Budgeting Methodologies: Analyzing the Advantages & Disadvantages

Recently, I served as a panelist for the webinar, “Budgeting Basics: How to Build a Strong Budget for 2015.” We discussed a variety of topics, including how budgets affect profitability, when to start building next year’s budget, planning framework and company stakeholders who need to be involved in the process.

One vital aspect of budgeting is to determine which type of budget methodology to use. Here, I outline three different budget methodologies—top-down, bottom-up and iterative—as well as their advantages and disadvantages. What type of budget works best for your company?

Top-Down
Top-down budgeting is the term given to a budgeting process based on estimating the cost of higher-level tasks first and using these estimates to constrain the estimates for lower level tasks. A crucial factor for successfully implementing this method for estimating budgets is the experience and judgment of those involved in producing the overall budget estimate.

Noteworthy details

  • Takes less time
  • Promotes upper-level commitment
  • Does not require multilevel participation
  • Lower management better understands what upper management expects
  • Presented down the ladder

Disadvantages

  • Translating long-range budgets into short-range budgets can be a challenge
  • Top management’s limited knowledge of specifics of project tasks and activities may lead to underestimation of costs
  • Can lead to competition for funds among lower-level managers trying to secure adequate funding for their operations
  • This process is a zero sum game –one person’s or area’s gain is another’s loss
  • Subordinate managers often feel that they have insufficient budget allocations to achieve the objectives

Advantages

  • Aggregate budget is quite accurate, even though some individual activities are subject to large error
  • Budgets are stable as a percent of total allocation and the statistical distribution of the budget is also stable, leading to high predictability
  • Small costly tasks don’t need to be identified early in this process; they are factored into overall estimate
  • Can be accomplished in a short time

Bottom-Up
Sometimes called zero-based budgeting, bottom-up budgeting begins with identifying all the constituent tasks that are involved in implementing a project and working out the resources and funding required by each. It provides the opportunity to create organization-level budgets by rolling up project budgets and creates centralized project-level budgets from their sub-project budgets. It also provides project managers with the flexibility to define their project budgets independently, and financial managers have the ability to centrally review the total project budget/s.

Noteworthy details

  • Takes more time
  • Involves cross-section of the organization
  • Presented up the ladder
  • Seeks participation at all levels
  • Encourages commitment to the plan

Disadvantages

  • Top management has limited influence over the budgeting process
  • Individuals tend to overstate their resource needs because they suspect that higher management will probably cut all budgets by the same percentage
  • More persuasive managers sometimes get a disproportionate share of resources
  • A significant portion of budget building is in the hands of the junior personnel in the organization
  • Sometimes critical activities are missed and left unbudgeted

Advantages

  • Higher accuracy of the budgets for individual tasks
  • Clear flow of information
  • Use of detailed data available at project management level as basic source of cost, schedule, and resource requirement information
  • Participation in the process leads to ownership and acceptance

Iterative Process
Iterative means “to repeat or do again.” The iterative process is a combination of top-down and bottom-up budget building. There is a higher project level (top-down) and a lower level (bottom-up) estimation of costs. The two estimations are compared, negotiated and reconciled.

Disadvantages

  • Relatively inefficient and time consuming nature of the negotiations over the budgets
  • Process may not work well when communication channels are either informal or blocked between lower-level managers and senior management

Advantages

  • Promotes employee involvement and stimulates a high degree of information flow between those involved in the project at different levels
  • Both senior management and lower level management closer to the actual process participate in the budgeting process

For more information on budget best practices, the webinar “Budgeting Basics: How to Build a Strong Budget for 2015” is available here.