Budgeting season is closely approaching. So, will you go for a bottom-up, top-down, or hybrid approach? Find out which method is right for you and your team by checking out this complete article.
The process of budgeting is an essential part of running a financially sound business. Companies tend to choose between a top-down or bottom-up approach when it comes to creating their annual budget. However, organizations that achieve the most beneficial outcomes tend to use both methods. While it takes work, time, and involvement from more people across the organization, employing both approaches concurrently with the help of budgeting software enables companies to better align their financials and create a more comprehensive outlook for both management and individual teams.
So what is the difference between a top-down vs. bottom-up budget? This article is here to break it down for you. Read on to learn about the essential differences between bottom-up vs. top-down budgeting so you can discover the best approach for you and your Finance team.
What is top-down budgeting?
Top-down budgeting is a method that a company’s upper management uses to create an annual budget for the upcoming financial year. Upper Management typically uses key data from the previous year to guide them. This includes a scrutiny of financial statements and each department’s previous budgetary allocation and actual expenditure. A top-down model also factors in organizational growth goals for the year ahead, as well as market developments, such as changes to trade conditions or tax obligations.
Upper Management then distributes the budget down the organizational hierarchy to departmental and team managers. The role of individual departments in a top-down budget is typically confined to deciding how to spend their budgetary allocation, which must be approved higher up the hierarchical chain.
How to create a top-down budget
The top-down model usually involves a similar set of steps from start to finish.
1. Upper Management defines high-level organizational goals
The annual financial budget is an important opportunity to reset company objectives. Previous performance, market outlook, and company plans should come together to inform the process of defining the next year’s overarching goals.
2. Upper Management decides broad accounts payable and receivable targets
Upper Management identifies the revenue and expense goals for the year ahead. This step is crucial, as it forms the basis for the entire budget. It should strike the right balance between ambitious and realistic.
3. Finance reviews, and creates department-specific budgets
The financial department is responsible for looking through Upper Management’s initial budget proposal. This is an essential step, in order to identify any areas that may be incorrect or cause problems later on in the year. Once the review process is complete, Finance then defines each departmental budget.
4. Individual departments propose how to use their budget
Once Finance shares budgetary allocation information with each department, it is then the job of the departments to decide how to spend their funding for the year ahead. Each department sends their budget proposal to Finance for approval. This may involve some back-and-forth, should Finance identify any expense proposals that require adjustments.
5. Finance creates one single budget
Once Finance approves all departmental budgets, they are then able to reconcile them all to form one master annual budget for the entire organization.
What is bottom-up budgeting?
A bottom-up budget differs from the traditional top-down budgeting in that it is an organization’s employees that create it, from ‘the floor’ up. Rather than Upper Management defining the budget for each department, it is the departments that tell Upper Management what funding they require and how it will be spent. Of course, a department has to be realistic with its budget proposal, which Upper Management either approves or returns for adjustments.
A bottom-up model tends to be more accurate than a top-down version. After all, a manager or supervisor understands the day-to-day operations of their department. In turn, employees that fill specialized positions within a department are more likely to understand how or where to better allocate funding pertaining to their area of expertise.
How to create a bottom-up budget
To create a bottom-up budget, companies can implement the following steps.
1. Define budget ownership for each department
First of all, ensure that all departments are accounted for. Then identify the prospective budget owners within each department. These individuals should come from all levels of departmental management. There should be one overall budget owner for each department. This is usually the head of the department, although not always.
2. Each department then identifies expenses
During this step, the stakeholders ofIf budget creation within a department make a list of all costs. For instance, these include salaries, software subscriptions, office supplies, equipment, and so forth. Each departmental budget should also ‘bake in’ funding allocation for variable and unexpected costs, such as equipment repair or replacement.
3. The approval process
Once each department finalizes their budget proposal, they send it to upper management for approval. Should expenses be too high or if upper management identifies anything that they disagree with, they can send a proposal back to the pertinent department for adjustments.
4. Budget finalization
Once each departmental budget is approved, the finance team combines them into one organization-wide budget for the coming year. At this stage, each department understands exactly what budget allocation to work with for the year, as well as where exactly it is to be allocated.
Pros of top-down budgeting
There are a number of important benefits to top-down budgeting.
It is a streamlined process, as it is a single budget and involves a concentrated number of stakeholders from upper management and Finance. Another important benefit is that upper management has a view of the entire organization and can align the budget with wider company goals and financial means.
Moreover, the centralized nature of a top-down budget means that any future changes are faster to implement, as it is upper management itself that enacts them, thereby negating the need for approval and back-and-forth communication.
Cons of top-down budgeting
Upper management creates the budget. Therefore, they usually don’t take into consideration the specialist knowledge that employees on ‘the floor’ and department managers can bring. As a result, upper management may miss out on valuable insights.
Another drawback is that the nature of imposing a budget on each department may generate frustration on the part of individual departments. This could arise because employees may feel that they have little say over the allocation of funding to finance their department’s operations. Moreover, it can also create resentment, for instance, if another department receives substantially more funding.
Pros of bottom-up budgeting
Taking a bottom-up model approach to budgeting brings important benefits.
It usually results in a far more accurate budget. This is because it puts the employees front and center of its creation. Employees are the people who understand the daily workings of their department better than anyone else. Therefore, they have a unique viewpoint of its best interests and how it can perform optimally.
Another crucial pro is that employees can feel empowered. Bottom-up methods tend to generate a feeling of ownership, and responsibility to generate an optimal return on investment, among the wider workforce. As a result, it increases motivation and productivity, as well as staff retention rates while supporting company-wide decisions.
Cons of bottom-up budgeting
While a bottom-up budget offers numerous benefits, it tends to take considerably longer than a top-down approach. It also requires the involvement of far more employees. This equates to a more complex, labor-intensive process compared to the top-down method.
Another important aspect to take into consideration is that individual departments don’t have the organization-wide viewpoint that upper management has. As a result, their budget proposal may not align with those of other departments or the wider organizational outlook.
Moreover, due to the limited role that upper management has in a bottom-up approach, the organization may miss out on their expertise and knowhow. After all, upper management in many organizations is made up of highly experienced, seasoned industry professionals and successful entrepreneurs with invaluable points of view. Plus, they are often the key decision makers and will have the greatest insight into the microeconomic factors that must be considered when budgeting.
Top-down vs Bottom-up budgeting: Which one is better?
The right choice between top-down vs. bottom-up budgeting depends on the company. For instance, a startup that needs to keep a tight rein on its finances would be best to go with a top-down budget. Another reason why it is more appropriate for startups and smaller SMEs is because the founders and wider C-suite tend to be more involved with operations across smaller companies. Therefore, they may already have considerable knowledge of each department.
For larger companies with more complex hierarchies, a bottom-up approach can yield stronger results, as it helps bridge any disconnect between upper management and specific departments, and because they usually have the financial means to invest in the long-term resources necessary for growth.
Using FP&A technology to get the best of both worlds
When discussing top-down vs- bottom-up budgeting, there’s not always a straightforward winner. In reality, both methods of budgeting have their pros and cons. Going with one over the other will lead to a certain set of benefits, but it will also take away another set. For this reason, the approach that the most successful companies choose is to execute both methods at the same time. While it is more demanding, using both approaches is oftentimes the best solution for organizations. It ensures that both upper management and on-the-ground employees have their say in how the company allocates funds.
Upper management benefits from seeing each department’s insider take, whereas departments benefit from upper management’s unique insights and organization-wide viewpoint. Moreover, it positions companies to better align individual department and wider organization outlooks. However, pursuing both methods creates more complexity. To execute in an effective, efficient manner, companies use solutions-focused financial planning software.
Abacum’s FP&A technology enables organizations to streamline the annual budgeting process by optimizing cross-functional collaboration and transforming the process of data collection and application. The result is that businesses are able to create highly precise, data-driven budgets for the year ahead.
