Companies use financial forecasting to create budgets and understand their revenue streams. This process helps create an expectation for companies to use as a reference in the future. On top of that, it also allows companies to control actual performance against the set benchmark. For companies, these tools are crucial in helping save costs and increase profits. In the absence of these budgets, companies cannot function efficiently.
Companies can prepare various types of budgets for the different operation areas. Usually, these budgets fall under operating budgets. Combined with other forecasts, these budgets constitute a company’s master budget.
Therefore, all of these contribute to the final figures that become a part of that budget. Each component is crucial in providing an accurate and reliable budget for actual use.
Companies use budgeting models to help in the preparation of their budgets. These models differ from one company to another based on historical usage. On top of that, each type may have its advantages and drawbacks.
Usually, companies can choose from different types of budgeting models for planning purposes. Before discussing those types, it is crucial to understand what budgeting models are.
What is a Budgeting Model?
A budgeting model is a tool that companies use to prepare their budgets. These models fall under the budget modeling process. Under this process, companies constitute budgets to align their current performance and financial goals. Usually, it involves estimating or predicting the performance in various areas. For example, companies may prepare sales, expenses, cash flow, asset, equity, and liability budgets.
Budgeting models help provide a base for companies to use when preparing budgets. Based on those models, companies can follow steps to create realistic budgets. Once companies use a budgeting model, they continue with it for a long time. Unless the budgeting model provides an unsatisfactory result, companies do not change it. However, each type of budgeting model may result in a different budget.
The choice of budgeting models depends on several factors. Usually, companies must evaluate their needs and assess the model that suits them. Furthermore, the historical usage of these models also plays a crucial role in which one a company will use. Sometimes, companies may alternate between different types of budget models. This way, they can identify any shortcomings and eliminate those during the process.
The budgeting model that companies choose can affect all operations. When implementing these models, companies must find one that suits their financial infrastructure. On top of that, they must also aim for seamless integration within that infrastructure. Companies can also change budgeting models, as mentioned. However, doing so frequently can increase costs and make the process inefficient.
Overall, budgeting models are tools that help companies forecast their financial performance. These models may come in different forms or types. Usually, companies can select between the budgeting models that suit their needs. Once chosen, though, they must stick to it to obtain the best results. If a company believes its budgeting model to be inefficient, it can also change it.
What are the types of Budgeting Models?
As mentioned, companies can use a variety of different budgeting models to create financial plans. Each model has its advantages and disadvantages. Companies must assess their needs and choose a budgeting model that fulfills those needs. Usually, companies select a model and stick to it for a long time. Companies can use one of the following types of budgeting models to satisfy their needs.
A static budget remains fixed throughout the budget period. Irrespective of the activity level, this budget does not change. Usually, companies use this budget when they expect their performance to be highly predictable. This budget is ideal for companies with predictable sales and expenses. In practice, however, it may not be reasonable to use.
Static budgets can be highly beneficial with the following advantages.
- It is easy to prepare and implement.
- It does not require continuous updates or adjustments.
- It can offer strong insights into a company’s costs and revenues.
- It can help control costs and make better decisions.
Static budgets may have significant disadvantages in practical use, including the ones below.
- It lacks the flexibility that comes with other budgeting models.
- It does not consider the fluctuations in activity levels.
- It does not allow for modifications due to variances.
- It may not be suitable for startups or new operations.
A flexible budget is the opposite of a static budget. It allows companies to adjust their existing budget for operations.
In essence, they provide a more applicable budgeting model for companies with varying activity levels. These budgets are more realistic than the fixed or static budgets that companies use. However, they may need to use those budgets as a base.
Flexible budgets can provide several advantages, of which some are below.
- It helps calculate performance at different activity levels.
- It can enable companies to determine the output level necessary to achieve desired profits.
- It helps companies adjust to different market and business conditions.
- It allows assessing management performance.
Companies can also get some disadvantages from using flexible budgets, some of which are below.
- It requires more work compared to fixed budgets.
- Any errors in the budgeting process can significantly alter the expectations.
- It depends on several factors, which may not be controllable.
An incremental budget takes an existing budget and adjusts it for various factors. Usually, these factors include inflation or changes in activity levels. Companies must use many assumptions for these factors. These budgets are easier to prepare and use by many companies. However, some experts may consider them a conservative approach to budgeting.
Incremental budgets can have various advantages, some of which are below.
- It is easier and simpler to prepare and implement.
- It provides more consistent results.
- It reduces internal rivalries and conflicts.
- It requires lesser cost, time and expertise.
Some of the crucial disadvantages of the incremental budgeting model are below.
- It does not identify any redundant activities.
- It may use unreal assumptions.
- It hampers potential growth.
- It lacks an incentive for a comprehensive review.
When companies start budgeting initially, they use a zero-based budgeting model. This model starts from scratch and allows companies to estimate everything from zero. With these budgets, companies can prepare expectations from the ground up. Some established companies may use this budget model to reestablish their expectations. However, it may involve more work.
A zero-based budget can have many advantages, including the following.
- It provides a more accurate and efficient budget.
- It promotes coordination and communications within a company.
- It identifies and eliminates any redundant activities from the budget.
- It does not use an inflation-based budget used in incremental budgeting.
The zero-based budgeting model can also have some disadvantages, as listed below.
- It is more time-consuming due to the more tedious process.
- It requires significant expertise and experience to be accurate.
- It can be more expensive to use this budgeting model.
A rolling budget requires companies to update continuously to add a new budget period. This budgeting model involves the same principle as incremental budgeting. However, it is an extension of the existing budget. It rolls the budget over for a shorter amount of time rather than doing so annually. Most companies use the rolling budgeting model since it is more consistent.
Rolling budgets can have the following advantages.
- It can help strengthen planning and control.
- It accounts for any unexpected events and makes changes promptly.
- It helps companies assess their strength and weaknesses.
Rolling budgets may involve the following disadvantages.
- It may create conflicts or confusion because of continuous changes.
- It does not suit companies that experience continuous changes.
- It may be costly to prepare and maintain these budgets.
Companies prepare budgets for planning, controlling, and monitoring purposes. For that, companies can use various budgeting models.
These models provide a base for companies to use when preparing budgets. Each model can have its advantages and disadvantages. Some of the most commonly used budgeting models are available above.