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When I served as a panelist for the webinar, “Budgeting Basics: How to Build a Strong Budget,” we discussed a variety of topics, including how budgets affect profitability, when to start building next year’s budget, planning frameworks and the company stakeholders who need to be involved in the process.
One vital aspect of budgeting is to determine which type of budgeting methodology to use. Here, I outline three different budget methodologies—top-down, bottom-up and iterative—as well as their advantages and disadvantages. For a broader perspective on budgeting, you might also enjoy this post on Business Budgeting Considerations.
What type of budget methodology works best for your company?
Top-Down
Top-down budgeting is the term given to a budgeting process based on senior management providing broad desired targets for revenue and costs and pushing the development of the underlying assumptions to lower levels of the organization. A crucial factor for successfully implementing a top-down budget is the experience and judgment of those involved in developing the overall budget assumptions.
Noteworthy Details
- Takes less time
- Promotes upper-level commitment
- Does not require multilevel participation
- Lower management better understands what upper management expects
- Presented down the ladder
Disadvantage
- Can be less accurate at the individual department or project level
- May be less buy-in across the organization as middle and lower level managers have generally had limited participation in the development of the assumptions and no input to the broad revenue and cost assumptions.
Advantage
- Budget will reflect senior management’s intentions
- Provides senior level directional guidance to department and project managers, so that they are not preparing budgets in a vacuum relative to expectations of senior leadership.
- Can be accomplished in a short time as it eliminates or mitigates internal meetings.
Bottom-Up
Sometimes called zero-based budgeting, bottom-up budgeting, as the name suggests, starts with a blank sheet at each department or project and is built up from there. Each department needs to enter this process with a clear understanding of their role and responsibility for delivery within the organization so they capture the costs required to fulfill their commitment. This budgeting methodology provides department and project managers with the flexibility to develop their budgets independently.
Noteworthy Details
- Takes more time
- Involves cross-section of the organization
- Presented up the ladder
- Seeks participation at all levels
- Encourages commitment to the plan
Disadvantages
- Top management has less influence over the budgeting process
- Individuals tend to overstate their resource needs because they suspect that higher management will probably cut all budgets by the same percentage
- More persuasive managers sometimes get a disproportionate share of resources
- A significant portion of budget building is in the hands of the junior personnel in the organization
Advantages
- Tends to be more accurate at the individual department or project level
- Clear flow of information
- Use of detailed data available at department or project level as basic source of cost, schedule, and resource requirement information
- Participation in the process leads to ownership and acceptance
Iterative Process
Iterative means “to repeat or do again.” The iterative process is a combination of top-down and bottom-up budget building. There is a higher project level (top-down) and a lower level (bottom-up) estimation of costs. The two estimations are compared, negotiated and reconciled.
Disadvantages
- Relatively inefficient and time-consuming nature of the negotiations over the budgets
- Process may not work well when communication channels are either informal or blocked between lower-level managers and senior management
Advantages
- Promotes employee involvement and stimulates a high degree of information flow between those involved in the project at different levels
- Both senior management and lower-level management closer to the actual process participate in the budgeting process
Are you struggling with these or similar issues? If you wonder sometimes what you don’t know or need assistance preparing your business for new levels of growth, request a consultation today from a vcfo expert. We have worked with more than 5,000 business teams in our 25 years. We would love to talk with you, hear your story and concerns, and share our experience and collective wisdom to see how we can help.
If you’re interested in a course on forecasting and budgeting, the Corporate Finance Institute has a wide range of training and certifications.
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