Traditional Budgets Still A Necessary Evil
- October 23, 2017
Budget Do's, Don'ts, Whys .
Traditional budgets can be detrimental to business managers and, worse, can undermine a company’s strategic goals. Here’s how progressive companies are re-engineering budgeting into a value-added process.
Budgeting is, perhaps, the most despised task a company must face. It’s often a numbers exercise that is disconnected from overall objectives. It’s influenced more by politics than strategy. It’s extremely time-consuming. And once the process is finally finished, most employees feel that its result has little to do with the realities of their business.
Budgets analyze minute spending without recognizing the bigger picture, such as the fact that the company may be losing customers or that a new product may be selling at only half of expectations. The traditional budget can undermine the growth potential of a company by forcing managers’ attention exclusively on the short-term financial numbers. It is estimated that the average budget contains 230 line items, and creating it takes four-and-a-half months.
One criticism of traditional budgeting systems is that departments and business units create their budgets based solely on what they spent the previous year. Another is that their resource allocations are inflexible. Managers may see opportunities to focus on a new area of the business but hesitate to spend resources on that area for fear of going over budget. Many managers who are evaluated and compensated according to how well they meet their numbers are powerless to step outside the box and act on opportunities. The fact that traditional budgets are based on a calendar or fiscal year creates artificial timelines that frequently don’t match new product schedules. Suppose, for example, that in February your marketing department unexpectedly announces that your company should introduce a new product and make it available for market in three months. If you use a 12-month calendar-based budget and have already allocated all your resources for the year, you probably won’t be able to find much cash to support the new product, regardless of how much money the company stands to profit from the venture.
Rolling Forecast Budgets
Upon recognizing the shortcomings of the traditional budgeting process, some companies have re-engineered it into more of a continuous planning process. One tool many have implemented in the transition is the rolling forecast budget.
Rolling forecast budgets can adjust to reflect a company’s shifting strategies. They generally extend six quarters into the future, and they are reviewed and modified quarterly by finance or cross-functional management team, so they can adapt to changing business conditions. When the marketing department of a company that uses rolling forecast budgeting announces early in the year that it wants a new product to ship in three months, the company is flexible enough to fund the venture. You can more tightly integrate your planning into a rolling forecast budget than you can with a calendar or fiscal-year budget.
Also, employees are more likely to accept rolling forecast budgets than traditional, calendar-based budgets because they give financial managers greater flexibility in funding new projects for different departments and business units.
However, critics point out that rolling forecast budgets are time-consuming and question whether the quality of the information they provide warrants the effort that creating them requires. Naysayers also argue that rolling forecast budgets don’t end political infighting or prevent managers from adjusting their numbers to meet projections.
Even so, the rolling forecast is clearly an improvement over the traditional annual budget, especially if it’s used for managing strategy rather than just for keeping spending on track. This type of budget promotes a process of continuous planning and pursuit of opportunities, instead of once-a-year decision-making.
Breaking Down the Behemoth
To break down the huge task of overhauling your budget, use a combination of the following three strategies to determine how much money to allocate to each budgeted item:
Business and performance management. Use a Balanced Scorecard approach that focuses on the key drivers of performance within your company, Gregory says.
Cost management. Develop a program of activity-based costing/ management (ABC/M) rather than trying to use a budget to manage costs, he recommends.
Resource allocation. Select a methodology for evaluating which resources you should allocate to each project based on the project’s size. For projects, you define as large (perhaps those costing $1 million or more), evaluate the merits and potential return on investment of each project on a case-by-case basis. For medium-sized projects (for example, $100,000 to $1 million), maintain a corporate pool of money, and conduct projected rate-of-return scenarios for each one. And for small projects (for example, under $100,000), treat allocations as they would expense, and monitor these expenditures from month to month.
Breaking down budgeting into these categories focuses your attention on achieving your business’s strategic objectives so that you can spend less time on minor concerns. By adding ABC/M and the Balanced Scorecard methodology to your planning process, you can use your company’s performance drivers and cost drivers to determine how to structure the budget, rather than basing it on last year’s numbers.
Texas Instruments actively uses budgets to meet its strategic goals. At Texas Instruments, top management sets external targets that focus on outperforming their competitors. Compensation is based more on how successful managers are in beating their competition than on how well a manager meets his or her budget numbers.
Before General Electric Co. (GE) began revamping its budgeting process, some managers were so focused on meeting their budgetary projections that they lost sight of nearly everything else. Those individuals were singled out by top management as being detrimental to the company’s goals.
In making the shift to decentralized management, CEOs must identify different types of managers and rank them based on how they fulfill the principles of the organization. Among them should be managers who meet their budget numbers but did so at almost any cost. These types of managers stepped over people, stole customers from other parts of the company, and withheld information to hit their numbers. Get rid of those managers, and send a strong message to other managers that such tactics are counterproductive to company goals.
Budgets can and often are called, the bane of corporate America. At one point, approximately 80 percent of companies’ efforts to flatten their organizations through initiatives like the Balanced Scorecard ended up failing, and I think it’s largely because those organizations chose to leave the traditional budget system in place.
Pete Zampino, director of research at CAM-I in Dallas, believes more companies will eventually make radical changes to their budgets. He expects many companies to institute management processes that are so fast, flexible and ingrained into the company’s strategies that they don’t resemble traditional calendar-based budgeting at all.
Managing without using the traditional budgetary processes is leading-edge thinking, but this is the direction that companies will likely be going in the future. Some companies may end up abandoning the budget altogether, while others may go to a type of budgeting system that is much more simplified, much faster and much more responsive to the strategic goals of the organization.
Revamped-Budget Success Stories
Svenska Handelsbanken, a Swedish bank with retail branch offices, abandoned its traditional budget process more than 20 years ago. Since then, it has become the most consistently profitable bank in Europe with the lowest cost-to-income ratio, and it has gained the highest customer-satisfaction ranking of any bank in Sweden. Much of Svenska Handelsbanken’s success resulted from its policy of allowing branch managers to allocate resources according to their preset targets.
Branch managers set their targets (such as a 10 percent higher customer-satisfaction rating or 20 percent greater revenue) based on their local demographic information. Targets for a branch in a well-to-do neighborhood would be different than targets for a branch in a poorer neighborhood.
The bank’s branch managers decide which products to promote, how to market them, which customer segments to pursue, how many employees to hire, and how much space they need. They are responsible for their balance sheets and profit-and-loss accounts.
But the bank’s success hasn’t been due solely to its revamped budgeting process. Svenska Handelsbanken made huge strides in some key areas, such as marketing and decentralized management. One of those areas happens to be what they’ve done with budgeting, but it’s certainly not the only reason for their success.
Other companies that have made radical changes in how they control their spending and planning, according to Hope, include Volvo Car Corp., one of Europe’s most profitable car companies; furniture maker Ikea; roller-bearing manufacturer SKF, petrochemical producer Borealis; Sweden’s largest retailer, KF; and oil service provider Schlumberger Ltd.
These businesses expect managers to evaluate strategic alternatives and make tactical decisions appropriate to their business units, then allocate resources accordingly. “Traditional budgets clog up these vital arteries,” says Hope. “By empowering frontline managers, these companies give themselves a much better chance of building strategic capabilities.”
At many companies, the budgeting process and business-planning process are separate. They need to converge into a unified system so that the budget facilitates implementation of strategic plans as opposed to standing in the way of those plans. Such an overhaul of budgeting requires managers’ mindsets to shift away from trying to hit their budget numbers and toward a team approach that focuses on hitting strategic targets. At the same time, finance has to evolve from passively recording results to actively offering input about where money should be spent in the future.
A budgeting and planning process should involve three basic steps: first, setting strategic targets; then, building a plan to achieve those targets; and finally, putting in place a budgeting system that lets you monitor progress and make course adjustments along the way. By incorporating these measures into the companywide planning cycle, you’ll improve your ability to meet corporate objectives, whether or not you shift more responsibility to frontline managers.
Basing budgets on last year’s spending and then using those numbers to gauge whether your business is on track will put you behind competitors who have transformed their old budgets into a more dynamic financial tool. Staying on track isn’t good enough anymore. You need a spending and planning tool that is integrated into your business processes and is flexible enough to respond quickly when circumstances change.
The Top 10 Do’s and Don’ts of Budget Retooling
Here are some ways to improve an old budgeting system:
- Establish a link between what your company does and what it spends money on. Often, the people who are responsible for creating the budget don’t know about some of their company’s major Form a cross-functional team from different departments to help gather that information.
- Think about what your organization measures. Try to identify five factors that are crucial to the business — for example, customer satisfaction, product development, even intellectual capital. Are any of these areas underfunded?
- Gain consensus outside the finance function about what the company’s measures should be, including both traditional financial metrics and nonfinancial metrics, such as customer retention. Make these agreed-upon performance measures the foundation for the planning process.
- Tie compensation to budget goals. Base reward mechanisms on results people can control and influence. Otherwise, the budgeting and planning process will continue to frustrate them.
- Don’t make forecasts in a vacuum; talk to other departments. The sales and marketing staffs, for example, may have some valuable ideas about product forecasts. Tap that expertise.
- Reduce the number of budget line items. Consider, for example, whether you need several lines under the expense category, or whether you could live with just one line item for expenses.
- Reduce the time the process takes. If budgeting usually takes you three to four months, eliminate some line items to reduce that time by a month.
- Allow managers the flexibility to meet their targets. Don’t hold people accountable for a tactic that was conceived six or nine months ago. Managers sometimes find better ways to meet their goals after the budget is complete.
- Don’t be bound by calendar-based or fiscal-based forecasts. A calendar-based budget isn’t flexible enough to respond to changes in the marketplace.
- Don’t expect technology to solve all of your budget-planning challenges. Software is a tool, not a panacea. Overloading it with too much data compromises its effectiveness.
Michele Y. Thompson is an author, contributing writer on MyStock911 and MortgageExpertGuide , commercial mortgage broker, entrepreneur, and finance coach. The culmination of her work in mortgage banker finance, global investor services, real estate, and debt consulting; along with her advanced degrees has driven her to help new and existing businesses reach their goals for over 20 years.