consuming, and burdensome, particularly if your organization continues to use old-fashioned processes.
Technology and automation can make financial planning and budgeting easier than it’s ever been. It doesn’t really matter which of these budgeting approaches you decide to use; there are always general needs for collaboration and discussion, version control, and automated workflows that just can’t be worked out by passing spreadsheets back and forth by email. Spreadsheets are prone to error and version control, so aren’t usually updated with live data from your ERP system, so budgets are then built on old information or must be manually updated.
Organizational agility is a must in today’s global economy, and most people-centric organizations are recognizing that financial planning and budgeting cannot continue to be annual processes. Rather, organizational leaders must now constantly monitor external conditions and make rapid adjustments to stay ahead of the competition.
How can Unit4 help you?
If your professional services organization wants to take planning and budgeting to the next level, Unit4 can provide ERP platforms specifically designed for the unique needs of people-focused organizations.
And our next-generation HCM and FP&A tools help you to manage and develop your people, attract world-class talent, and ensure and proactively encourage engagement, learning, and development.
To discover more, click here to book a demo and see what our ERP solution can do for your organization yourself
