3.2 Different types of budget
There are a number of ways in which an organisation may prepare a budget for the coming period. You may not know the technical term for your department or organisation’s budget, but you might recognise it from one of these descriptions:
- Incremental budgets: Here, the next budget is based on the previous period’s budget. There are generally few adjustments: perhaps an increase to allow for inflation, but sometimes there may be a reduction to encourage quality improvement and efficiency. It is simple, but it may reduce the process to an annual ritual without questioning the assumptions or reflecting changes in the real world.
- Zero-based budgeting: At the start of each budget round, managers ‘go back to square one’ and start from a blank sheet of paper. This may be time consuming, but it does mean that managers are required to examine their operation and question what they do. It may not be appropriate to use this method for each period, but doing so once in a while can be valuable.
- Rolling budgets: This approach is intended to allow for changes in the external environment that may impact on a budget. Based on the idea that the time horizon for many managers is quite short, it breaks down the budget for the overall period (for example, 12 months) into shorter periods (for example, three months). At the end of each short period the budget is reviewed in the light of reality, so that variations from planned budgets can be noted and explained. This may help if there are seasonal effects in the work that organisations do.
- Flexible budgeting: Here a budget is altered (flexed) to reflect changes in the level of activity over the previous year. This makes it more adaptable and realistic than an incremental budget. In doing so, a more meaningful analysis can be carried out.
Activity 3 Identifying types of budget
Identify the type of budget that the manager is discussing below. Do you see any difficulties with the manager’s approach to budgeting?
I know my department’s activities really well, probably much better than the operations director, so I’m very confident in saying that next year, the current costs in my department will increase by the rate of inflation.
Actually, I like to add a bit on top of my final budget figures because then I know I’m covered if costs rise more than I anticipate.
The manager is using an incremental budget approach, which takes the current period’s costs and adds an amount to take inflation into account. When the manager can justify that this is likely to happen (perhaps by looking back at a trend from past years’ costs), this approach is acceptable.
But what about the manager adding ‘a bit on top’? Can the manager’s actions be justified? If not, then inflating budget costs in this way leads to an unrealistic expectation of future costs and favours the manager when the actual costs appear to be lower than budgeted costs. It will appear that the manager is being effective in controlling costs when, in actual fact, the budget was overstated in the first place.
Using a zero-based budgeting approach removes the temptation to ‘add a bit on top’. This approach asks, ‘What activities will we need to do to carry out this operation and how much will each activity cost?’ The activity cost is calculated from external sources as if the organisation was starting from zero.