Accounting and Finance Teams typically dread the annual budgeting process, and if you’re relying solely on your Finance Function to manage it from start to finish, it’s easy to understand their pain. However, it doesn’t have to be this way. Capital budgeting is necessary to help frame decisions that can lead to prosperous outcomes for your organization.
When speaking to many board of directors and management teams there are many different budgeting processes espoused: top-down, bottom-up, zero-based budgeting. First of all, what do each of these types of budgeting methods mean and how do you go about implementing them?
There are many budgeting methods to choose from, but we wish to focus on those that apply to the majority of organizations. In this post, we compare the differences between top-down, bottom-up and zero-based budgeting and which process might be the best option for you.
Top-down budgeting is where a finance function is primarily responsible to generate the budgets, with some management intervention that is then passed down to the individual team members of each department. Some companies might begin with an Excel spreadsheet and create a budget without a lot of involvement from the other parts of the organization.
The problem with the top-down budgeting process alone is that sometimes the executives are aware of the budget, but it really doesn't filter down to be an actionable plan for the people involved. If your team members are too far removed from visibility into the budget, it’s difficult for them to formulate precise actions necessary to fulfill the targets set within the framework of the budget.
Bottoms-up budgeting on the other hand, requires Finance to collect the individual targets from the department heads. With individual budgets gathered, you then build a detailed budget, department by department, team member by team member.
The problem with bottom-up budgeting is there are no parameters to guide departments as they develop a budget, which oftentimes is laced with overspending.
For example, when I was the CFO for a company we took public, we attempted to set targets for the next budget year. And the CEO said, no, let's just see what everybody comes back with — typical a bottom-up budgeting method. Well, the problem was the amount of a loss they came back with, or the amount of spending was overwhelming and not at all palatable.
Then, we had to evaluate all of those budgets and provide new targets that were more appropriate. As expected, this led to frustration and complaining that we cut their budget when the budget never really existed that way in the first place.
For most cases, you can't simply let team members craft a budget without some kind of parameter or some kind of a target in mind. This is where the opportunity to develop more of a hybrid approach of top-down and bottom-up budgeting can be ideal.
The zero-based budgeting process is another method that requires you to look at each year as a clean slate. Zero-based budgeting requires you to determine how you will allocate each dollar for a given year (assuming it's an annual budget). You essentially start with zero each year and decide, with input from management and budget owners, how are you going to spend any dollar.
It’s the exact opposite of what the government does, where they say we spent a million dollars last year, so it's going to go up by 4%. Zero-based budgeting processes provide an annual opportunity to tailor KPIs and targets given the learnings of what has, and hasn't worked in the past, without restricting allocation opportunities. It fuels informed, strategic discussions with insights that can have a profound impact on the following year's success.
At FutureView, we build our budgets vendor-by-vendor and headcount-by-headcount, with a zero-based budgeting process approach. Despite the benefits of the zero-based budgeting method, it’s important to use a hybrid approach, where you begin by deciding where you would like to end up when you finish the detailed budget, then go back and get your team to build that detailed budget. It's the destination that will allow you to work from the ground up and create a budget that can have the most profound impact on the company.
In a hybrid budgeting method, you establish the broad parameters of a target for budget, with your executives and your board (top-down). Make sure that when you build this budget at a detailed level, that it's going to be a budget that actually hits. Something that the board and management are going to find acceptable.
Then once you've agreed on those broad targets, and they could be revenue and profit and maybe, you know, some major decisions around marketing spend or investment, then you go back and you allocate those targets out and you build a detailed budget by department.
Your annual budget should be stress-tested by involving budget owners in discussions as to why some targets may or may not be met given the parameters. For example, if you give the marketing team a limited budget, they will respond by saying you're not going to hit the sales numbers or revenue with this budget.
It’s these types of discussions you want to have when creating a budget, and that's what budgets are supposed to be about. They're supposed to be about decision-making not about, just putting numbers into a system or a spreadsheet.
It's about making decisions and that brings to light the difference between budgets versus forecasts. The key thing in any budget is it sets your destination much like a GPS. You determine where you’d like to end up. You need to know what your destination is first. Then you can start to build a detailed path to get there.
A well-informed budget requires a collaborative process with inputs from department heads. You must collect information from all different parts of the organization and pull it together for a consolidated view. This requires cross-functional and individual discussions with each budget owner to identify items such as:
Finance can incorporate this information into a Budgeting and Forecasting Platform, where it automatically rolls up the data and you can view the entire budget at a department level or collectively, which does the following two things:
1. It makes sure that you've captured all the budget information in a collaborative, detailed way. And it's automatically rolled up, as opposed to having millions of spreadsheets come at you from a finance perspective and trying to put them all together.
2. It allows you to force department heads and budget owners to think about the choices they're making in a budget. This collaborative process provides every budget owner a P&L and you can sit down with those budget owners and talk about their plans for the year and what they're going to try to accomplish.
From there, the Finance team can pull together all the P&Ls and develop balance sheets and cash flow statements, which can be automated using an FP&A Platform. With this, all spending decisions and revenue decisions are reflected in the budget. This budgeting process eliminates much of the back-and-fork and guesswork, culminating in a much more rapid budgeting process that isn’t as lengthy or cumbersome. As the year progresses, you’re able to evaluate actuals and variance analysis to identify where's my budget now, versus the established targets.