What’s it: Top-down budgeting is a budgeting approach in which top executives set a budget and then pass it on to managers for implementation. Budgeting will be following the targets and objectives to be achieved by management.
Company executives consider the past experience and current market conditions. They can use the previous year’s budget and financial reports as a benchmark for making allocations to business departments and functions.
They also can take input from lower-level managers to find out how much budget is needed. They also use internal and external factors as input, such as economic conditions, changes in tax regulations, conditions of profitability margins, etc.
When do companies use a top-down budgeting
The business’s size and structure are usually the primary considerations in deciding whether or not a top-down budgeting method.
In smaller business structures, the chain of command between top-level executives and lower-level managers is shorter. Typically, top-level executives are familiar with day-to-day operations. In those situations, the top-down budgeting method makes more sense because it saves more time.
But, as the company starts to grow, the structure becomes more complicated. The chain of command is also longer. Executives should consider getting more input from department managers in the business. Thus, bottom-up budgeting is more applicable.
Top-down budgeting stages
The top-down budgeting process begins with the executive setting company goals and targets. They discuss and determine what the company accomplishes in terms of sales, expenses, and profits.
When formulating the numbers, they take into account several variables such as:
- Previous year’s achievements
- Projections of the future business environment such as economic growth, inflation, and interest rates
- Competition conditions in the next year
- Market demand trends
- Contribution of each department to the achievements of the previous year
Usually, managers and lower-level staff do not participate in such meetings. However, they may have suggestions for consideration.
After management has finished preparing the targets, the finance department’s objectives are passed to allocate each department’s budgets.
Allocate departmental budget
The finance department is responsible for allocations for each department. They can base previous year’s figures to split allocations. For example, suppose the marketing department spent 10% of the total last year’s expenditure. In that case, they can allocate the same percentage next year.
Or, the percentage may be higher or lower, depending on the overall goals of the company. For example, suppose the company plans to launch a new product to market. In that case, the finance department may increase the marketing department’s budget allocation to cover the new product’s promotional costs.
After the finance department allocates a budget to each department, department heads take targets and prepare their own budgets.
Ideally, the department head will define the department’s targets into various activities planned for the next year. They then estimate contributions and costs for each type of activity. After that, they can allocate a budget.
The target and activity specifications make it easy for future evaluation.
Align departmental budget
Each department then submitted its budget to the finance department for harmonization. The finance department reviews individual budgets to ensure that they are aligned with the company’s overall goals.
Suppose there is a department with an insufficient or excessive budget. In that case, the finance department can ask the department head to revise it.
After department budgets are finalized, they enter the financial system to track monthly expenses.
Management deploys resources based on targets. The department receives monthly or periodic reports to show the expenses incurred from the allocated budget and the revenue generated vis-à-vis its targets.
The difference between top-down budgeting and bottom-up budgeting
Unlike top-down budgeting, bottom-up budgeting starts at the departmental level. Then, it goes to top management.
Department heads prepare their budgets based on current information and past experiences. They then pass it on to senior management for approval.
As in top-up budgeting, department heads must consider targets and activities planned for the next year. They then allocate costs to each activity.
Then, the department head submits the department budget to top management. It contains details about each item and its justification.
Advantages and disadvantages of top-down budgeting
Is a top-down budgeting method the most ideal? It depends on each company.
Well, I will discuss the advantages and disadvantages of top-down budgets.
The advantages of top-down budgeting
- More prioritize on overall business growth. The executive sets company targets and then adjusts the budget. Executives can allocate resources to departments to drive the company’s growth, starting with the most critical departments. That contrasts with the bottom-up approach to budgeting, which emphasizes departmental targets first.
- Better target synchronization. Each department sets targets according to company targets, enabling them to be more synergized. Conversely, under the bottom-up budgeting method, each department sets its own targets. It may not align with other departmental targets or company targets.
- Save more time for small and medium-sized businesses. Instead of spending time creating budgets from scratch, executives can formulate budgets to run in each department. That, of course, saves time and resources. That lower-level manager only focuses on these targets and day-to-day operations.
Disadvantages of top-down budgeting
- Decreased motivation by lower-level managers. They feel uninvolved in what they think is important. They cannot be actively involved in the budgeting process. By not participating, they may lack the incentive to ensure success.
- Bias by executives. Executives are often not involved in the day-to-day operations of the company. They may set unrealistic targets for individual departments. Therefore, lower-level managers may find it challenging to implement the budget.
- Less accurate. Budgets may not be accurate because department heads are not involved. In fact, they have a better understanding of their department’s financial needs than company executives. Creating a budget without input from key personnel can result in underfunding or overspending from a department.
- The conflict between lower-level managers and company executives. With a top-down budgeting process, managers and employees may be angry that their input is not valued in the budgeting process. It can lead to conflict, which disrupts the rhythm of day-to-day operations.