Top-down and bottom-up approaches are used in many areas of business, finance, and economics. The former goes from the general to the specific, and the latter from the specific to the general. These methods often will be applied, either singly or as checks upon each other, in areas such as:
- Goal setting
- Business forecasting
- Securities analysis
- Company analysis
- Economic forecasting
Below, we'll examine several examples.
In corporate budgeting, a top-down approach would start by setting spending limits at high levels of aggregation, such as total spending for the company as a whole, and possibly also total spending for each line item of expense in its accounting hierarchy. Meanwhile, a bottom-up method also is likely to be underway, with departments or reporting units preparing their own spending wish lists, broken out by line item of expense.
More often than not, the latter method will produce higher spending targets than were envisaged under the former, and a reconciliation process will have to occur, to produce a company-wide budget in which all the parts equal the whole.
This is often closely intertwined with budgeting. Executive management is bound to set top-down company-wide goals for revenues and other key metrics. In a parallel bottom-up process, departments and business units will offer their own plans and targets. Once again, a reconciliation process is bound to ensue.
Bottom-up methods for budgeting, goal setting, and business forecasting tend to have an inherent bias toward underestimating revenues and overestimating expenses and headcount requirements. Performance measurement and compensation systems reward the meeting and exceeding of goals, so managers have incentives to set up goals that they expect to achieve.
On a top-down basis, sales may be forecasted starting with broad categories of products or components, then broken down into successively narrower categories, and eventually to specific items. The process also may generate further detail by factors such as sales channel, geographic sales region, customer category or even specific customer (in the case of especially large customers that contribute a significant portion of the firm's sales). A bottom-up methodology, by contrast, would start with projections for each specific product or component, perhaps also by sales channel, geographic sales region, or customer type.
Securities and Company Analysis
Likewise, an independent analyst projecting a company's results can take a top-down approach (such as by using macroeconomic indicators to forecast total sales and profits) or a bottom-up methodology that builds to a company total from projections of specific products, product lines and/or business divisions.
A top-down approach may project a trend in a large aggregate such as GDP, then use historic relationships to derive the components of that total, such as personal consumption expenditures. A bottom-up method would go in the opposite direction, working from finer levels of detail (such as trends in population growth and business inventories) to generate a GDP projection.
Pros and Cons
Top-down budgeting and forecasting methods may have greater potential accuracy regarding large aggregates. A bottom-up approach may have errors that accumulate as one rolls up results to larger totals. However, disaggregating the high-level totals in a purely top-down process may have a significant element of force fitting to it, thereby producing some unrealistic numbers at the level of individual departments and products. Meanwhile, proponents of bottom-up processes insist that a logically coherent estimate of an aggregate must flow from its component parts.
Even purportedly bottom-up methods often must have a significant top-down element mixed in. For example, departments and business units frequently budget by factoring the prior year's results up or down by set percentages, instead of taking a truly bottom-up approach to each line item of revenue or expense. Producing a truly bottom-up budget for employee compensation, for instance, would require projections of each individual's pay and bonus for the year. With new hires, it also would rely on estimates of when each person would start work. Budgeting at such a finely-grained level of detail often is deemed to be impractical.
The Bottom Line
Top down and bottom up methodologies for forecasting and budgeting each have associated pros and cons, in whatever contexts they are used. The most robust analytic processes try to use both approaches in tandem, in an attempt to best take advantage of their relative strengths and mitigate their weaknesses.