The Three Types of Business Budgeting

by Chris on April 19, 2012

The more I learn about budgeting, the more I learn that there are just thousands of ways to do it.  I’ve also learned that there are a lot of similarities between budgeting for your household and budgeting for a business.

With that said, let’s take a look at some basic forms of business budgeting.  I vaguely remember learning about these in one of my business classes, maybe in managerial accounting?  Anyway, there are really three main types of budgets that are used to control and forecast expenses for businesses.  Today, I’ll briefly discuss a little about each one.

Top Down Budgeting Method

Types of Business BudgetsA top down approach to budgeting for business means that the estimates for expenses originate at the top of the organization, and at the department level.  In essence, upper management looks at the growth prospects for the company and then sets forth a budget to match those projections.  From there, individual budgets are handed down to each department and the manager of each department must manage their business based on that budget.  As its name implies, the budgeting process starts at the top of the organization and focuses on the big picture to assign budgets to the lower levels of the organization.  With this method, the owner of the business or executives typically make most of the budget decisions.

Of course, this type of budget has its advantages and disadvantages.  Here is what Chron.com has to say about the pros and cons of using top down budgeting for business:

Advantages

The advantage of using a top-down budgeting method is that you do not have to rely on lower-level managers to come up with budgeting information. Your business can allow the lower-level managers to focus on their departments and what they do best. If you were to use a bottom-up method instead, you would have to wait for the individual departments to come up with budgets and then compile them all into a company-wide budget. Using a top-down method often saves time overall.

Drawbacks

Using the top-down method is not always the ideal choice as it does have a few drawbacks. For instance, the upper-level executives of a company may not have enough knowledge about the individual departments to come up with a budget. In many cases, the budgets may not be realistic because of this lack of intimate knowledge. Although they do help departments to understand what is expected of them, they may not provide enough resources for departments to do their jobs well. In other cases they may allocate too many resources to a particular department.

Read the rest of this article at http://smallbusiness.chron.com/topdown-method-23876.html.

Bottom Up Budget Method

A bottom up budget starts at the lower levels of the organization.  Department managers create budgets for their department and then send them up the chain of command, so that all of the individual budgets come together to form the entire business budget.  However, the executives still have to approve the department budgets, which are sent back to the managers again and again until managers and executives can agree and finalize the budget.  During this process, costs are estimated from the bottom up, starting with such things as salary, materials, overhead and all of the expenses associated with each department.  The level of detail in this type of budget can be quite significant.

According to Business Knowledge Resource, this type of budget has the following pros and cons:

Disadvantages of bottom-up budgeting

One of the primary disadvantages of bottom-up budgeting is that it can lead those who are in charge of tasks and also project managers to ask for more funding than will actually be needed.  This is done in order to ensure that enough money is procured for each task to be accomplished, since most people assume that they will not be given all of the money that they request.  This situation can lead to a waste of money and also a situation of distrust between various members of projects and different managers.

Another drawback to bottom-up budgeting is that it is difficult to actually draw up a complete and thorough list of every step and task that will be necessary for the completion of a project.  It is easy to overlook a step of a project or a task, a problem that will lead to major issues in the overall budget.

Advantages of bottom-up budgeting

One of the major advantages of bottom-up budgeting is that the budget can be quite accurate for individual tasks.  As long as no tasks have been forgotten, then this can work quite well.  Also, bottom-up budgeting involves all members of a particular project, which can be a benefit in terms of company morale and involvement.

You can read the rest of this article at http://www.businessknowledgesource.com/finance/a_comparison_of_topdown_to_bottomup_budgeting_024713.html.

Zero Based Budgeting

The final type of business budget is called a zero based budget.  Most budgets typically start by looking at previous versions of the budget.  For example, if you run the marketing department for a company and your budget for the last quarter was $500,000, you’d probably assume that you would start with a $500,000 budget for the next quarter.  With zero based budgeting, that’s not the case. With zero based budgeting, each new budget period starts from scratch.  Individuals and managers in each department must come up with a business plan and create a detailed budget specific to the next budgeting period.  By using this type of budget, companies are forced to have to estimate and justify their proposed budget each period.

As with the other methods of budgeting, there are also pros and cons to this method.  Yahoo Voices listed them as follows:

Advantages of Zero-Based Budgeting

  1. Efficient allocation of resources, as it is based on needs and benefits.
  2. Drives managers to find cost effective ways to improve operations.
  3. Detects inflated budgets.
  4. Useful for service departments where the output is difficult to identify.
  5. Increases staff motivation by providing greater initiative and responsibility in decision-making.
  6. Increases communication and coordination within the organization.
  7. Identifies and eliminates wasteful and obsolete operations.
  8. Identifies opportunities for outsourcing.
  9. Forces cost centers to identify their mission and their relationship to overall goals.

Disadvantages of Zero-Based Budgeting

  1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.
  2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.
  3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.
  4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.
  5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.

You can read the rest of this article at http://voices.yahoo.com/zero-based-budgeting-5389105.html?cat=3.

The Takeaway

The purpose of this article was mostly to educate you and refresh my knowledge of the various business techniques for budgeting.  Hopefully you can now differentiate between these three different methods.  If you run a small business or work for a large company, you are probably somewhat involved in one of these methods already.  If you aren’t, getting insight into these methods can also be applied to your everyday budgeting needs, but we’ll save that for another article.

{ 1 comment… read it below or add one }

LoveSanta October 22, 2012 at 2:13 am

Interesting – I’d never really thought about different methods within a business for budgeting. I certainly have worked in companies (and known of many more) where you have to spend last year’s budget or get less next year – if you spend $90K this year instead of $100K, next year you’ll only get $90K. It means a lot of courses and booked and equipment bought in the last month or so of the financial year :)

I think I like the idea of top down with each department putting in a submission for major expenses or higher budget needs than previously accounted for. That way, departments can educate top management of their needs but it gets done more efficiently and with the overall business in mind.

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