Peering into the Budgeting Process

The budget that a company sets for itself relies on a lot of careful calculations and some guesswork about the amount of revenue it expects from the sale of products and services, as well as the expenses it will incur to manufacture or purchase the products it sells and to cover the other operating expenses during the next year. Creating a budget is a lot more complicated than just making a list of expected revenues and expenses. I talk more about the basics of revenue and expenses in Chapters 4 and 7.

Companies use one of two approaches to budgeting:

✓ Top down approach: Key executives set budgets and give them to department heads to meet. Most employees aren't involved in the budgeting process; instead, those at the top impose the numbers on the employees, who are expected to meet them. The big problem with this type of budget process is that the employees don't feel any ownership of the budget and frequently complain that the budget handed down to them is unrealistic, which is why they can't meet expectations.

Few large corporations use the top down approach today. You're more likely to find this approach in small businesses run by one person or a small group of partners.

✓ Bottom up approach: Budgets are created at the department level based on overall companywide goals and guidelines that the board of directors and top executives set. This approach encourages employee participation in the budgeting process, so the employees have more of a sense of budget ownership. Because they help develop the budget, they can't later claim that the budget is unrealistic if it turns out that they don't meet expectations.

Most management studies show that the bottom up approach works better because managers and staff members are more likely to take a budget seriously and follow it if they have some involvement in developing it. In this chapter, I focus on the process for bottom up budget development, which is the most commonly used budgeting process in large corporations today.

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