How many people in your organization love the annual budgeting process? Probably none. The mere mention of the word "budget" raises eyebrows and evokes cynicism. It should. That's because the agonizing annual budget process may include:
- Obsolete budgeting - The budget data is obsolete within weeks after it is published because of ongoing changes in the environment.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 behavior 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 organization often reshuffles 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-scrutinized budgeting - Often the budget is revised midyear or, more frequently, with new forecast spending. An excess amount of attention then focuses on analyzing 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 on. This reporting provides lifetime job security for the budget analysts in the accounting department.
- Sandbagging budgeting - The budget numbers that roll up from lower- and mid-level managers often mislead senior executives because of sandbagging (i.e., pad ding) by the veteran managers who know how to play the game.
- 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.
- 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.
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 behavior counter to the organization's changing goals and its unwritten "earnings contract" with shareholders? And, if the budget is abandoned, what should replace its underlying purpose?
The Evolutionary History of Budgets1
Why were budgets invented? Organizations seem to go through an irreversible lifecycle that leads them toward specialization and eventually to turf protection. When organizations 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 well as the needs of their customers. This introduces complexity and results in more indirect expenses and overhead to manage the newly created complexity.
Following an organization's initial creation, all of the workers are reasonably focused on fulfilling the needs of whatever created the organization in the first place. Despite early attempts to maintain flexibility, organizations 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.
With the passing of more time, organizations then become internally hierarchical. This structure exists even though the transactions and workflows that provide value and service to the ultimate customers pass through and across internal and artificial organizational boundaries. These now-accepted management hierarchies are often referred to, within the organization 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 organization becomes less sensitive to the sources of demand placed on it from the outside and to changes in customer needs. In other words, the organization begins to lose sight of its raison d'etre. The functional silos compete for resources and blame one another for any of the organization's inexplicable and continuing failures to meet the needs of its customers. Arguments emerge about the source of the organization's inefficiencies, but they are difficult to explain.
By this evolution point, there is poor end-to-end visibility about what exactly drives what inside the organization. Some organizations eventually evolve into intransigent bureaucracies. Some functions become so embedded inside the broader organization that their work level is insensitive to changes in the number and types of external requests. Fulfilling these requests were the origin of 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 chief financial officer (CFO)? How many times have you seen the obligatory diagram with the organization shown in a central circle and a dozen inward-pointing arrows representing the menacing forces and pressures the organization faces - such as outsourcing, globalization, governance, brand preservation and so on? Well, it's all true and real. But 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 as a river:
- 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.
- Nonrecurring expenses - The budget includes the one-time investments or project cash outlays to implement strategic initiatives.
- Discretionary expenses - The budget includes optional spending that is nonstrategic.
Of the broad portfolio of interdependent methodologies that make up today's performance management framework, two methods deliver the capability to accurately project the recurring and nonrecurring spending streams:
- Activity-based planning - In the 1990s, activity-based costing (ABC) solved the structural deficiencies of myopic general-ledger cost-center reporting for calculating accurate costs of outputs (such as products, channels and customers). The general ledger does not recognize cross-functional business processes that deliver the results, and its broad-brush 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.
- 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, nonrecurring expenses are funded. Without that spending, managers will be unjustly flagged red as failing to achieve the key performance indicators (KPIs) 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 organization'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 organization and driving higher value must shift from hand-slap controlling toward automated forward-looking planning. With a common platform replacing disparate data sources, enhanced with input data integrity cleansing features and data mining capabilities, an organization can create a flexible and collaborative planning environment. It can provide on-demand information access to all for what-if scenario 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. Organizations need to be able to answer more questions than "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 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 signaling dashboards, profitability reporting and analysis, consolidation reporting, dynamic drill down, customizable exception alert messaging to minimize surprises, Excel linkages, multiple versioning and more - is available for decision-making on a single shared solution architecture platform. Performance management resolves major problems: 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.
Performance management provides confidence in the numbers, which improves trust among managers. What today will accelerate the adoption of reforms to the budgeting process and a performance management culture - senior management's attitude and willpower or the information technology that can realize the vision described here? I'd choose both.
1. This section is drawn from Better Budgeting; Brian Plowman; 2004; ww.develin.co.uk.