A business creates a budget when it wants to match its actual future performance to an ideal scenario that incorporates its best estimates of sales, expenses, asset replacements, cash flows, and other factors. There are a number of alternative budgeting models available.
The following list summarizes the key aspects and disadvantages of each type of budgeting model:
- Static budgeting. This is the classic form of budgeting, where a business creates a model of its expected results and financial position for the next year, and then attempts to force actual results during that period to align with the budget model as closely as possible. This budget format is typically based on a single expected outcome, which can be extremely difficult to achieve. It also tends to introduce a great deal of rigidity into an organization, rather than allowing it to react quickly to ongoing changes in its environment.
- Zero-base budgeting. A zero-base budget involves determining what outcomes management wants, and developing a package of expenditures that will support each outcome. By combining the various outcome-expenditure packages, a budget is derived that should result in a specific set of outcomes for the entire business. This approach is most useful in service-level entities, such as governments, where the provision of services is paramount. However, it also takes a considerable amount of time to develop, in comparison to the static budget.
- Flexible budgeting. A flexible budget model allows you to enter different sales levels in the model, which will then adjust planned expense levels to match the sales levels that have been entered. This approach is useful when sales levels are difficult to estimate, and a significant proportion of expenses vary with sales. This type of model is more difficult to prepare than a static budget model, but tends to yield a budget that is reasonably comparable to actual results.
- Incremental budgeting. Incremental budgeting is an easy way to update a budget model, since it assumes that what has happened in the past can be rolled forward into the future. Though this approach results in simplified budget updates, it does not provoke a detailed examination of company efficiencies and expenditures, and so does not assist in the creation of a lean and efficient enterprise.
- The rolling budget. A rolling budget requires that a new budget period be added as soon as the most recent period has been completed. By doing so, the budget always extends a uniform distance into the future. However, it also requires a considerable amount of budgeting work in every accounting period to formulate the next incremental update. Thus, it is the least efficient budgeting alternative, though it does focus ongoing attention on the budget.
- The rolling forecast. A rolling forecast is not really a budget, but rather a regular update to the sales forecast, frequently on a monthly basis. The organization then models its short-term spending on the expected revenue level. This approach has the advantages of being very easy to update and requiring no budgeting infrastructure.
Of the budgeting models shown here, the static model is by far the most common, despite being unwieldy and rarely attained. A considerably different alternative is to use a rolling forecast, and allow managers to adjust their expenditures "on the fly" to match short-term revenue expectations. Organizations may find that the rolling forecast is a more productive form of budget model, given its high degree of flexibility.