10
WHAT’S BROKEN ABOUT BUDGETING?
How many people in your organisation love the annual budgeting process? Probably none. The mere mention of the word budget raises eyebrows and evokes cynicism. As a simple test, how many options in Box 10-1 would be checked off as applicable to your organisation? If you check all, you are not alone.
Source: Copyright Gary Cokins. Used with permission.
What is broken about the annual budgeting process? We will more deeply discuss some of the following issues related to budgeting:
• Obsolete budgeting. The budget data is obsolete within weeks after it is published because of ongoing changes in the environment. Customers and competitors usually change their behaviour after the budget is published, and a prudent reaction to these changes often cannot be accommodated in the budget. In addition, today’s budget process takes an extraordinarily long time, sometimes exceeding a year, during which the organisation often re-shuffles and resizes.
• Bean-counter budgeting. The budget is considered a fiscal exercise produced by the accountants and is disconnected from the strategy of the executive team—and from the mission-critical spending needed to implement the strategy.
• Political budgeting. The loudest voice, the greatest political muscle and the prior year’s budget levels should not be valid ways to award resources for next year’s spending.
• Over-scrutinised budgeting. Often the budget is revised mid-year or, more frequently, with new forecast spending. Then, an excess amount of attention focuses on analysing the differences between the actual and projected expenses. These include budget-to-forecast, last-forecast-to-current-forecast, actual-to-budget, actual-to-forecast and so forth. This reporting provides lifetime job security for the budget analysts in the accounting department.
• Sandbagging budgeting. The budget numbers that come from lower- and mid-level managers often mislead senior executives because of sandbagging (ie, padding) by the veteran managers who know how to play the game.
• Wasteful budgeting. Budgets do not identify waste. In fact, inefficiencies in the current business processes are often ‘baked into’ next year’s budget. Budgets do not support continuous improvement.
• Blow-it-all budgeting. Reckless use-it-or-lose-it spending is standard practice for managers during the last fiscal quarter. Budgets can be an invitation to managers to spend needlessly.
The annual budget is steeped in tradition, yet the effort of producing it heavily outweighs the benefits it supposedly yields. How can budgeting be reformed? Or should the budget process be abandoned altogether because its inflexible, fixed, social contract incentives to managers drives behaviour counter to the organisation’s changing goals and its unwritten earnings contract with shareholders? If the budget is abandoned, then what should replace its underlying purpose?
THE EVOLUTIONARY HISTORY OF BUDGETS
Why were budgets invented? Organisations seem to go through an irreversible life cycle that leads them toward specialisation and, eventually, to turf protection. When organisations are originally created, managing spending is fairly straightforward. With the passing of time, the number and variety of their products and service lines change, as do the needs of their customers. This introduces complexity and results in more indirect expenses and overhead to manage the newly created complexity.
Following an organisation’s initial creation, all the workers are reasonably focused on fulfilling the needs of whatever created the organisation in the first place. Despite early attempts to maintain flexibility, organisations slowly evolve into separate functions. As the functions create their own identities and staff, they seem to become fortresses. In many of them, the work becomes the jealously guarded property of the occupants. Inside each fortress, allegiances grow, and people speak their own languages—an effective way to spot intruders and confuse communications.
As more time passes, organisations become internally hierarchical. This structure exists even though the transactions and workflows that provide value and service to the customers pass through and across internal and artificial organisational boundaries. These now-accepted management hierarchies are often referred to within the organisation itself, as well as in management literature, as silos, stovepipes or smokestacks. The structure causes managers to act in a self-serving way, placing their functional needs above those of the cross-functional processes to which each function contributes. In effect, the managers place their personal needs above the needs of their co-workers and customers.
At this stage in its life, the organisation becomes less sensitive to the sources of demand placed on it from the outside and changes in customer needs. In other words, the organisation begins to lose sight of its raison d’être. The functional silos compete for resources and blame one another for any of the organisation’s inexplicable and continuing failures to meet the needs of its customers. Arguments emerge about the source of the organisation’s inefficiencies, but they are difficult to explain.
The accountants do not help matters. They equate the functional silos to the responsibility cost centre view that they capture expense transactions in their general ledger accounting system. When they request each cost centre manager to submit the next year’s budget, it ultimately is an increment or decrement game, that is, each manager begins with their best estimate of their current year’s expected total spending—line item by line item—and they incrementally increase it with a percentage. Budgeting software reinforces this bad habit by making it easy to make these calculations. At the very extreme, next year’s spending for each line is computed as shown in Figure 10-1. Using spreadsheet software, you multiply the first line item expense by the increment, in this example, by 5%, and simply copy and paste that formula for every line item below it. This is what leads to the use-it-or-lose-it, unnecessary, blow-it-all spending earlier described.
Figure 10-1: Spreadsheet Budgeting—It Is Incremental
Source: Copyright Gary Cokins. Used with permission.
By this evolution point in budgeting, there is poor end-to-end visibility about what exactly drives what inside the organisation. Some organisations eventually evolve into intransigent bureaucracies. Some functions become so embedded inside the broader organisation that their work level is insensitive to changes in the number and types of external requests. Fulfilling these requests was the reason why their function was created in the first place. They become insulated from the outside world. This is not a pleasant story, but it is pervasive.
A SEA CHANGE IN ACCOUNTING AND FINANCE
How can budgeting be reformed? Let’s step back and ask broader questions. What are the impacts of the changing role of the CFO? How many times have you seen the obligatory diagram with the organisation shown in a central circle and a dozen inward-pointing arrows representing the menacing forces and pressures the organisation faces, such as outsourcing, globalisation, governance, brand preservation and so forth? Well, it’s all true and real. If the CFO’s function is evolving from a bean counter and reporter of history into a strategic business adviser and an enterprise risk and regulatory compliance manager, what are CFOs doing about the archaic budget process?
Progressive CFOs now view budgeting as consisting of three streams of spending that converge into one:
• Recurring expenses. Budgeting becomes an ongoing resource capacity planning exercise, similar to a 1970s factory manager who must project the operation’s manpower planning and material purchasing requirements.
• Non-recurring expenses. The budget includes one-time investments or project cash outlays to implement strategic initiatives.
• Discretionary expenses. The budget includes optional spending that is non-strategic.
Of the broad portfolio of interdependent methodologies that make up today’s enterprise performance management (EPM) framework, two methods deliver the capability to accurately project the recurring and non-recurring spending streams:
1. Activity-based planning. In the 1990s, activity-based costing (ABC) solved the structural deficiencies of myopic general ledger cost-centre reporting for calculating accurate costs of outputs (such as products, channels and customers). The general ledger does not recognise cross-functional business processes that deliver the results, and its broad cost allocations of the now substantial indirect expenses introduce grotesque cost distortions. ABC corrects those deficiencies. Advances to ABC’s historical snapshot view transformed it into activity-based management (ABM). These advances project forecasts of customer demand item volume and mix and forecast the elusive customer cost-to-serve requirements. In effect, ABC is calculated backward and named activity-based planning, based on ABC’s calibrated consumption rates to determine the needed capacity and, thus, the needed recurring expenses. Without that spending, service levels will deteriorate.
2. The balanced scorecard and strategy maps. By communicating the executive strategy and involving managers and employee teams to identify the projects and initiatives required to achieve the strategy map’s objectives, non-recurring expenses are funded. Without that spending, managers will be unjustly flagged as failing to achieve the key performance indicators they are responsible for in their balanced scorecards.
THE FINANCIAL MANAGEMENT INTEGRATED INFORMATION DELIVERY PORTAL
Today’s solution to solve the budgeting conundrum and the organisation’s backward-looking focus is to begin with a single, integrated data platform—popularly called a business intelligence platform—and its Web-based reporting and analysis capabilities. Speed to knowledge is now a competitive differentiator.
The emphasis for improving an organisation and driving higher value must shift from stringent controlling to automated, forward-looking planning. With a common platform replacing disparate data sources, enhanced with input data integrity cleansing features and data mining capabilities, an organisation can create a flexible and collaborative planning environment. It can provide on-demand information access to all for what-if scenarios and trade-off analysis. For the bold CFO, who is not wary of radical change, continuous and valid rolling financial forecasts can replace the rigid annual budget. Organisations need to be able to answer more questions than just ‘Are we going to hit our numbers in December?’ That’s not planning but, rather, performance evaluation. For the traditional CFO, the integrated data platform offers a sorely needed high speed budgeting process.
In addition, statistical forecasting can be combined with the integrated information on the platform, resulting in customer demand forecasting that seamlessly links to operational systems, activity-based planning and balanced scorecard initiatives for the ultimate financial view that the CFO can now offer to his or her managers. Real time or right time feedback to managers is part of the package.
All of this—traffic light dashboards, profitability reporting and analysis, consolidation reporting, dynamic drill-down, customisable exception alert messaging to minimise surprises, Excel linkages, multiple versioning and more—is available for decision making on a single shared solution architecture platform. EPM resolves major problems, including lack of visibility to causality, lack of timely and reliable information, poor understanding of the executive team’s strategy and wasted resources due to misaligned work processes.
Some organisations have become sufficiently frustrated with the annual budgeting process that they have abandoned creating a budget. An international research and membership collaborative called the Beyond Budgeting Round Table (BBRT)1 advocates that rather than attempting to tightly control spending on a line-by-line basis, it is better to step back and question what the purposes of budgeting are. Their conclusion is that organisations would be better off moving away from long-term financial projections at a detailed level and replacing this form of monitoring by empowering managers with more freedom to make local spending decisions, including hiring employees. BBRT believes in removing second-guess approvals from higher level managers and granting managers more decision rights. BBRT views fiscal year-end budget figures as if they are a fixed contract that managers will strive for rather than react to unassumed changes when the budget was created. In place of budget spending variance controls, BBRT advocates a shift in reporting emphasis and also accountability with consequences on outcomes (performance reporting) not on the inputs. BBRT believes that secondary purposes for budgeting, such as cash flow projections for the treasury function, can be attained with modelling techniques performed by analysts.
Regardless of how an organisation approaches its own reforms to budgeting, EPM provides confidence in the numbers, which improves trust among managers. What will currently accelerate the adoption of reforms to the budgeting process and an EPM culture—senior management’s attitude and willpower or the information technology that can realise the vision described here? I would choose both.
Endnotes
1 For more information, go to www.bbrt.org.