Developing budgets is a necessary element for operational and financial success within a company. A budget analyzes a company’s expected costs and resources. The process to develop, review and approve budgets is usually time-consuming. Some budgeting methods require more time or documentation than others. Knowing the characteristics of the various types of budgeting methods can help you choose the right method for your company, so that you develop effective budgets in an efficient manner.
The zero-based method to formulating a budget starts with a baseline of zero instead of the baseline for the previous year’s budget. Many government agencies and nonprofit organizations use the zero-based method to construct budgets. In zero-based budgeting, managers must justify every expense. The documentation process of zero-based budgeting is extensive because every function within an organization is analyzed and assigned a cost. The advantage of using zero-based budgeting is that it may lower costs because no consideration is given to the previous year’s budget or activities. If something is not needed, it is not added to the budget.
The top-down budgeting method starts from the top levels within the organization and works its way down. Upper-level management sets the budgeting guidelines and gives lower-level management directions on how to make budget calculations. This method gives lower-level management little input. Upper-level management must possess the experience necessary to come up with the organization’s budgets. An advantage of using the top-down method is that the process is structured and promotes a certain organizational culture. Companies that emphasize hierarchy in their firms perform well using the top-down method. A disadvantage is that lower-level employees may feel as if management fails to value their input and simply dictates to them.
The bottom-up method incorporates the input of lower-level management in the process of constructing the budget. The guidelines and processes for the budget are still developed by upper-level management, but lower-level management employees determine the budgets for their individual departments. After they construct the budgets, they send the budgets to upper-level management for review and approval. If upper-level management finds problems with the budget, the upper-level managers usually send the budget back for revision until a final budget is reached. The advantage of using this method is that it boosts employee morale because employees deal hands-on with an important element of the organization. The disadvantage is that this method of budgeting is usually time-consuming because of the back-and-forth process.
Using this budgeting method, the costs within the budget are assigned to the activities of the firm. The activity-based budgeting method is in direct contrast to traditional budgeting methods, such as top-down and bottom-up budgeting. Activity-based budgeting uses the volume of a particular activity instead of historical expenses. Companies use activity-based budgeting to control costs. The advantage of using activity-based budgeting is that it can increase productivity and improve business practices. The disadvantage of activity-based budgeting is that some employees may feel negatively about managers analyzing their productivity.