Top-Down vs. Bottom-Up Budgeting
There are many ways to approach budgeting. However, most fall under two main categories; top-down or bottom-up budgeting.
- Top-down budgeting: With this approach, the leadership team sets goals and budgets for the entire business. Based on the company goals and objectives, resources are allocated accordingly to each department and team for the upcoming year. Usually, the management will use previous data, such as the previous year's budget and performance metrics, to create the new budget. Typically, after the goals are defined by the company's leadership, the departments and team need to figure out how to reach them.
- Bottom-up budgeting: In contrast, a bottom-up budgeting approach starts at the department, or rather team level, and you make your way up the ranks. Thus, the budget keeps on accumulating, which is then presented to the company's management and consolidated to form the company budget. Often, bottom-up budgeting goes hand-in-hand with driver-based budgeting. Here, instead of defining revenues and costs top-down (e.g., 10% revenue growth), the core drivers of a business are planned, and the company's revenues and costs are a direct result of that.
The objective of both methods is the same, but they approach the budgeting process differently. Top-down budgeting has its advantages being a faster approach as it focuses on creating a company-wide budget by the leadership team as opposed to separate department budgets that are then combined. The budget can also be easily aligned as it is set by senior management who are aligned with the company goals and objectives and assessing decisions that can further it as a whole.
However, bottom-up budgeting is the more granular (see driver-based planning) and thus the more accurate approach. Individual departments and teams generally have a more in-depth understanding of their needs, expenses, and the resources required to achieve their objectives which improves the accuracy of the projections. It also increases ownership and accountability for the team as they set their own budgets and goals, motivating them to reach those goals.
The best budgets are driven by the finance team with deep interactions with and a lot of involvement from other team members and various parts of the organization. CFOs gather data from different sources throughout the company and consolidate it into a single source of truth. That way, they can leverage collaboration to create an accurate budget and eliminate data silos in the process.
Once you've defined your approach, let's discuss how you can prepare for the annual budgeting season to ensure a structured and productive budgeting process.
Discover what budgeting is, the goals and questions your budget needs to answer, and why creating a budget is essential for any business.READ MORE
1. Be clear about company goals
In order to be prepared to build a solid budget, it is crucial to understand the company's goals and priorities. Do you want to grow your top line to become a market leader, or do you need to restructure the business to survive?
Such goals and priorities dictate a company's budget, which translates them into financial and operational goals. Make sure everybody involved in the budgeting process fully understands the company's vision and objectives. This way, you ensure that everyone knows what's expected from them, and they'll become more involved and equipped to contribute high-quality input.
2. Understand the business
Before you start creating your budget, you need to make sure that you fully grasp how your business works. This goes beyond a high-level understanding of how the company operates and makes money.
You should be able to answer questions like:
- How many new orders will we have if we increase our marketing spend by 10%?
- What share of new users do we expect to churn after 3, 6, or 12 months?
- How will additional customer support employees contribute to customer retention?
- How will the number of customers/users/sales change if we change our pricing structure?
- How will our HR costs change if we adjust the variable component of the compensation for our sales team?
Of course, these questions may vary depending on your business model and industry. But being able to answer questions at this level of detail ensures that you understand the drivers and interdependencies of your company. You can then translate that into a financial model and know whom to involve in the budgeting process.
3. Involve stakeholders
While it is crucial that you understand where the company is headed (its goals and priorities) and how the business works (its drivers and interdependencies), relevant information and know-how will likely be scattered across the organization.
For example, the Marketing department will be best equipped to estimate the impact of a particular marketing campaign on new customers or users, and the HR department should be able to give you a solid indication of the recruiting costs expected for the upcoming period.
There are several additional advantages to having an inclusive company budgeting process:
- Information transfer: Sharing information about the budget is critical for department-level management. Teams or employees involved get to discuss budget preparation, challenges, and different points of view and figure out different ways of solving problems. This often also results in better alignment of the company's goals and priorities.
- Employee motivation: When employees participate in the budgeting process, it provides them with a sense of participation and ownership through opinions valued by the upper management. This involvement improves their morale, encouraging them to work harder and attain goals together as one.
- Goal conformity: Team involvement means setting joint goals that move the company in the right direction. Without conformity, it's impossible to achieve the predetermined company budget goals.
To prepare an accurate budget, it is imperative to involve the relevant stakeholders in the budgeting process and make use of the decentralized know-how in the organization. They also need to have tools and processes that allow them to easily pitch in and exchange data without any disruptions to the process.
Will Stewart, Corporate Controller at SonarSource, stressed the need for collaboration and delegation across different members and departments during the planning process. He put it simply in three steps "Request inputs from other departments, create models based on our legal entity organization, and consolidate the data."
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4. Define the output
There are many types of budgets. A budget can be anything from a rough estimation of costs and profits to full-fledged financial statements. Depending on the stage, size, and nature of your business and the available resources, you need to decide what you want to accomplish with your budget and what type of output is necessary for that.
The most common approach is to budget on a Profit and Loss (P&L) basis, enriched with operational metrics (e.g., the number of sales and users). Such a format typically contains the most relevant line items for monitoring and steering the business. These line items show revenues and expenses owned or managed by different departments, which is why it's vital for teams to be able to contribute to the budget.
While the P&L statement is the most common format for a budget, it may not be sufficient. Investments (capital expenditures), incoming payments, and outgoing payments cannot be inferred from a P&L statement. And depending on a company's funding, it is imperative to understand your cash flows to ensure you won't run out of cash. This is where a Cash Flow statement helps.
Apart from the type or form of your budget, you also need to decide on the level of granularity, both regarding the time aspect and the line items included.
- Should your budget have a quarterly or monthly breakdown?
- Is one line item for marketing spend sufficient, or do you need a breakdown by marketing channel?
- Can overhead costs be consolidated into a single line item, or do you need transparency on its components (e.g., rent, legal fees, accounting costs, etc.)?
More details in your budget typically require more effort in their preparation and also maintenance. Accordingly, you should be wise about what to include and what can be left out and ask yourself whether the additional information or accuracy justifies the required effort.
- Does breaking down an item provide valuable insights for decision-making?
- Can the broken-down items be forecasted accurately?
- What is the labor cost invested in breaking down the budget, and is it valuable or a waste of time and resources?
As a general rule of thumb, you want to include as little detail as possible but as much as necessary for alignment, monitoring, and steering.
No matter which format you pick, your budget should always give you a reliable picture of the financial health of your business.
5. Plan ahead
Budgeting takes time and usually requires a few iterations. Depending on the size of your business and your goals, budgeting can take anywhere from a few days to several months.
This is why it's suggested that companies approach their budgeting process with sufficient lead time. Martin Betzwieser, CFO at ottonova, does exactly that, saying, "Already during the year, we collect commercial insights and questions for the next budget round. Once we are running into late summer, we define the key drivers and adjust the previous planning model accordingly."
That way, no matter the size of your organization, you have enough time to prepare a comprehensive budget, iterate and revise. The time needed for this is often underestimated. Plan accordingly and remember that aligning between one department's budget and the company's overall goals or synchronizing assumptions across departments can be very time-consuming.
You should also remember that budgeting is an ongoing exercise. Budgets should be updated regularly and monitored throughout the year to adapt to the changing needs of the business. So it is pivotal that you implement the tools and workflows needed to facilitate the process of having multiple teams constantly updating your budget. Oliver Cen, Director of Controlling and Accounting at Mister Spex, said that "Ideally, budgeting is a continuous process with little special efforts," making it smoother and more efficient instead of cramming it all into a couple of months.
While static budgets act as a guideline (and serve as a basis for your budget vs. actual comparison), dynamic budgets adjust to the changes in a changing environment and serve as an ongoing forecasting tool.
Learn why budgeting is important for any company in our article on what budgeting is and why it is important for a business, or download our full Budgeting Survival guide.
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