Difference between top down budgeting and bottom up budgeting

Creating a budget gives you the agility to prioritize expenses and understand financial strengths and weaknesses. Budgets also help you monitor and balance your financial health. Additionally, comparing actual costs with budget estimates helps you pinpoint areas of income leak that wouldn’t be possible without a target financial figure.

The only way to improve the efficiency of your company is to have financial goals to measure progress against. Yet, while you will want to outline a budget and try to maintain it, don’t be afraid to adjust it. Whatever budget you use, its purpose is to help you monitor and adjust your financial strategy to achieve key targets. Remember, the purpose of a budget is to guide you, not necessarily restrict you. The structures top-down budgeting and bottom-up budgeting help you do this, but in different ways. 

Top-Down Budgeting

Top-down budgeting takes the organization’s finances from a very holistic view. The company’s C-level and higher-level management define an overarching budget for the organization to function. The organization’s wealth and liabilities are examined. Sales numbers and profits, expenses, and other assets are evaluated against the direction the company wants to go. The C-Level leadership focuses on the next steps for company growth, so this budget is designed for progression. 

Executives gather accounting and relevant data from the individual departments to define the year’s budget and new metrics. They then examine expenses incurred and the return-on-investment for various initiatives. These factors influence how the budget is allocated to different departments and funds. Next, these allocations are dispersed to department heads who will form their budgets based on these figures. 

Example

The previous year, the human resources (HR) department contributed to 5% of the overall expenses for the year. The new top-down budget would account for this by allocating enough budget to cover a similar amount of costs. More budget may be allocated for increasing expenses and needs, or the budget is reduced to conserve more cash.  

Pros

• Reduces time constraints of management, so they can prioritize on other key tasks instead of developing budgets.
• Creates a single overarching budget that gives a single direction for the whole company. 
• Very useful for making actionable financial decisions needed for company growth. 

Cons

• This may exclude day-to-day leaders who can offer critical insight needed for the budget to be effective.
• There are risks of not accounting for unseen factors or new developments in various departments.
• Could ostracize middle management and leadership. 

Bottom-Up Budgeting

Bottom-up budgeting takes the opposite approach of top-down budgeting. Here, department leaders look over the year’s finances and then developing a proposed budget. Departments review expenses, initiatives, company metrics, and accomplishments to create proposed budgets. Then, the budget (or budgets) is presented to the highest leadership.

Managers also take market factors and unique circumstances into consideration to develop a grounded financial plan. The mindset behind this is that if the departments are successful, the company is successful. The growth and development of the company is still the overarching goal. 

Example

A sales director builds a sales budget using numbers reflecting staff salaries and expenses for surrounding trade shows. We’ll put this number at $100K. They also account for new equipment and IT tools, perhaps $70K. After this, the sales director adds a cushion for emergencies or change to produce a budget of $180K. 

Pros

• These budgets can be more accurate and practical because they’re drawn from hands-on experience designed to maximize department efficiency.
• Useful for creating tailored plans for using budgets and developing new key performance indicators (KPI)s. 
• This method creates more ownership and accountability throughout the company. This also gives morale boost to teams by entrusting them with steering the company. 

Cons

• It’s very easy, even common, to over budget with this method.
• This method can draw leaders away from priority tasks to focus on the budget. As a result, other team members’ time and focus may also need to prioritize budgeting tasks over primary tasks.  
• Management can become competitive for budget allocations and create internal politics and friction.
• Overarching company goals might be overshadowed with a focus on departments. Multiple budgets are created to manage and assess, which may lead to confusion or desynchronization.

Which is Better Top-Down Budgeting or Bottom-Up Budgeting?

The reality is that neither method is better than the other. Therefore, choosing between top-down budgeting or bottom-up budgeting should be based on which works best for your organization. You could even do both and then choose which budget strategy you want to proceed with. Or, combine aspects of both budget sets. The tricky part is simply maintaining your budgets in a consolidated, organized manner. 

Your Accounting System Defines Your Budget Management 

Whether type of budget you go with, you need an accounting system with a flexible chart of accounts. This lets you organize and allocate funds as you need while letting you structure your budget(s) in a single location. 

Remember, having a budget is only effective if you can track and manage it. To this extent, in-depth features like audit trail and account drill-down are very important. These features help pinpoint financial trends to see how your initiatives are performing relative to budget goals. Additionally, Real-time visibility into your accounts is important for letting you isolate account behaviors and statuses. 

Top-down and bottom-up approaches are methods used to analyze and choose securities. However, the terms also appear in many other areas of business, finance, investing, and economics. While the two schemes are common terms, many investors get them confused or don't fully understand the differences between the approaches.

Each approach can be quite simple—the top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general. These methods are possible approaches for a wide range of endeavors, such as goal setting, budgeting, and forecasting. In the financial world, analysts or whole companies may be tasked with focusing on one over the other, so understanding the nuances of both is important.

• Top-down usually encompasses a vast universe of macro variables while bottom-up is more narrowly focused.
• Top-down investing strategies typically focus on exploiting opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
• While top-down and bottom-up can be very distinctly different they are often each used in all types of financial approaches like checks and balances.

Top-down analysis generally refers to using comprehensive factors as a basis for decision making. The top-down approach seeks to identify the big picture and all of its components. These components are usually the driving force for the end goal.

Top-down is commonly associated with the word "macro" or macroeconomics. Macroeconomics itself is an area of economics that looks at the biggest factors affecting the economy as a whole. These factors often include things like the federal funds rate, unemployment rates, global and country-specific gross domestic product, and inflation rates.

An analyst seeking a top-down perspective wants to look at how systematic factors affect an outcome. In corporate finance, this can mean understanding how big picture trends are affecting the entire industry. In budgeting, goal setting, and forecasting, the same concept can also apply to understand and manage the macro factors.

In the investing world, top-down investors or investment strategies focus on the macroeconomic environment and cycle. These types of investors usually want to balance consumer discretionary investing against staples depending on the current economy. Historically, discretionary stocks are known to follow economic cycles, with consumers buying more discretionary goods and services in expansions and less in contractions.

Consumer staples tend to offer viable investment opportunities through all types of economic cycles since they include goods and services that remain in demand regardless of the economy’s movement. When an economy is expanding, discretionary overweight can be relied on to produce returns. Alternatively, when an economy is contracting or in a recession, top-down investors are usually overweight to havens and staples.

Investment management firms and investment managers can focus an entire investment strategy on top-down management that identifies investment trading opportunities purely based on top-down macroeconomic variables. These funds can have a global or domestic focus, which also increases the complexity of the scope.

Typically, these funds are called macro funds. They make portfolio decisions by looking at global then country-level economics. They further refine the view to a particular sector, and then to the individual companies within that sector.

Top-down investing strategies typically focus on profiting from opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.

The bottom-up analysis takes a completely different approach. Generally, the bottom-up approach focuses its analysis on specific characteristics and micro attributes of an individual stock. In bottom-up investing concentration is on business-by-business or sector-by-sector fundamentals. This analysis seeks to identify profitable opportunities through the idiosyncrasies of a company’s attributes and its valuations in comparison to the market.

Bottom-up investing begins its research at the company level but does not stop there. These analyses weigh company fundamentals heavily but also look at the sector, and microeconomic factors as well. As such, bottom-up investing can be somewhat broad across an entire industry or laser-focused on identifying key attributes.

Most often, bottom-up investors are buy-and-hold investors who have a deep understanding of a company's fundamentals. Fund managers may also use a bottom-up methodology.

For example, a portfolio team may be tasked with a bottom-up investing approach within a specified sector like technology. They are required to find the best investments using a fundamental approach that identifies the companies with the best fundamental ratios or industry-leading attributes. They would then investigate those stocks in regards to macro and global influences.

Metric focused smart-beta index funds are another example of bottom-up investing. Funds like the AAM S&P 500 High Dividend Value ETF (SPDV) and the Schwab Fundamental U.S. Large Company Index ETF (FNDX) focus on specific fundamental bottom-up attributes that are expected to be key performance drivers. 

Generally, while top-down and bottom-up can be very distinctly different they are often used in all types of financial approaches like checks and balances. For example, while a top-down investment fund might primarily focus on investing according to macro trends, it will still look at the fundamentals of its investments before making an investing decision.

Vice versa, while a bottom-up approach focuses on the fundamentals of investments, investors still want to consider systematic effects on individual holdings before making a decision.