Budgeting methods

Budgeting is an essential part of running a business. It helps plan, control, and monitor how money is spent. To manage a business effectively, four main budgeting methods are commonly used: incremental budgeting, activity-based budgeting, flexible budgeting, and zero-based budgeting.

1. Incremental budgeting

Incremental budgeting is a budgeting method where the current period’s budget is based on the previous period’s budget, with incremental adjustments (usually increases or decreases) applied for the new period. These adjustments are often a fixed percentage, reflecting expected changes in costs, revenues, or inflation.

BENEFITS	LIMITS
Simplicity: Easy to implement as it is based on available data. No complex calculations required.	Low motivation to improve efficiency: Because budgets are based on previous allocations, there’s little reason to optimize spending or rethink processes.
Funding Stability: It guarantees continuity in resource management from one year to the next. Expenses are relatively easy to project.	Inflexible to changes: This method assumes business operations remain stable, so it may not adapt well to unexpected events or market shifts.
	Limited review of expenditures: With stable, incremental budgets, management is less likely to conduct thorough reviews, which can allow errors or unnecessary costs to continue.
KEY TAKEAWAYS
Incremental budgeting is simple and easy to use, which makes it attractive for many businesses. However, this method also has some important drawbacks. Because incremental budgeting relies on previous budgets, it is often conservative and inflexible. It can be slow to respond to internal changes, like new business priorities, or external changes, such as market shifts. For companies in today’s fast-moving business environment, this can cause problems.
When to use it
Incremental budgeting works best when a company’s expenses and operations are expected to remain stable, with only small changes each year. If the business is growing, changing, or facing uncertain conditions, it is usually better to use more advanced budgeting methods that allow for flexibility and innovation.

Example: Incremental Budgeting for a Café

Expense	Last Year (€)
Food & Drinks	100 000
Staff salaries	80 000
Utilities & Rent	20 000

This year, costs are expected to rise by 5% due to inflation and local price increases. Using incremental budgeting, the café adjusts each item by 5%:

Expense	New budget (€)
Food & Drinks	105 000
Staff salaries	84 000
Utilities & Rent	21 000

Total Budget for this year: 210 000€

The café simply takes last year’s budget and applies a small increase. This method is straightforward and easy to use, but it does not question whether each expense is still necessary.

Limitations to the use of incremental budgeting in this example:

Inflation and changing costs as prices for ingredients, utilities and services can change faster than the incremental adjustments.
New Regulations and taxes
Seasonal or tourist variations
Innovation and growth, including new investments, are not accounted for.

2. Activity-Based Budgeting (ABB)

Activity-based budgeting (ABB) focuses on the main activities that drive a business and allocates resources according to their importance. It prioritizes the tasks and operations that generate the most value, allowing the company to plan its spending more accurately. By examining what causes costs and seeking ways to use resources efficiently, ABB helps reduce waste and increase profitability. Unlike traditional budgeting, which is based on last year’s numbers, ABB builds the budget from the ground up based on the current needs of the business, making it particularly useful for growing or changing companies.

The ABB process is carried out in three main steps:

Recognize the key activities: Identify the tasks or processes that generate costs or revenue for the business.
Measure activity levels: Determine how many times each activity occurs, which will serve as the basis for budgeting calculations.
Calculate costs per activity: Work out the cost of a single unit of each activity and multiply it by the total activity level to estimate the total cost.

It should be noted that newer companies, which lack historical budgeting data, cannot use this method.

BENEFITS	LIMITS
Helps cut costs: Identifies inefficient activities and reduces unnecessary spending.	More expensive to implement: Requires additional resources, tools, and expertise to set up.
Improves Resource Allocation: Allocates budgets based on actual activities and business needs.	More time consuming to perform: Requires detailed analysis and ongoing monitoring of activities.
Increases cross-departmental budget allocation: Encourages coordination between departments by linking shared activities.	Needs historical financial data: Requires accurate past data to identify cost drivers reliably.
More Control over the budget: Provides better visibility over where and why money is spent.
KEY TAKEAWAYS
Activity-Based Budgeting helps businesses understand how money is spent by linking budgets to actual activities. It improves cost control and resource allocation by focusing on what truly creates value. However, ABB requires more time, data, and effort to implement, making it more suitable for businesses with stable operations and sufficient financial information.
When to use it
Activity-Based Budgeting is best used when a business has complex operations, multiple activities, or high indirect costs. It is particularly useful for organisations seeking better cost control, improved efficiency, or more accurate pricing. ABB works best when reliable financial and operational data is available.

Example:

A restaurant wants to prepare its budget using Activity-Based Budgeting instead of relying on last year’s spending.

Step 1: Identify key activities

The restaurant identifies its main activities:

Preparing meals
Serving customers
Cleaning and maintenance

Step 2: Measure activity levels

Based on forecasts for the next month:

2,000 meals will be prepared
1,500 customer service interactions will take place
300 hours will be spent on cleaning and maintenance

Step 3: Calculate cost per activity

The restaurant estimates the cost of each activity:

Meal preparation: 6€ per meal
Customer service: 4€ per interaction
Cleaning and maintenance: 10€ per hour

Step 4: Build the budget

Meal preparation: 2,000 × 6€ = 12,000€
Customer service: 1,500 × 4€ = 6,000€
Cleaning and maintenance: 300 × 10 = €3,000€

Total ABB budget: 21,000€

The budget is built based on actual activities and expected demand, not on last year’s figures. This helps the restaurant control costs, reduce waste, and allocate resources more accurately.

3. Flexible budgeting

Flexible budgeting allows a business to revise its expected income and expenses according to real operating results. Instead of setting fixed figures for an entire year, this approach updatesthe budget when changes occur in sales volume, production levels, or customer demand. It is particularly useful for businesses that face seasonal fluctuations or uncertain market conditions.

The use of flexible budgeting increased significantly during the COVID-19 crisis, when organisations needed to react quickly to sudden disruptions. Many financial experts highlighted the need to move away from rigid, long-term budgets in favour of more adaptable planning tools. This approach remains relevant today, as companies continue to operate in an environment of ongoing economic change.

A flexible budget is built around four key components that work together to form a financial model capable of adjusting to actual business performance as it occurs:

COMPONENTS	DESCRIPTION
Sales Activity
Fixed-Costs	These costs do not change with variations in business activity. Typical examples include rent, salaried wages, and insurance. Fixed costs establish a stable cost foundation, ensuring that essential obligations are met regardless of changes in operating volume.
Semi-variable Costs	These costs combine both fixed and variable elements. Common examples include sales compensation structures with a fixed base salary plus performance-based commissions, and utility expenses that include a fixed service charge alongside usage-based fees. Semi-variable costs introduce greater complexity but offer a more precise representation of expenses that partially fluctuate with activity levels
Revenue Expectations	These represent forecasted income amounts calculated at varying levels of business activity. Typical examples include sales revenue, service charges, and subscription income. Accurately estimating revenue across different activity scenarios is essential to ensure the budget reflects realistic financial expectations and achievable performance objectives.

3.1 How to build a flexible budget

Select an activity driver: Choose a measure that best represents business activity. While sales revenue is commonly used, other drivers, such as units sold, customer volumes, or hours worked, may better capture operational reality.
Establish a baseline Budget: Develop an initial budget framework using forecasts or historical financial information. This provides a starting reference before introducing flexibility.
Identify variable and semi-variable costs: Determine which expenses fluctuate with activity levels and which include both fixed and variable components. These costs will be adjusted as actual performance changes.
Define adjustment rules: For each variable or semi-variable cost, set clear adjustment rates tied to the activity driver (for example, increasing cost of goods sold by a fixed amount for each additional unit sold).
Monitor actual results: As real activity data becomes available, input it into the model so the budget automatically recalculates expected expense levels.
Review and refine assumptions: Linking costs to activity is an iterative process. Regularly evaluate whether the flexible budget is producing meaningful insights and refine the assumptions and adjustment factors as needed.

BENEFITS	LIMITS
Adapts to actual activity levels: Adjusts budgets automatically based on real sales, production, or customer volume.	Requires accurate cost behaviour knowledge: Must correctly classify fixed, variable, and semi-variable costs to be effective.
Improves operational decision-making: Helps managers respond quickly to changes in demand or performance.	Can be complex to set up: Needs formulas, adjustment factors, and activity drivers for multiple cost categories.
Supports variance analysis: Differences between actual results and flexible budget highlight true efficiency or inefficiency.	Dependent on timely data: Requires up-to-date activity and cost information for meaningful results.
Better cost control: Provides insight into how costs scale with operations, preventing over- or under-spending.	Limited strategic insight: Focuses on short-term operational alignment rather than evaluating whether all costs are necessary.
KEY TAKEAWAYS
Flexible Budgeting allows businesses to create budgets that adjust automatically to actual business activity, providing a dynamic tool for operational control and performance analysis. It helps managers separate variances caused by changes in volume from those caused by efficiency or waste, supporting better decision-making. However, FB requires a clear understanding of cost behaviour and timely data, and it may be more complex to implement than static budgets.
When to use it
Flexible Budgeting is most useful when a business experiences variable demand or fluctuating operational activity, such as seasonal sales in restaurants, variable customer traffic, or shifting production volumes. FB works best when cost structures are well-understood, and managers have access to accurate, timely data on both activity levels and expenses. It is particularly valuable for businesses seeking real-time operational insights and effective short-term cost control.

Example:

A mid-size casual restaurant wants a budget that adjusts automatically to changes in demand. Management chooses to apply a structured flexible budgeting methodology to ensure costs reflect actual business activity.

Step 1: Select the sales activity measurement

The restaurant identifies number of covers served per month as the primary activity driver, as it directly influences food usage, labor hours, and utilities more accurately than revenue alone.

Step 2: Establish a Baseline Budget

Based on historical data and forecasts, management prepares an initial monthly budget assuming 5,000.

Cost Category	Budget Assumption (€)
Food & Beverages	40 000
Hourly labour	30 000
Utilities	4 500
Rent	5 000
Management salaries	7 000

This baseline provides a reference point but is not treated as fixed

Step 3: Identify Variable and Semi-Variable Costs

Cost Category	Cost Type
Food & Beverages	Variable
Hourly labour	Variable
Utilities	Semi-variable
Rent	Fixed
Management salaries	Fixed

Step 4: Define Adjustment Rules

Adjustment factors are established using the activity driver (covers served):

Food & beverages: €8 per cover
Hourly labor: €6 per cover
Utilities: €2,000 fixed + €0.50 per cover
Rent and management salaries remain fixed

These rules allow the budget to flex automatically.

Step 5: Monitor Actual Performance

At month-end, actual activity is 6,000 covers, higher than forecast.

The flexible budget recalculates expected costs:

Cost Category	Calculation	Flexible Budget
Food & Beverages	6 000 x 8€	48 000
Hourly labour	6 000 x 6€	36 000
Utilities	2 000+ (6 000x 0.5€)	5 000
Rent	Fixed	5 000
Management salaries	Fixed	7 000
Total Cost		101 000

Step 6: Review and Refine

Management compares actual costs to the flexible budget at 6,000 covers, not to the original static budget. Any variance now reflects operational efficiency (waste, productivity, pricing), rather than differences in volume.

Over time, the restaurant refines:

Cost-per-cover assumptions
Labor scheduling standards
Utility usage rates

to improve the accuracy and usefulness of the model.

4. Zero-Based Budgeting

Zero-based budgeting (ZBB) is a budgeting methodology in which all revenues and expenses for a given period are planned and justified starting from a zero baseline, rather than being derived from prior-period budgets. Under ZBB, every cost must be explicitly evaluated, justified, and aligned with strategic or financial objectives before resources are allocated.

In an organizational context, ZBB serves as a rigorous planning and control tool that translates strategic goals into detailed, measurable financial plans. By requiring justification of each expense, it strengthens cost discipline, enforces ownership and accountability, eliminates inefficient or non-value-adding expenditures, and redirects resources toward high-priority, high-return initiatives.

In essence, zero-based budgeting is a disciplined, objective-driven approach to financial planning that emphasizes intentional decision-making, transparency, and alignment between resources and desired outcomes.

BENEFITS	LIMITS
Benefits Limits: Strong cost reduction discipline: Forces justification of every expense, helping eliminate waste such as unused subscriptions, excess inventory, or overstaffing.	Highly time-consuming: Requires detailed review and justification of all costs for each budgeting cycle.
Improves cost accountability: Assigns clear ownership for each cost category (food, labour, marketing, utilities, etc.).	High managerial effort: Demands strong financial skills and active involvement from managers and department heads.
Aligns spending with strategic priorities: Ensures resources are allocated only to activities that support profitability and customer experience.	Risk of short-term focus: May discourage long-term investments (training, innovation) if not managed carefully.
Enhances budget transparency and control: Provides clear visibility into where money is spent and why.	Potential operational disruption: Excessive cost scrutiny may slow decision-making in fast-paced environments like restaurants.
KEY TAKEAWAYS
Zero-Based Budgeting requires organizations to build their budgets from scratch each period, justifying every cost based on necessity and value creation rather than historical spending. In the gastronomy sector, ZBB is particularly effective for tightening cost control, improving margins, and ensuring that limited resources are spent on activities that directly support operations and guest satisfaction. However, its intensity and complexity make it more demanding to implement than traditional budgeting approaches.
When to use it
Zero-Based Budgeting is best used when a business needs aggressive cost control, margin improvement, or a financial reset—such as during periods of declining profitability, rapid growth, restructuring, or rising food and labour costs. ZBB works best in organizations with strong managerial discipline and access to detailed cost data, and is particularly suitable for restaurant groups or food service businesses seeking to eliminate legacy costs and ensure spending is fully aligned with strategic and operational priorities.

Budgeting methods

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