Budgeting

The annual budget process in most businesses is often characterized as a death march. This death march annually offers a lot of pain and seemingly very little gain. The annual budget has been blamed for being counter productive and very costly. In fact, many experts advocate abandoning the annual budget. They may well be right.

It's past time to evaluate the performance of the budgeting process, the cost, and the benefits. While most companies have been budgeting this way for decades, it's time for us to re-evaluate why we're budgeting the way we do. But before we blow up the budget, let's examine its objectives. What most don't realize is that ending budgeting requires more attention to other management activities.

We rely on the budget for three primary management purposes: 1) to set targets; 2) to compensate performance; and 3) to allocate our scarce resources. So if we blow it up, how do we do these essential activities?

First, Setting Targets. We all know that budget targets are obsolete almost before the budget is complete and implemented. So why do we do it this way? The most effective alternative is to set dynamic targets. These targets are relative to the market and to competition. Dynamic targets require a different setting process but can be so much more valuable than a negotiated budget based target. Dynamic targets avoid rewarding performance when it is simply the result of a booming market. In contrast, they would recognize growing the business or at least holding your own in a weak, shrinking environment.

Related to target setting, companies need more scenario practicing. What if a critical input commodity doubles in price like oil did recently? How should the business react to survive and thrive? What if a key customer takes its business elsewhere? What if the unthinkable happened? It would be much better to practice these scenarios with play money instead of real money where real money reflects the suffering of employees, customers, and vendors. Don't athletic teams practice plays before the real game? Don't elite military squads practice before they go into real combat? Don't airline pilots practice in simulators many life-threatening situations long before encountering the real thing?

While more scenario practicing is needed, the budget process in most companies is the wrong way to practice. Bad practice does not generate good habits and results. Simulating the business with driver-based forecasts or Activity-Based Planning & Budgeting techniques is much more rewarding. Then deep dive where problem areas are indicated. Failing to plan is planning to fail.

Second, Performance Based Compensation. Most budget discussions eventually complain about people sandbagging the budget. Budget based performance compensation is practically a guarantee for "buffers" in the budget. Any reasonable human being wants to succeed. When projecting a target in the future, it is natural to hedge to ensure the target can be attained. This generates conflict as the boss tries to push targets higher while the subordinate pushes targets lower. This same conflict afflicts all levels of the business up to and including the board of directors.

How much operational and financial manipulation results from budget based compensation? Manipulation is practically guaranteed! Some manipulation is simply a natural result of choices made to maximize compensation by advancing or delaying expenditures or revenues. As stakes are raised, people push the envelope more and more in order to maximize their compensation. In the extreme, this becomes illegal manipulation. We have ample public examples where executives have gone over the line to show good performance. Sarbanes-Oxley was enacted as a result. However, Sarbanes-Oxley only addresses symptoms and not the root cause.

To avoid budget sandbagging and to reduce the temptation to manipulate results, disconnect performance compensation from budget performance. There are much better ways to reward top performance than via the budget.

Third, Resource Allocation. Since most budget assumptions are obsolete or just flat out wrong before the budget period, why should resource allocations be based on the budget. Shouldn't there be a method to allocate business resources that reflects current business conditions? This is perhaps the hardest one to solve. This will be a delicate balancing act for most companies. One thing for sure, the budget is about the worst way to do the job.

It would be tempting to simply stop budgeting to stop the pain and the cost of this often inefficient and ineffective process. Instead, stop and consider this an opportunity to implement good processes. These processes include planning targets, rewarding great performance, and allocating resources to grow the business and its profits.