When planning compensation budgets, organizations often choose between a bottoms-up or top-down approach. Each method has its unique benefits and challenges, and selecting the right one depends on organizational goals, resources, and desired outcomes.
Bottoms-Up Budgeting
In a bottoms-up approach, a company-wide budget target is distributed based on granular, algorithmic calculations. Budgets are generated per employee, taking into account factors such as market data, performance metrics, and specific quantitative inputs (e.g., start dates, vesting schedules).
Benefits of Bottoms-Up Budgeting:
- Data-Driven Precision: Utilizes historical trends, market data, and performance metrics to create highly accurate compensation plans.
- Scalability: Algorithms handle large data sets efficiently, making it feasible for organizations with complex structures or multiple teams.
- Objective Insights: Reduces human bias by relying on data inputs, such as role benchmarks, tenure, and market positioning.
- Employee-Centric: Captures team and individual needs, ensuring fairness and alignment with employee contributions.
- Perceived Fairness: Employees tend to view the process as equitable because distributions are based on data-driven algorithms rather than subjective human decision-making.
- Simplified Planning for Managers: Budgets are pre-allocated for managers based on team performance and market benchmarks, making the process more straightforward.
- Greater Leader Control Over Policies: Global rules, such as excluding employees with a "Needs Improvement" rating from increases, can be implemented easily and consistently.
Easily manage & analyze your budget while planning in Pequity
Top-Down Budgeting
In a top-down approach, a company-wide budget target is manually divided among organizational leaders. Managers are then entrusted to allocate budgets within their teams as they see fit.
Benefits of Top-Down Budgeting:
- Efficiency: It’s faster to allocate a flat dollar amount or percentage across the organization.
- Managerial Discretion: Allows leaders to prioritize top performers and exercise greater flexibility in budget distribution.
- Simplified Forecasting: Reduces administrative complexity, making financial planning and reporting easier.
Challenges with Both Approaches:
- Risk of Budget Imbalance: Without factoring in team performance or market rates, some managers may receive too much or too little budget. Over-budgeted managers may over-reward talent, while under-budgeted ones may struggle to retain key employees.
- Lack of Objectivity:
- In a bottoms-up approach without clear communication of rules, employees and managers may not fully understand why certain increases are applied. Publishing the rules, e.g. “A Needs Improvement rating is not eligible for increases” helps with this dilemma.
- In a top-down approach, reliance on subjective managerial judgment increases the risk of bias, as managers must recall performance, market data, and individual details for each employee. This can lead to instinct-driven decisions rather than data-backed ones, and open the company for difficult conversations or legal threats.
- Managerial Overload: Top-down budgeting places a significant cognitive burden on managers. Without clear guidance, they may find it difficult to manage numerous data points (e.g., start dates, market rates, performance metrics). Behavioral economics suggests that in such situations, managers may default to intuitive decisions for increases over objective decision making, which can skew allocations based on biases.
- Communication Challenges:
- In both approaches, if the process isn't transparent, it becomes challenging to explain to employees why specific increases were given.
- This lack of clarity can erode trust and employee satisfaction over time.
Key Takeaways
While there’s no one-size-fits-all solution, a bottoms-up approach often provides a more objective, data-driven foundation that aligns compensation with organizational goals and market realities. While it can take more time to create the rules, it’s self-sustaining once implemented and reduces the mental load for leaders and teams. On the other hand, a top-down approach offers speed and flexibility on the upfront implementation, but has a higher mental load for leaders and teams, as well as risks inconsistencies and subjective bias.
Many organizations find success with a hybrid approach, combining the precision of bottoms-up budgeting with the strategic oversight of top-down allocations. This ensures fairness, aligns with market benchmarks, and empowers managers to make informed, data-backed decisions. This is typically what Pequity’s approach consists of; where we allocate budget bottoms up to ensure accuracy, and then allow managers to apply some discretion to the modeled amounts. The use of flags and alerts in the system can also aid managers in planning, and reduce the risk associated with discretionary plans – e.g. you can flag if they push an employee below range, or if they are aiming to give an increase to someone who is ineligible.