From software developers to capital investors, most business professionals understand that budgeting is vital for sustainable growth. But few understand that a company’s budgeting methodology can make the difference between financial success and ruin.
In this article, we discuss four traditional types of budgeting. Then, we offer insight into driver-based budgeting – an innovative and flexible technique that allows companies to focus on factors that directly influence future success.
What Are the Traditional Types of Budgeting?
Many companies follow traditional budgeting approaches, including:
- Incremental budgeting
- Activity-based budgeting
- Zero-based budgeting
- Value proposition budgeting
Each methodology has unique advantages as well as downfalls.
This popular budgeting technique involves using the current budget as a starting point for next year’s budget. From there, you can adjust specific line items.
A cost of living raise may equate to a 2.5% increase in personnel spending, for example. Or, a merger may lead to a 4% reduction in production costs.
Though incremental budgeting provides funding stability, it can also contribute to unnecessary spending.
- Straight-forward and easy to understand; no complex calculations are required
- Budgets remain consistent over time
- Less internal conflict; departments know what to expect from year to year
- May lead to unnecessary spending; departments feel compelled to spend all the money in their budget
- Doesn’t account for unforeseen or external factors
- Leaves little room for innovation or creativity
Activity-based budgeting is a top-down approach. Companies start with a key business objective and then ask, “What must we do to accomplish this goal?” Resources are allocated thusly.
For example, if the goal is to generate $6 million in revenue from a new product line, an organization may decide to increase its personnel budget to hire more sales representatives.
Though activity-based budgeting helps companies make goal-centric decisions, it can be tedious and time-consuming.
- Allows companies to focus on factors that influence the bottom line
- Company leadership is more likely to identify budget inefficiencies
- Affords flexibility; changes can be made in response to internal and external events
- Time-consuming and expensive
- Can lead to short-term thinking in pursuit of annual goals
- May be difficult for younger companies to implement
Zero-based budgeting starts with a blank slate. Every year, department heads must create a budget from scratch, justifying each line item without reference to the prior year’s numbers.
This budgeting approach is an excellent way to eliminate wasteful spending as it allows company leaders to aggressively cut fat while prioritizing key activities.
However, zero-based budgeting is very time-consuming.
- Streamlines inflated budgets
- Holds department heads responsible for costs
- Helpful during restructuring
- Incredibly time-consuming and frustrating for department heads
- May reward short-sighted decision-making rather than big-picture thinking
Value Proposition Budgeting
Value proposition budgeting is a happy medium between incremental budgeting (which, some argue, is too blasé) and zero-based budgeting (which, some argue, is too scrupulous).
The approach involves evaluating each line item by asking:
- Why are we spending this money?
- What value does this provide to our stakeholders, customers, and employees?
- Does the value outweigh the cost?
Though value proposition budgeting is useful for cutting wasteful spending, it can be difficult to operationalize “value” (i.e. what’s valuable to one person may not be valuable to another).
- Allows leaders to identify expenses that bring little to no value to the organization
- Keeps companies customer-centered
- Great for cutting wasteful spending
- “Value” is hard to operationalize
- Perceived value may change based on cultural, social, economic, or technological influences beyond the company’s control
The Problem With Conventional Budgeting Methods
While each traditional budgeting type has clear advantages, these methods are rigid, making it challenging for companies to pivot in response to a rapidly shifting economy.
By contrast, driver-based planning is innovative and flexible. This type of forecasting allows companies to focus models on key drivers that directly influence financial success.
Simply put, this top-down approach helps businesses focus on the metrics that actually matter.
How Driver-Based Budgeting Works
Implementing a driver-based model involves four high-level steps.
Step 1: Identify Qualitative Goals
As with all budgeting, driver-based planning begins with an overarching goal. Your company may, for example, aim to drive revenue growth or increase profitability.
Step 2: Isolate Quantitative KPIs
After determining a qualitative goal, your team should work to identify key performance indicators (KPIs). These quantitative metrics can be used to gauge progress.
Step 3: Define Key Drivers
Now, your business must define the key drivers that have the most significant impact on its KPIs. Examples include website traffic, product price, and call volume.
Step 4: Create Your Model
Finally, you need to develop a mathematical model that investigates the relationship between the key drivers and your overarching goal.
This model should allow you to survey different scenarios. For example, you may want to explore how net profits will change in the wake of a 2% product price increase.
What Key Drivers To Select for Your Model
Key drivers vary from business to business. However, they generally fall into one of five categories:
Typically, key drivers are controllable. They are inputs that companies can easily manipulate, such as the number of sales personnel.
Why Savvy Business Owners Opt For Driver-Based Budgeting
Most traditional budgeting techniques force company leadership to slog through unnecessary information. But with driver-based budgeting, executives can break through the noise – concentrating on the key drivers that affect the bottom line.
Efficiency and Effectiveness
With driver-based planning, your business can focus on the variables that impact organizational success.
Using a driver-based model, teams can quickly assess how different scenarios may affect financial outcomes.
A driver-based approach encourages collaborative thinking across departments.
A driver-based model allows companies to collect a smaller amount of more accurate and valid data.
Why Your Company Needs Driver-Based Budgeting Software
Driver-based models help companies explore the causal relationships between key drivers and financial outputs. These models also afford visibility, allowing businesses to run different scenarios and explore what may happen in the wake of future changes.
However, building a driver-based model in a spreadsheet can be very time-consuming. Large spreadsheets also struggle to handle the macros and equations needed for these models.
Fortunately, there’s a better way. Driver-based financial planning and analysis (FP&A) software can provide the state-of-the-art budgeting and forecasting solutions you need to catalyze your business.
Lavoie CPA and Jirav Software Solutions
At Lavoie CPA, our goal is to deliver cutting-edge financial support so that clients can focus on soaring to greatness. With this in mind, we have partnered with Jirav, a driver-based financial planning tool.
“Jirav affords the flexibility and visibility required to scale, focus, and grow a business.”
— Sharai Lavoie, CEO of Lavoie CPA
As our preferred FP&A software, Jirav gives companies the confidence to navigate complex business challenges. With forecasting, budgeting, reporting, and analytics, this all-in-one tool has everything you need to make your next big move.
Contact Lavoie’s financial experts to see if Jirav is the right software solution for your business.