Rethinking budgeting, Whither budgeting

Ch Rajeshwer, Sowdeepti A
Traditional model of budgeting is coming under heavy criticism for outliving its utility. A
management practice that has not evolved in sync with the business environment,
budgeting is being seen as a burden. Alternatives range from streamlining the existing
process to going budget less.
Jack Welch, former CEO of GE, once remarked that annual budget is the `bane of
'corporate America' and an `exercise in minimalization'. He was indeed echoing the voice
of growing dissatisfaction with budgets. Surveys of finance executives have, time and
again revealed the angst against budgeting.
Why have budgets, the quintessential part of corporate management for more than a
century, become the subject of ridicule? There are two reasons for budgets losing their
sheen. One is related to the budgeting itself. The other is its abuse.
Budgeting blues
Developed in the 1920s, budgeting was originally meant to track costs and cash flows.
Then it became central planning and control system. It was in the 1960s that it began to
be used as a tool for cost and resource management as well as rewarding employees.
The system worked very well in the industrial era, when the business environment was
largely free of the kind of uncertainties and dynamics that are very much prevalent
today. Companies could make and sell relatively easily. Planning worked well when
things were playing out as planned. Then the business environment changed drastically
beyond recognition.
Aggressive competition, faster innovation, lowering prices and resultant lowering of
margins, increase in risk and uncertainty, and emergence of new technologies have all
changed the corporate landscape into a new world order. In the new order, sensing the
environment and responding to it quickly is vital, not just to be successful but even to
survive.
Traditional budgeting prevents companies from responding fast to the changes in the
external environment. Foremost among the reasons is the enormous time and cost it
takes to craft the budgets. A 1998 benchmarking study conducted by Hackett
Benchmarking & Research, a US consulting firm, shows that an average company
invests more than 25,000 person days per billion dollars of revenue in the planning and
performance measurement processes. And the average time to complete a budget is 112
days, and the process is "often done as an exercise to get to a number that is acceptable
to management."
In the increasingly real-time scenario, budgets are becoming out-of-date the moment
they are ready. If beating the competition is the name of the game, plans and resources
shall change as fast as the externalities change. Failing to do so means losing the
competitive battle. Budgets inhibit this flexibility, for they are annual events. A KPMG
study showed that inefficient budgeting eats up 20 to 30% of senior executives' and
financial managers' time. Two large European companies, Volvo Cars and Borealis,
have calculated that over 20% of management time is taken up by budgeting and
reporting processes. By changing traditional planning, budgeting and control processes
at Volvo, managers have not only saved significant costs but they have more time to
focus on strategy, action planning and beating the competition.
Companies can no longer afford to squander huge sums for an activity that adds little
value.
On account of its emphasis on centralization, budgeting also reinforces vertical
command and controls. This is the case when companies have come a long way in
making the structures flat and hierarchical structures, into networking structures. This is
clearly at odds with the evolving structures within the companies.
The budgets culminate in GAAP-compliant financial statements that focus on cost
control. Rightly so, costs have to be controlled, but the most important aspect of
competition today is cost reduction. When budgets do not incentivize cost reduction,
they do not lead to bottom line improvement and competitive edge. Thus, an important
contributor to value creation does not get the focus it deserves. As one expert put it,
"budgets are reliable tools to manage financial results but not optimize the results".
Traditional budgeting fails to tackle one of the most important developments in the
recent pastnon-financial metrics. Budgets lag behind new tools like balanced scorecard
when it comes to dealing with non-financial metrics.
Any management tool delivers intended results as long as it is put to use appropriately.
Abuse of tools makes the tools counterproductive and in extreme cases, harms the
interests of the organization. Budgeting is no exception. A common criticism is that
many organizations do not align strategic goals and budget targets. The result of such a
disconnect is that while strategy points in one direction, the teams march in another
direction that is dictated by the budget. This happens since the rewards are linked to
beating the budgets. Even the use of new tools like balanced scorecard that seek to
deliver strategic goals, may be difficult when the traditional budgeting conflicts with the
new tools.
Budgets are also accused of encouraging politicking and gaming, both of which are
harmful from the wealth creation perspective. At GE, managers were so focused on
meeting the budget numbers that they cannibalized existing products, acted against the
interests of other departments, and also resorted to numbers game to hit the targets.
They met their numbers at any cost. To address this problem, Jack Welch got rid of
such managers as they were acting against the interests of the company and revamped
the budgeting process.
Is there light at the end of the tunnel?
One may wonder that, if budgets were such a thing of the past and roadblocks to
corporate prosperity, how are companies not only managing better but also emerging as
winners in the market place? The answers are not far to seek. Any practice that becomes
ritualistic in nature loses importance. While companies may continue to do it as a matter
of routine, it is safe to conclude that they must surely have found better ways of doing
things. Otherwise, the free market ensures that those that do not play to its tune would
perish.
The alternatives found by companies to remove the ills of traditional budgeting range
from streamlining to total abandonment. One of them is making rolling forecasts. These
rolling forecasts provide a continuum to the process. They always look ahead into the
same distance. The focus shifts from annual targets to key performance variables.
Ericsson used to spend more than six months on the budgeting exercise before it moved
into rolling forecasts. It tailored its forecasts to focus on the market segments, brought
interactive ness and accuracy into the process. Borealis, a Danish petrochemicals
company, too switched to rolling forecasts. In doing so, it also integrated balanced
scorecard metrics with rolling forecasts which went beyond financial metrics.
Another model is to focus on the key drivers that create value and ignore the rest.
Budgeting traditionally emphasized on details. In its efforts to produce GAAPcompliant
financial statements, it goes into all line items and related details. This is both
time consuming and costly. There are instances of companies that have benefitted from
focusing on those variables that matter most to their companies. Texas Instruments and
Union Pacific Railroad have transformed their budgets into instruments that move in the
direction of strategic goals. In doing so, they got rid of the plethora of details into which
their budgets went earlier.
Foremost among those voicing concerns against budgeting are Jeremy Hope and Robin
Fraser. They are the proponents of the beyond budgeting (BB) model. They advise the
companies to abandon traditional budgeting and adopt the BB model. The BB model
relinquishes the fixed targets of traditional budgeting that perpetuated the fixed
performance contract culture. The model emphasizes that companies should focus on
key ratios that matter most like the cost to expense ratios. It also encourages companies
to compare their performance with competitors and peers rather than their own
budgeted targets.
Svenska Handelsbanken (a Swedish bank) is in the limelight as the prime example of a
company that has gone budget less and became a successful bank for over 30 years
now. It boasts of lower costs of banking in Europe's banking sector. The latest to join
the fray are Volvo (one of Europe's most profitable car manufacturers), IKEA (the
world's largest furniture manufacturer and retailer), SKF (the world leader in rollerbearings),
Borealis (one of Europe's largest petrochemical companies), KF (Sweden's
largest retailer), Schlumberger (one of the world's largest oil services companies) and
Boots (one of the UK's most profitable large retailers).
What is emerging crystal clear is that companies cannot afford to let their budgeting
system wreak havoc with their future. The choice is to reform the process in order to
focus on value creation culture and to make budgeting flexible so that companies can
compete in the dynamic market place effectively or abandon the traditional form of
budgeting and move on to another plane.
Emerging best practices
Beat the competition, and not the budget. Leading companies are extremely externally
focused. Targets are set not based on current performance but by reference to external
benchmarks. Incentives are disconnected from budget and are tied to beating
competitors both financial and non-financial external benchmarks.
Rolling forecast approach that typically extends out six quarters and updates budgeting
numbers each quarter based on the latest forecasts and strategy shifts.
Instead of fixed annual targets, companies are basing their goals on achieving profit
potential and continuously improving against benchmarked key performance indicators
(KPIs), such as cost-to-income ratios, free cash flows, and return on capital. The fewer
the measures, the better it is to track performance.
Companies are evaluating and rewarding employees on relative improvement.
Performance is assessed against benchmarks, at the end of each period, considering how
well the team did, given prevailing conditions and compared with peers, competitors,
and prior periods. At Texas Instruments, compensation is based more on how successful
managers are beating their competition than on meeting the budget numbers.
Operating managers are allowed to regulate their own performance, and take whatever
action is required to meet their medium-term goals within agreed-upon governance
principles and strategic boundaries, as long as KPIs stay within limits. Companies are
using real-time information systems and collaborative knowledge sharing to produce
forward-looking information based on rolling forecasts and leading indicators that's
open and transparent.
By eliminating traditional controls from the budgeting system, managers are far from
being deprived of vital control information. With a fast open accounting system,
managers benefit from a much richer seam of information that improves decisionmaking.
Resources are made available as required. Managers acquire what they need when they
need it within agreed-upon key performance indicator boundaries (ratios), but with the
expectation that they will shed excess resources if demand falls.
Explicit forecasting models that are separated from their financial management systems
are used. The models are based on clear assumptions and if and when the world
changes, the assumptions are changed and a new forecast is generated quickly with
virtually no manual intervention.
Source: www.bbrt.org and Should you trash the budget by Tad Leahy, October 2001
issue of Business Finance.
Core Principles of the Beyond Budgeting Model
Build a basis for devolution through clarity of purpose. Don't exert control from a
central location.
Empower managers to act without constraints.
Hold managers accountable for hitting performance targets, not budget numbers.
Organize the business around customer-oriented business units, not hierarchical
departments.
Let market-like forces dictate resource allocation requirements, not central planning and
budgeting.
Don't command and control people. Challenge and coach them.
Beat the competition by setting and hitting performance targets, not budget targets.
Make strategy an ongoing process, not an annual event.
Use technology to keep abreast of performance in relation to strategies, and change
strategies when conditions warrant.
Allocate resources when needed, not according to an annual budget.
Avoid micromanagement and provide quick access to up-to-date information about the
company.
Reward on the basis of reaching performance targets, not predetermined negotiated
targets.
The New Deal
Traditional budgets Beyond budgeting
Fixed targets Relative targets
Fixed Incentives Relative rewards
Fixed planning Continuous planning
Resource allocations Resources on demand
Central coordination Dynamic coordination
Variance controls Relative KPI controls
Forward-thinking companies are moving to contracts that emphasize relative
improvement rather than fixed performance goals
About the Authors
Ch Rajeshwer, Associate Editor, is the head of ICFAI Pressa constituent of the ICFAI
University. He can be reached at rajeshwer@icfaipress.org.
Sowdeepti A, is Analyst at ICFAI Press
Reference # 09-03-06-01
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