Approaches to Budgeting Expenses for an Annual Operating Plan

When it comes to building a company's expense budget for an upcoming fiscal year, there are several approaches, but I like to break it down into three main methods:

1) Bottoms-Up ✔️ 

Drills down to the building blocks, such as individual vendors, and allows department leads to take ownership of budgets and understand the building blocks that drive their numbers.

There are two key types:

◾ Zero based budgeting

➡️Assumes budgets are zero and must be justified from scratch

➡️Can be very time-consuming

◾ Value Proposition Budgeting

➡️Instead of starting from zero, this approach evaluates whether each cost creates value for the business and its stakeholders

Note: Bottoms-up is best for budgeting discretionary costs such as travel & entertainment and marketing, rather than core operating costs such as rent, salaries, and web hosting.

2) Top down ✔️ 

Top down, sometimes also known as activity based budgeting, sets budgets based on overall business objectives rather than building up from individual expenses.

◾ Revenue targets determine the required inputs (e.g., staffing levels, marketing spend, etc.) to support growth

◾ Often used by leadership to align spending with revenue growth

3) Year-over-year and Percent of Revenue ✔️ 

◾ Year-over-year budgeting, aka Incremental budgeting, adjusts the prior year's budget by a percentage or amount to come up with a new budget

➡️ Very common due to its simplicity

➡️ Becomes very difficult to explain variances

◾ Percent of Revenue, aka Variable budgeting, involves allocating costs as a percentage of revenue

➡️ Allocates costs as a fixed percentage of revenue (e.g., COGS at 30% of revenue, marketing at 15%)

➡️ Keeps costs aligned with growth but can oversimplify financial planning and makes it harder to explain variances

💡 Bottoms-up is my preferred approach because it forces teams to own their budgets and makes it possible to create detailed variance explanations.  However, I’ve seen all of these methods used effectively depending on the company’s needs.