Bottom-up Budgeting
It is the budget creation process that appreciates the inputs from the lower management levels
What Is Bottom-Up Budgeting?
Bottom-Up Budgeting is a tool where all the management levels can create budgets. As the name suggests, the budget is created using the inputs from the bottom levels to the top.
Budgeting involves creating a map of the business's activities for a defined period. Budgets are the monetary tools describing activities, especially revenues and expenses, in the budgeting process.
Creating a budget is paramount for businesses every year, month, or project. Organizations have their missions and strategies that specify their long-term goals. By budgeting, an organization can take a step closer to its goal effectively.
In creating the budget, there must be a participation of various management levels. An organizational structure comprises top-level or senior management, middle management, and lower management.
The senior management is responsible for creating strategies by which the organization can effectively achieve its goals. They appoint a budget committee accountable for the institution's fiscal policies.
They create a master budget and approve the departmental budgets sent by the lower management levels. They oversee that all the departments abide by the budgets and that those budgets meet the requirements in a budget manual.
A budget manual is a standardized rule that must be followed during a budget formation and provides guidelines for its reporting. Large-scale organizations preferably use it.
Departments within an organization could also follow a hierarchy separating the higher, middle, and lower managers. Budgets made by the higher management may not accurately reflect the performance, causing the budget to be impractical.
Thus, a budget can be made more realistic by involving the middle and lower management levels that are much more aware of the employee's strengths and weaknesses. This kind of budgeting process is known as Bottom-Up Budgeting.
Key Takeaways
- Bottom-up budgeting, or participative budgeting, is the budget creation process that appreciates the inputs from the lower management levels.
- As the budgets are created accurately, it leads to optimal decision-making and much greater employee acceptance.
- The budget begins from the lower management level and is sent upwards to various levels of approval.
- Bottom-up budgeting could result in budgetary slack where the budgets are fabricated by plugging in underestimated revenues or overestimated costs.
- An alternative to Bottom-Up Budgeting is the Top-Down Budgeting process.
Understanding the Bottom-Up Budgeting
Bottom-up budgeting, or participative budgeting, is the budget creation process that appreciates the inputs from the lower management levels. They assist in the process of setting their budgets.
In a bottom-up approach, as the name suggests, the budgets are set at the bottom levels and work their way upwards to the senior management. Through this process, the lower management levels sense belongingness towards the organization.
When lower management creates a budget for their specialized activity, the allocations are more likely to be accurately reflected. There are lower possibilities that there are any budget variances.
Note
Budget variances are the differences between the standard or ideal outputs and the actual outputs.
As the budgets are created accurately, it leads to optimal decision-making and much greater employee acceptance. Acceptance of the budget refers to the situation when the employees are motivated to achieve the budget.
There is an increased popularity among companies opting for this type of budgeting. To put things into perspective, 55% of businesses operating in various industries recognize the need for employing Bottom-Up Budgeting and have implemented the same.
Note
Before forming department budgets using the Bottom-Up approach, it is crucial to understand the company's different subgroups and functional levels.
After this, the functional levels must formulate their profit plans (budgets) by projecting their estimated revenues and expenses. All information that should be included, like new projects, etc., must be included.
The budget committee must understand the internal and external factors that could affect the revenues and expenses of the particular department. By this, they can quickly evaluate the budgets created by each functional level. This constitutes the approval stage.
Finally, the committee must create the master budget by adding every approved departmental budget.
Creating a budget is not a standard document of records; it must be re-evaluated based on the current performance levels.
Suppose the raw materials prices have increased; the sales department's budgets would show a high unfavorable variance. Such a situation can be avoided by re-evaluating the budget whenever necessary.
Although all the organizational departments work towards a common goal, the lower managers could be more interested in creating budgets supporting their departmental objectives than the organization.
This is avoided by fostering a sense of goal congruence among the managers to align their motives with the overall organization.
Advantages of Bottom-Up Budgeting
The advantages of Bottom-Up Budgeting are highlighted below. Companies are inclined to opt for this type of budgeting based on the following advantages.
The recent popularity behind this was sparked by a need to understand and prioritize employee needs.
1. Employee Motivation
A crucial aspect of the budgeting approach is associating the employees at the lower management levels.
When each department is involved in the process, it boosts the employee's morale as they would perceive that the organization requires their input and is vital to them.
Additionally, as the employee thinks about the department's future revenues and expenses, they form their department goals and work toward achieving them.
2. Higher Accuracy
A department manager is well aware of the expenses that must be included in the budgets. Furthermore, they understand the external factors that could negatively affect their departments' revenue.
Consequently, a department manager should actively create their budgets, rather than the top management, who would only partially comprehend some influencing factors.
3. Higher Budget Acceptance
As employees are directly involved in setting their budgets, it creates a sense of ownership toward them and encourages them to work harder to achieve them. This is known as budget acceptance.
If the budgets were set only by the top management, the budgets are more likely to demand excess unattainable performance. So, usually, there is a shallow acceptance of those budgets.
Disadvantages of Bottom-Up Budgeting
The disadvantages, on the other hand, are highlighted below. Companies are required to understand the limitations behind the new and popular budgeting technique.
Apart from the advantages, the disadvantages must equally be considered.
1. Time-Consuming And Costly
Creating and approving a budget is time-consuming and costly when multiple departments or responsibility centers are within an organization. The budget begins from the lower management level and is sent upwards to various levels of approval.
The budget committee, which is at the senior management level, must approve the budget. Before it is sent to the senior management, it must be approved by the middle management level.
Every management level must scrutinize each budget sent by their subordinates. The whole process becomes time-consuming as there could be many revisions and resubmissions. With this, differences could arise, creating conflicts.
2. Possible Frauds
Budgets affect every employee in the organization. In the same way, maintaining performance in line with budgetary standards becomes essential. Thus, a budget affects the performance and the behavior of the employee.
Generally, when rewards are attached to performance, it could negatively affect the employee's behaviors. They could attempt to create a budgetary slack or indulge in accounting fraud to gain a higher reward.
Note
Budgetary slack is a budget fabrication by plugging in underestimated revenues or overestimated costs.
While creating the budget, the employee may falsify the estimated projections.
When revenue estimates in the budget are lower than actual earnings, and the employee's performance exceeds those estimates, the employee is considered to have exceeded expectations.
In reality, they created achievable budgets and would be rewarded commensurately for their performance.
Additionally, an employee may manipulate the revenue or cost records to show that the performance exceeded the budget. They would do so to pocket a higher incentive.
Bottom-Up Vs. Top-Down Budgeting
Budgets can be prepared in two manners - by involving employees or without. The process by which the budgets are directly imposed on the employees without considering their opinions is known as Top-Down Budgeting.
The senior management creates a budget and imposes it on the subordinates. This is also known as authoritative budgeting. The top managers make the budget, and the lower managers are expected to deploy resources within the budget created.
The senior managers create the budgets to envision the company's future market position and create company-wide objectives. During the process, the managers make these budgets independently, creating a stringent budget. There is a lower budget acceptance.
There is also a lower chance that the budgets deviate from the overall organizational goals. When the top management creates the overall budget and allocates the resources to each department, they are only expecting the achievement of the organization's strategies.
These budgets are constructed using the departments' historical performance and previous budget data. However, these do not accurately reflect the future performance as a business's performance can be impacted by many factors.
Some factors that can affect a business unexpectedly include a sudden change in raw material prices, regulatory restrictions, tax implications, and financial crisis.
There is a higher possibility of a budget variance - both favorable and unfavorable.
- Favorable variance is when the actual output is higher than the standard output
- Unfavorable variance occurs when the standard output is lower than the actual output.
Furthermore, as the budgets are created only by the top management, it is approved faster and less time-consuming without the management's intervention. Unlike Bottom-Up Budgeting, it does not require multiple levels of approval.
| Basis | Bottom-Up Budgeting | Top-Down Budgeting |
|---|---|---|
| Approach | Participative | Authoritative |
| Budget Acceptance | High | Low |
| Time and Costs | High due to approval delays | Low due to lack of approval requirements |
| Employee Motivation | Very high as employees are directly involved in the budget setting process | Low as budgets are directly imposed on employees |
| Budget Variances | Very low as lower level managers set their own budgets | Higher possibility as the senior managers may not be fully aware of the functioning of the departments |
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