It’s that time of year again – no, we are not referring to the holiday displays starting to appear in stores which seems to happen earlier each year as the holiday season gets longer. We are referring to the equally long season of budgeting that is ongoing for many of you reading this. CFO Magazine estimates that the average company spends 32 days on their annual planning and budgeting and worst performing companies spend 56 days or more! And that is just calendar time – when it comes to person-hours and opportunity cost, the reality may be even worse. Some years ago, Ford Motor Company calculated that annual budgeting cost their organization $1.2 billion! And by most accounts, Ford has a better than average finance function.
On top of all this effort, budgets are frequently developed and implemented in ways that drive counter-productive behaviors. Everyone who lives through this process knows that you have to ask for more than you actually need, as cost budgets will get reduced and sales targets will be increased. Often a tremendous amount of work is done to develop bottom-up budgets that are then completely overridden by top-down ‘stretch targets’ that not only create re-work at lower levels to make the numbers tie, but sometimes aren’t approved until several weeks into the new year.
This is also the time of year when many departments engage in what one of our clients call “fiscal follies.” Since budgets usually can’t be transferred to other cost centers, department leaders feel that they have to ‘spend it or lose it.’ This reflex is not driven by cost-benefit analysis, rather it is the fear that not spending will be seen as proof that you really didn’t need it in the first place and practically assures that you will be stuck with a lower budget next year.
All of these issues have been well documented over multiple decades and yet budgeting processes have changed very little. A recent client experience highlights the difficulty of changing past practices. We were asked by a long-term client to re-engineer their annual budgeting process. This is not typically work we would pursue, but we were concurrently working on a corporate strategy and the balance of effort between business units and the corporate center was squarely in our scope, especially as all the business units described the corporate requirements around budgeting as one of their pain points.
Sticking to our principle of getting to root causes, we kicked off our first meeting by asking the seemingly innocuous question ‘Why do we need budgets?’ After a long awkward silence, we eventually had a robust discussion. At our second meeting we had generated a list of possible reasons for budgeting and began to think about alternatives to the current process to achieve these objectives. The client team eagerly engaged in the chance to dramatically change this time-consuming and frustrating process. By the end of that second meeting, we had one camp advocating for a dramatically simplified rolling budget process and a second group that wanted to eliminate budgets altogether.
We were looking forward to the third meeting when we got an email from the client’s CFO that the project was being postponed indefinitely. The CFO gruffly informed us that we were wasting too much of his team’s time on ‘theoretical issues’ when he needed them to get busy working on annual budgets! You can’t make this stuff up.
So, why do you need budgets? From this work and other experiences, we have come up with a number of reasons and possible alternatives:
|Potential Purpose of Budget||Potential Alternatives|
|– Give earnings guidance to Wall Street – justify and set targets||– Some successful companies do not give guidance|
– EPS guidance requires macro forecasting, not detailed line-item budgets
|– Give the board confidence that we are being aggressive and that we can deliver (see above)||– Does not require detailed line item budgets|
– Some companies have central strategy groups to analyze trends and potential to set targets by business unit
|– Unified volume forecasts to coordinate department-level planning||– Required detailed forecasting (SKU level) for operations, but normally weekly or monthly (not annually)|
– Best practice is a robust S&OP process
|– Spending control for cost centers||– Variable budgets would be more responsive to unplanned changes in volume|
– Best practice is evolving to parameterized metrics (e.g., IT cost per employee)
|– Target-setting for incentive comp||– Need unified targets to motivate behavior and align functions…|
– …But ‘bright-line’ incentives tend to drive dysfunctional behavior
We don’t claim to know the answer, this list may not even be exhaustive, but we do know that you can’t fix a problem without understanding how you got here. And, if this past year has taught us nothing else, it has reinforced that our assumptions are always wrong, sometimes wildly off. Chasing false precision through a detailed budget process may be comfortable because we have always done it that way. But that detail requires a lot of work and does not seem to translate to better business performance. With a little creativity, we are confident that companies can develop compelling alternatives to today’s detailed budgets.
We know it is stretch, but imagine a future where every department and individual is making decisions based on the world that we actually experience, not based outdated assumptions made a year ago through a process that we know is broken. Recall that ‘framework for making decisions among competing alternatives’ is one of our definitions of strategy. How much better could those strategies be if they were developed with the same level of effort and rigor as the current budgets?