Budgets play an important role in financial planning and control measures. Budgets often represent quantitative measures of performance appraisals known as “targets”.
Deviation from these targets is measured through variance analysis. An organization can take many approaches consistent with its corporate governance set up in the budgeting process.
In large organizations with a more authoritative approach, budgeting is often planned at top-level management. Top-down budgeting is a process defined as:
“Budgeting plan defined by top-level management and communicated towards the middle and lower management for implementation”
As the name suggests, the top-level management decides on the performance metrics and budget targets. This type of budgeting approach suits larger organizations, where top-level management takes all the strategic decisions.
In this approach, top management evaluates the past performances using variance and deviation analysis, incorporates business objectives, and sets new targets. Operational and department managers are often ignored in this budget approach, which may sometimes lead to conflicts.
Operational and department managers receive set budgets often adjusted with historic financial data. Departments then make their detailed budgets for various activities such as material purchases, repairs, and maintenance, labor and energy, and so on.
The allocation of resources and department break-down of budgets is often inflation-adjusted. Also, special consideration is given to specific needs such as new machinery purchase, the launch of a new product, or staff hiring.
The Finance department reviews department budgets regularly, with adjustments made to ensure the total budget targets are achieved.
This approach offers great control to the top level management and makes performance measurement easier.
Some advantages of top-down budgeting include:
- Budgeting is a complex and complicated job, top-down approach relieves operational and department managers from this cumbersome duty
- Top-level management has access to the required information and resources to analyze and allocate budget in-line with business objectives
- Operational managers are tasked with readily set performance targets
- It offers an increased sense of control and performance measurement
However, the top-down budgeting approach often creates conflicts and has some limitations:
- Operational and departmental managers find demotivation without participation in the budgeting process
- The process may prolong and cause delays if the allocated budgets do not match with department needs
- Top management uses historic data, budgets are set at the beginning of the period which may lead to outdated targets
- It may cause conflict in the performance appraisal of lower staff
Performance and rewards are closely linked in any organization; however, managers should only be appraised for the controllable actions.
Flexibility and responsiveness can eliminate the friction between top-level and lower management in the top-down budgeting approach. One positive aspect of this approach though is it challenges the limitations of department managers and operational staff, which can motivate them to achieve tough targets.
In financial terms, budgets are set as targets, too rigid, and tough targets may lead to demotivation and too easy targets to complacency.
Top management is concerned with business objectives at ideal levels of performance that can be difficult to achieve for operational managers.
Performance measurement can take both financial and non-financial metrics. The budget-oriented approach concerns with a rigid approach to achieving targets within the set limits.
In contrast, the profit-oriented approach often disregards the budgetary targets and focuses on profit targets.
The non-financial performance measurement may take several parameters for performance appraisal such as customer turnover, staff turnover, customer complaints, etc.
In conclusion, the imposing style of top-down budgeting offers great control to the top management; however, it demands flexibility to achieve effective results.
Increased participation and feedback can enhance the overall performance of the organization. Motivation and rewards are closely linked with performance measurement, so a higher level of participation would result in higher performance.
On one hand, it saves operational managers the time and resources required for the budgeting process. It also challenges them to achieve targets within the set parameters. For top management, the approach provides great control and a performance appraisal tool.