Tying functions to the financials at the most granular level is why they pay us the big bucks.

There are two approaches to implementing a budget process and building an operating model:

1. Top-down
2. Bottom-up.

Top-down budget processes usually start by defining the desired corporate sales or profitability targets and backfilling department-specific goals that add up to those corporate targets. Budgets created in this way can be vague and lack detailed department-level metrics, KPIs, and goals. Top-down approaches might say, “we achieved a 5% sales growth last year over the previous year, we will likely grow the top line another 5% this year.” Top-down approaches do not appreciate the underlying functions that work together to drive corporate performance. Say you wanted to cut expenses by 10%. A top-down approach might just give all departments in the company a blanket mandate to cut 10%. Without studying personnel, processes, and the interconnectivity between functions, you might unknowingly cause departments that need an additional 10% in resources to cut their productivity while allowing departments that should really cut 20% of their expenses to keep spending inefficiently.

Bottom-up budget processes plan at the individual function or department level and then add each function’s budget together to arrive at an overall corporate budget. In the 10% cost reduction example above, a bottom-up methodology might mean running vendor rationalization first in each department individually to see which vendors or agreements are needed first. Naturally, this will result in different needs or levels of reduction for each function. However, if you added up each function’s cuts or additions together and the total corporate reduction ends up being 10%, then you have achieved your goal, even though each department cut different percentages.

Bottom-up modeling frameworks require the analyst and management teams to drill all the way down to the company’s foundation and assign dollar values to specific customer behaviors, marketing relationships, and revenue drivers.

The reason I use the term “operating model” interchangeably with “budget model” is because I want the terminology to inform the underlying construction and contents.

When I say “operating model,” I want to imply a thorough, bottom-up budget framework through which we can better understand the interconnectivity of each business function and how each ties to financial performance.

Operating models are important for a couple of reasons:

1. Creating an operating model from the bottom up requires management teams to take the elevator to the ground floor of their company and understand the roles and responsibilities of each function on the ride back up.
2. The actual process of creating a bottom-up budget reveals the sticky issues hiding in the corporate corners.

Furthermore, I would argue that top-down approaches contain more bias towards favorable outcomes in financial projections than bottom-up approaches. Management teams can easily cobble together top-down financial estimates and ignore the actual, underlying customer and product-level data that may or may not support those estimates. Top-down operating models are like icebergs. Management teams care only for the top outputs that poke through the veil of the deep ocean. They ignore the massive hulk moving below the surface that contains unseen hazards, determines ultimate trajectory, or impacts growth.

Top-down financial projections can be appealing for management teams in that the pressure that the board and investors place on them to grow the company is real, and top-down estimates create opportunities for management teams to gloss over the real drivers of results if they miss targets. This type of budget also involves more speculation when comparing actual results and explaining variances since they are not built on underlying KPIs and metrics.

Budget processes also reveal waste. A couple of years ago, I implemented a new budget process for a $75 million company that never had a formal budget process in their fifteen-year history. In the very first week, I found $100,000 in savings in the finance department alone.

Humor me with a quick exercise: right now, go to your accounting system and download a list of all your vendors and corresponding expenditures from the past year. Scan through it. You might be surprised at the amount you are spending on “lost services” you have never heard of before.

When I approach a budget process, I run this exercise, officially called “vendor rationalization,” with every function and department. Department leaders must justify every expense and vendor in their department to make this an effective exercise. I nearly always find some fun things buried in last year’s expenses. The vendor rationalization process is just one example of the value created through a bottom-up budget process.

Let’s keep going — in the next part, we’ll walk through practical applications and timelines of how I deploy operating models within companies in real life.