To some, the Fall means the start of pumpkin spice items, mums, and Halloween decorations. However, for corporate finance professionals, the Fall means the beginning of the budgeting season. Creating a proper financial budget is one of the most important tasks any business should do before starting a new fiscal year. While there are many different methodologies to prepare a company’s annual budget, I think it is important to identify the top three methods used to create the best in class budget.
Three of the most popular methodologies/approaches to creating a budget are Top-Down, Bottoms-up, and Zero-Based Budgeting (ZBB). Each method has its positives and negatives and is dependent on the situation on what you should utilize. The first approach we will discuss is the Top Down approach. In a Top-Down budget, the executive team comes up with a total budget and then allocates the budget to the individual department. The department heads then build a lower level budget based on the amount provided by senior management. This approach tends to take the least amount of time, since you are given the set parameters ahead of time. The biggest negative is that because the total budget is provided by senior management, it does not take into account the day to day costs that are normally involved in the business.
The second approach is the Bottoms-Up approach. In this approach, the department heads put together a budget that they submit up for approval. Senior management can either accept, revise, or reject the submission. Once all the departments’ budget submissions are approved, a master budget is put together. The biggest positive to using this process is that it allows for a large amount of ownership at the department level. It also allows for more accuracy on day to day spending as the lowest level decision-makers are involved. While there are many positives to budgeting, this one does have many drawbacks. The first is that it is a very time-consuming process due to all the different management levels the budgets have to go through. Another disadvantage is that managers will frequently try to pad (Sandbag) their budgets with the extra expense; this is a negative as it will allocate limited resources to something that will never be spent as well as give the manager a chance to artificially improve performance. A final drawback is that with each department creating its own budget, it can cause the company’s target number as a whole to be over or off with corporate objectives.
The last approach is the Zero-Based budgeting (ZBB) process. In this process, you start your budget at zero, and it increases as you justify each expense. This process’s advantage is that managers have to justify all costs; it also keeps legacy expenses in check because managers have to explain them and can’t just accept them as is. The ZBB process has plenty of downsides. The first is that it is also an extremely time-consuming process that requires a lot of buy-in from all the different management levels. A second negative is that this methodology tends to favor higher revenue-producing departments and does not focus on departments that generate long term growth like Research and Development.
No matter what process you choose, it’s essential to make sure you complete a reasonable budget that you and your company can hold accountable to at the beginning of the Fiscal year.
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