Budgets are management tools and there is not a single approach that works perfectly for every organization. In fact, it may be a combination of approaches that works best for your organization. Some examples of methodologies include;
Top Down Budgeting
A high-level budget is developed by ‘top’ management and allocated ‘down’ through the enterprise. Top down budgeting is the most widely used and is well suited to the traditional hierarchically structured organization. One of the risks associated with this methodology is that lower level managers may not receive sufficient resources to accomplish the goals they are accountable for.
Bottom Up Budgeting
Operating plans constructed by line management or department heads at the ‘bottom’ of the enterprise and rolled ‘up’ to derive enterprise-wide financial targets. This approach ensures sufficient funding at the lower levels since estimates come from those most closely involved in managing operational performance. However lower level managers can deliberately seek higher funding than necessary, and there are usually several cycles of review/revise between top management and department heads before approval.
Zero Based Budgeting
Traditional budgeting (top down and bottom up) can allow managers to take the previous year’s budget and simply tack on an increase based on assumptions like inflation or expected headcount increases. Zero based budgeting requires managers to start at “zero” and build a budget from scratch as if no base line existed. In theory every expense will be looked at and justify based on the business case. Although it can help control cost, assessing and evaluating all material expenditures is very time consuming.
Driver Based Budgeting
Business drivers such as sales volumes and resource consumption rates are used to predict line item expenses. Defining the drivers and their impact on performance is the hard part with driver based budgeting as well as ensuring the accuracy of forecasts. However it does enable quick re-forecasting by simply updating a few assumptions.
Forecasts are never 100% accurate, rolling forecasts attempt to improve decision making by replacing annual planning cycles with more regular reviews of results against plans to adjust the balance of the year forecast based on current trends and patterns. There is a lot of variability in implementation of rolling forecasts but re-forecasting four or six quarters ahead at the end of every quarter is the most common approach. Many companies also combine driver based budgeting with rolling forecasts.