In this lesson, we will explain the purpose of budget controls and explore several key related concepts including top-down budgeting, bottom-up budgeting, zero-based budgeting and flexible budgeting.
What Is a Budget?
In this lesson, we will explore various types of budget controls used in organizations. In order to understand the various budget controls, let’s first define the term ‘budget.’
A budget is a financial plan for saving, spending and borrowing money. A budget helps an organization determine whether it can operate based on projected income and expenses for a period of time. A budget is generally prepared for a period of one year but is broken down monthly for various spending and saving purposes. Accurate projection of revenue and expenses is vital for organizational planning for resources like people, materials and money. The purpose of a budget is:
- To provide a projection of revenues and expenses
- To forecast an organization’s financial future based on the outcomes of organizational plans
- To measure and compare projected expenses to actual expenses
- To establish a cost ceiling for operational, or short-term day-to-day expenses, and capital, or long-term expenses for major projects
We now know that a budget is used to project income and expenses for a period of time. But how are budgets used as a management control? Let’s visit a few universities to see how budget controls work for them.
Types of Budget Controls
There are several budget controls used in organizations:
- Top-down budgeting
- Bottom-up budgeting
- Zero-based budgeting
- Flexible budgeting
Top-down budgeting starts at the top of an organization and is handed down to lower departments. There are several pros and cons to this type of budget control.
TD University’s science department uses top-down budgeting. Top management creates the department’s budget based on a combination of forecasting for future revenues and expenses and the previous year’s actual budget results and sends the money down the university pipeline.
Top-down budgeting can be a good thing because lower management does not have to take time to prepare the budget. This is a time-saver for lower management, who are more involved in the operational process rather than the overall strategic plan.
However, a budget prepared by those who are not directly involved with the day-to-day operations of a department may not be aware of the particular expenses related to the department. This could be problematic for lower-level managers who may not be able to retain the necessary resources to meet organizational objectives. Once the budget is given to the department, monies can be spent according to what has been allocated. Supplies can be purchased, professors can be paid and student activities can be planned.
Bottom-up budgeting starts at the bottom of an organization. A budget is decided by lower-level management and then presented to top management for approval. Top management will either approve the proposed budget or send it back down to lower management for review and modification. There are several pros and cons to this type of budget control.
Budget University’s art department uses bottom-up budgeting. The dean of the art department decides how much money he needs to run the department. These decisions are based on the same sort of information used in top-down budgeting, like forecasting and the previous year’s actual results.
Bottom-up budgeting can be a good thing because lower management plans the budget based on the needs of the specific department. A manager of a department is more familiar with what is required, like supplies, labor and capital, to meet departmental goals.
However, lower management may not have the experience in creating complicated financial documents. Lower management may not be aware of the overall strategic plan of the organization. The budget may not be feasible because of top management plans to allocate resources elsewhere in the organization, like toward capital improvements or a major purchase of equipment.
Rather than the decisions being made by those who are outside of the department, those who are closest to the department make the decisions. Professors and staff in the department provide the dean with a list of their anticipated needs, and he creates a budget around the costs of things like buying clay, brushes and paint. While this method is practical because the dean of the art department knows what he needs to teach aspiring young artists, he is not an expert in accounting. He may not know how to write the document correctly.
Zero-based budgeting starts at a zero balance, and expenses are added as they are deemed necessary and are justified. This type of budget does not rely on a previous year’s performance or actual results. Expenses are added on a per-item basis. Each item is analyzed for alternatives that cost less. It is also not compared to a prior year’s budget. It does not matter if the new budget exceeds the spending in a prior year as long as the expenses are justified and have been compared for alternatives. There are several pros and cons to this type of budget control.
ZB Public University’s culinary department uses zero-based budgeting. The chef instructors review their lesson plans and any special events they may be hosting throughout a period of time. This could be a quarter or a year. Each chef instructor makes a list of things they need for their classrooms and programs. The dean reviews the lists and asks the instructors to look at alternative items that may cost less.
Zero-based budgeting is a good thing because it forces a manager to take a good look at expenses and justify the expenses or look at alternative products and services. It can streamline spending by always looking for new ways to cut costs. However, because zero-based budgeting does not rely on forecasting or past budgets, expenses can fluctuate vastly. Alternatives that existed in the past may not be available in the new period.
Zero-based budgeting is done directly by the employees or manager and is based on the needs for the execution of projects in an organization. It has no beginning balance and no ending balance. It is solely based on what is needed at a particular time and comparing alternatives for lower-cost items. It may be very time-consuming for the department members to look for alternatives, alternatives may not exist or alternatives may simply not be available for the particular time. For example, seasonal produce is less expensive than produce shipped from faraway places. However, it may be necessary for ZB University’s culinary department to spend the extra money because they need seasonal produce for items on their curriculum.
Unlike top-down or bottom-up budgeting, where money is allocated for a fixed set of expenses during a period, flexible budgeting allows for changes in a budget depending on the cost of different organizational goals or activities. Adjustments can be made to the budget if unexpected changes occur in the cost of a project or activity. There are several pros and cons to this type of budget control.
Flex University’s athletic department uses flexible budgeting. Flex U built a new stadium for its football team, the Flex Felines, and needs to sell tickets to games. Flexible budgeting allows the marketing department to seize new marketing opportunities without having to stick to a predetermined budget. If a local television station offers low-cost advertising and promotion for the Felines’ games, the marketing department can jump on the chance to secure the television spot.
Flexible budgeting can be a good thing because it allows for the allocation of extra monies to a project that costs more than originally planned. The flexibility of this type of budgeting works well when new opportunities present themselves during the course of a project or activity.
However, flexible budgeting must be carefully monitored because resources are not unlimited. If too much money is spent on one project or on one opportunity, there may not be enough money left to complete other projects or activities.
Although flexible budgeting does allow for plenty of freedom for serendipitous sales and deals, this can create problems. Everyone in the department may feel their project is the most important or needs the most money allocated to its purpose. Since there is only so much money to go around, it must be managed appropriately.
In summary, there are four types of budget controls organizations use to allocate resources to departments to accomplish organizational goals.
- Top-down budgeting starts at the top management level of an organization. Top management decides how all resources should be allocated, and then the budget is distributed to the lower managers to use to accomplish organizational goals like projects and activities.
- Bottom-up budgeting starts at the bottom level of the organization. Lower-level managers and employees determine what they believe the expenses of the department will be based on upcoming projects or goals that need to be met and then send the budget to top management for approval.
- Zero-based budgeting starts with a zero balance and ends with a zero balance. Budget lines are added as projects and activities are planned, and top management reviews the proposed items.
- Flexible budgeting starts with a budget, but unlike traditional budgets, it allows for flexibility in the amount required for projects and activities. Additional money can be allocated for special projects if a good opportunity presents itself.
There is no budget better than another. Each budget has its pros and cons. Depending on the nature of the business, the best budget is a budget that keeps costs low while meeting organizational goals.
At the end of this video, you will be able to describe the advantages and disadvantages of top-down, bottom-up, zero-based and flexible budgeting.