As you may know, budgeting is one of the most important aspects of financial management. It is not only a valuable skill for individual daily tasks, but it is also beneficial and implemented by the government and all businesses.
Without budgeting, people and companies would be incapable of managing their finances, inevitably leading to their downfall.
Budgeting involves various complex aspects, but a simple definition is that a budget is a plan or an estimation that allows you to effectively manage/use your money. A budget allows you to allocate money to different areas so that you know exactly how much money you need and never “run out.”
What Are the 4 Main Types of Budgeting Methods?
Your budget is similar to your personal financial plan, which includes how you spend, save, and invest your money. Its main purpose is to prevent you from overspending and allow you to gain more control over your finances.
Although the concept of budgeting may sound straightforward, there are actually various budgeting methods. The 4 main types of budgeting methods that this ultimate guide by Darbaar explains are incremental budgeting, activity-based budgeting, zero-based budgeting, value proposition budgeting.
Incremental budgeting is the most popular type of budgeting method because of how easy it is to understand and employ.
How To Use Incremental Budgeting?
In this method, your new budget is developed by making changes to the current budget. In other words, your current budget is the base amount to which you make incremental changes to.
The incremental changes that you make are based on what you expect to occur in the future. For instance, if you expect produce prices to go up in the near future, you will allocate more money to grocery expenses.
What Are Its Advantages and Disadvantages?
As mentioned before, incremental budgeting is the most commonly used because it’s easy to use. Since incremental budgeting allows you to use your current budget, you do not need to compute complex calculations, like some other budgeting methods require.
As a result, the simplicity and ease of incremental budgeting allows you to save time, which is a major benefit.
Furthermore, incremental budgeting ensures stability and consistency. Since you use your old budget to devise a new budget, the new budgets remain fairly consistent and stable over time.
Nevertheless, despite its simplicity and consistency, some people do not prefer incremental budgeting because it may promote unnecessary spending. Since incremental budgeting typically adds more funds to the new budget, every area gets more money to spend. However, many areas do not need that extra money, yet you still spend all of it.
For example, let’s say you reserve $500 for kitchen supplies in your old budget, but add $50 to it in your new budget because you think prices will increase. However, you end up not spending all of it because you found a cheaper blender.
Now that you have extra money for kitchen supplies, you will probably buy another kitchen supply instead of saving or investing it. As a result, you unnecessarily spent extra money on a kitchen supply that you likely did not need.
Activity-Based Budgeting (ABB)
Activity-based budgeting is when budgets are formed based on a thorough analysis of cost-creating activities. Every activity that incurs a cost is analyzed for ways to mitigate that cost. After this analysis, the budget is made accordingly.
Due to this heavy analysis, activity-based budgeting is more rigorous than typical budgeting methods. This rigor, however, is eminently beneficial because it helps you reduce your costs, allowing you to make more profit.
Furthermore, activity-based budgeting is broken down into three primary steps:
- Identify relevant activities. This is when you identify the cost-creating activities that you will analyze, as discussed above.
- Determine the number of units related to every activity you found. The resulting number is the baseline for calculations.
- Delineate the cost per unit of each activity and multiply that result by the activity level.
As you can see, activity-based budgeting is far more complex than traditional budgeting methods. However, the thorough analysis of cost-creating activities serves well to reduce expenses, which is something that not all budgeting methods are capable of doing.
Zero-Based Budgeting (ZBB)
Zero-based budgeting is when the budget for each new period is determined by analyzing the needs and costs of every potential spending area (Here are some examples by Capital One). In other words, all expenses must be justified for every area in order to allocate money to that area.
If you are unable to justify a need for money in a certain area, you will have to allocate 0 dollars to that area.
The budgets are then built based on what you expect you need for the upcoming period, regardless of what the previous budget was.
Furthermore, in order to accurately make the budget, managers must pay close attention to detail. As a result, zero-based budgeting is a very time-consuming process that takes much longer than traditional budgeting methods.
The good part, however, is that it can help lower your costs as all expenses must be justified.
Value Proposition Budgeting
Note: this strategy is primarily intended for businesses because it focuses on creating more revenue. However, you can still gain insight and tips from this budgeting method.
As the name suggests, value proposition budgeting is primarily intended to drive more value. Therefore, similar to zero-based budgeting, you must justify all expenses. However, in addition to justifying expenses, you must also figure out how much value each dollar spent should bring in.
Upon gathering this information, the business can eliminate unnecessary spending and spend more on areas that drive more value. As you have read so far, the other budgeting methods do not analyze value drivers, making value proposition budgeting unique.
The ultimate goal of value proposition budgeting is figuring out where a business should spend money for maximum return. After that, the business can allocate a greater portion of their budget to the sectors that return the most value.
To effectively do this, value proposition budgeting requires you to ask the following questions:
- What is the purpose of spending this money?
- Why is this amount included in the budget?
- Does the item create value for customers, staff, or other stakeholders?
- Is the value of the item greater than its cost? If not, is it possible for us to justify its cost?
Are There Any Disadvantages to Value Proposition Budgeting?
Although value proposition budgeting may seem perfect, it does have a few cons. Primarily, it can be difficult to accurately quantify the value something returns. For instance, the value of gold will not remain the same year-round, indicating that the value of items can fluctuate.
As a result, businesses must continuously update their budget so that they do not spend excessively on invaluable items, making this budget more difficult to sustain.
Ultimately, there are many more budgeting methods; however, the methods described above are the most popular and effective. It is imperative for you to implement a budgeting method so that you can manage your finances more effectively.
If you are a beginner to budgeting and personal financial management, we recommend using the incremental budgeting method because it is easy to understand and implement.
However, if you are experienced with budgeting and would like a more complex approach that works better, you should consider employing the activity-based budgeting or zero-based budget.
Finally, we also advise that you hire a financial advisor if you can afford one and create a personal financial plan for increased financial stability.