Approaches to budgeting

Budgeting is very essential for every business to enable it to plan and track its performance. There are two approaches to prepare a budget and each of these approaches has advantages and shortcomings. We will discuss these different approaches in this article.

A budget is defined as a detailed financial plan which highlights projected revenues and expenses of an organization for a future period usually a year. It is prepared in line with the strategic plan of an organisation after considering the different internal as well as external factors prevailing at that time. The finance department plays a significant role in the preparation of the budget in consultation with top management and other departments. The budget helps in planning, performance management and helps in the decision-making process.

There are two major approaches that are used when preparing budget: namely, top-down approach and bottom-up approach.
Under the top-down approach, the top management is the only management level that prepares the budget according to the objectives of the organization as laid out in the strategic plan and gives it to the lower level managers to implement.

There could be some minimal consultations with lower level managers for their suggestions but top management have sole discretion to adopt their suggestions. In preparing the budget management will look at the previous trends and experiences and then estimate revenues and costs in line with external influences. It is very important to consider past experience and current market conditions as these will determine the accuracy and reasonableness of the estimates.

Management will also consider relevant macro-economic factors such as inflation, changes in tax legislation, as well as internal factors such as resource allocation. Before finalisation top management might seek some input from lower level managers and may consider the inputs provided by the managers in the final document.

There are some benefits in adopting this approach. The budget will have an overall corporate approach rather than a divisional approach since management’s concern will be the overall growth of the organization. It will therefore be linked to the strategic objectives in the strategic plan since top management would have been involved in the crafting of the strategic plan. The budget will not take too much time to prepare since it would have been prepared by experienced management.

There are shortcomings to this approach though. Lower management will be demotivated since they do not own the budget as they were not involved in its preparation and sometimes feel that top management has set targets which are impossible to achieve.

In most cases top management lack the information on the ground and therefore may not have close information about the organization which might impact on the organisation and hence the budget. There is no coordination with other departments and so there could be no linkage of departmental activities. Top management will not have accurate information in terms of detailed revenues or expenditure which are known by lower level managers.

The bottom-up approach involves lower level managers in preparing the budget by preparing their departmental or business unit budgets based on the information prevailing at the time and also from past experiences. The bottom-up approach begins by top management identifying the different operations and tasks performed by the organization. Each unit of the organization will then indicate resources and funds required by them in their individual budgets.

In preparing the budgets managers are expected to take into account market conditions and any other external influence likely to impact on the organisation and any internal pressures that are needed to ensure the budget is more realistic. The finance department then consolidates the different unit budgets and the combined budget is sent to top management for the approval. The approved budget is then sent back to the managers for implementation.

The advantages of this approach are that the managers will be motivated as the ownership of the budget is in their hands. The budget will also be viewed as more realistic as managers will have a better local knowledge of the operations of the organization. Since managers were involved in the preparation of the budget they will be more committed to the budget implementation and targets set by them as they are the owners of the same.

Top management will no longer spend much time on operational issues but will only have to concentrate on the overall business strategy rather than a business unit. Managers know the local conditions in which the unit operates and therefore the budget will be reasonably accurate which leads to overall accuracy over the total budget.

However we have to bear in mind the shortcomings of this approach. The budget may not be properly linked to overall corporate objectives of the organization as it would be prepared by the managers at the business unit level. The preparation process tends to take time because of inter-departmental consultations. There is also bound to be disputes between departments in terms of resource allocation. Managers may set targets that are easy to achieve to reduce pressure from top management.

The choice of which approach to use will be determined by how knowledgeable the lower managers are in how budgets are prepared. If managers lack the skills it’s advisable to adopt the top down approach because the budget preparation will not take time and the budget will be accurate. If managers have the skills it’s important to include them because then they will own the budget and will be motivated to achieve it.

Stewart Jakarasi is a business and financial strategist and a lecturer in business strategy, advanced performance management and entrepreneurship. For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062.