Explanation
There are four common types of budgets that companies use: (1) incremental, (2) activity-based, (3) value proposition, and (4) zero-based.
Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget. It is the most common method of budgeting because it is simple and easy to understand.
Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company. For example, a company sets an out-put target of $100 million in revenues. The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these ac-tivities.
In value proposition budgeting, the budgeter considers the following questions:
- Why is this amount included in the budget?
- Does the item create value for customers, staff, or other stakeholders?
- Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?
Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unneces-sary expenditures – although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.
As one of the most commonly used budgeting methods, zero-based budgeting starts with the as-sumption that all department budgets are zero and must be rebuilt from scratch. Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”. This is the method used in the scenario.
[Reference:, - CIPS study guide page 58, - Types of Budgets - The Four Most Common Budgeting Methods (corporatefinanceinstitute.com), LO 1, AC 1.4]
