Budgeting Approaches: Bottom-Up vs. Top-Down

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When it comes to budgeting, organizations often follow a functional and strategic hierarchy to make decisions. Generally, we differentiate between “bottom-up” and “top-down” approaches.

The Bottom-Up Approach

The bottom-up approach progresses upwards, starting from the lowest level of details. Finance professionals compile various inputs in a comprehensive model the output of which forms the Budget expectations.

Suppose that you are the Sales Manager at Spaceland – a boutique hotel situated in the heart of Hokkaido, Japan. Your current task is to predict the company’s annual revenue for the coming year, using the bottom-up approach.

You start with the total number of rooms available in that hotel – let’s say 3,000 rooms.

Then, you dig deeper and ask yourself “How many of these rooms will be occupied throughout the period?”. You do know that different seasons bring in a different number of tourists, and therefore the occupancy rate fluctuates. In any case, an average occupancy rate of 60% seems like a reasonable assumption based on past data.

Once you have this information at the ready, you simply multiply the number of hotel rooms by the occupancy rate to arrive at the expected number of rooms to be sold:

Number of available rooms × Occupancy rate = Expected number of rooms to be sold
= 3,000 × 60% = 1,800

Finally, you multiply the result by the average daily rate charged per room ($100) to obtain the expected revenue for next year:

Expected number of rooms to be sold × Average price per room = Expected revenue
= 1,800 × $100 = $180,000

The Top-Down Approach

The top-down approach evaluates macro indicators and top-level variables. It moves from macro inputs downward to micro indicators. That’s just the opposite of the bottom-up technique, where we begin with the entity-specific inputs and progressively make our way up to the top level of detail.

Let’s calculate the expected annual revenue of Spaceland hotel using the top-down approach. For this, we will require a different set of data.

Suppose that 20,000 tourists are coming to the island of Hokkaido every year. The hotel has a 20% market share, so Spaceland management predicts that 4,000 tourists will most likely book a stay at the hotel next year:

Number of tourists × Market share = Expected number of hotel guests
= 20,000 × 20% = 4,000

In hospitality, professionals usually make estimates on a double occupancy rate. Based on this common practice, Spaceland’s number of occupied rooms arrives at 2,000:

Expected number of hotel guests / 2 = Expected number of hotel rooms
= 4,000/2 = 2,000

In the end, we multiply the projected number of rooms by the average price per double-bed room ($100) to obtain the expected annual revenue of $200,000:

Expected number of rooms to be sold × Average price per room = Expected revenue
= 2,000 × $100 = $200,000

Since both approaches employ a different set of variables, the obtained results, although not always tremendously, may differ. Hence, organizations must adopt a budgeting technique that suits their needs best.

Choosing a Budgeting Approach

The following three aspects determine which budgeting approach to employ:

  • The time horizon involved
  • The level of accuracy required
  • The level of details available

For short-term planning, firms tend to use both approaches and compare them in order to triangulate the results. This means that, ideally, the bottom-up and the top-down method should agree on similar projections. In our example, Spaceland’s management should agree on revenue expectations for the next year in the range between $180,000 and $200,000. More often than not, organizations will take the average of the two.

When it comes to long-term budgeting, firms avoid implementing the bottom-up approach, as there are far too many unknown variables to project. The unavailability of detailed information makes the bottom-up approach useless for strategic planning. Thus, they turn to top-down budgeting, which seems to require a lower level of detail.

Whatever the budgeting approach, however, a company always follows certain steps to complete its Budget. Thus, we recommend that you learn about the Key Steps of Budget Preparation.

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