Why are budgets important?

A budget is an estimate of how much an organisation plans to spend and what it plans to spend it on over a set period of time – usually 12 months. It is also an estimate of how much income is expected to come in over the same period, allowing for a comparison of income against expenditure.

This provides the organisation with vital information about how much its planned activities for the year are likely to cost and whether there will be sufficient income to pay for them. An organisation can therefore plan its activities for the year ahead based on what it is able to afford.

Setting a budget is also a useful tool for linking costs to organisational objectives, ensuring aims and strategies are aligned at all levels.

 

What is incremental budgeting?

Incremental budgeting is the most common method of setting a budget. The starting point is simply to take last year’s budget and roll it forward to the next year, on the basis that the organisation is likely to continue doing many of the same activities as it has previously done. The budget can then be adjusted to take out anything that is not being continued, and to add in anything new. Further adjustments will be necessary to take into account items such as growth, inflation, legislative changes and pay awards.

The main advantage of incremental budgeting is that it is simple and quick. It operates on the principle of ‘business as usual’ and assumes that there will be a great deal of continuity between one year and the next. However, there are a few key disadvantages to this approach:

• Any mistakes in the old budget will be carried forward into the new budget – such as incorrect estimates or misstatements.
• It does not encourage participation from budget-holders, preventing them from bringing forward new ideas or opportunities for innovation.
• It is backwards-looking, and therefore does not take account of changes in the organisation’s objectives and operational requirements.

 

Why change to zero-based budgeting?

Zero-based budgeting offers a completely different approach to the process of setting a budget. The principle is to start with a blank page and then add items one by one. Every activity that is included in the budget has to be justified in terms of its benefit to the organisation and its contribution to organisational objectives. Therefore there must be a clear business case for all budgeted expenditure.

The advantage of zero-based budgeting is that it is completely forward-looking, focused only on what is planned for the future. It also ensures that the organisation only spends money on those activities that are aligned with its objectives – and so these must be clear and well-understood by all stakeholders. Every activity is evaluated and assessed on this basis.

The disadvantage of zero-based budgeting is that it is very complex and therefore time-consuming. Most organisations will not have the capacity to fully implement zero-based budgeting all at once.

 

How can these approaches be combined?

It is common for organisations to combine both incremental and zero-based budgeting to gain the benefits of both. As under incremental budgeting, continuing activities will be carried forward into the new budget from the previous year but with an eye on whether these activities continue to meet the organisation’s objectives. The organisation will also examine its objectives and actively identify new opportunities and activities that will help meet them.

Each new activity will then go through a full cost analysis. It is likely that the organisation will not have sufficient income to pay for all proposed activities, so it will need to decide which ones to include by ranking them in order of priority. Those setting the budget will need to consider both the potential benefits to the organisation derived from each activity, and equally any adverse consequences that could arise if it is not undertaken. The highest-ranked activities will be included in the budget on a cumulative cost basis until the total cost matches the available income; any left over will be discarded.

 

Further information:

CIPFA Financial Advisory Service