“The budget is the ruin of Corporate America. It should never have existed.”
Jack Welch, CEO of General Electric
Budgets are one of the accounting tools most widely used in the planning and control of organizations. However, there is ongoing debate as to the usefulness of the traditional budget. How can budgets be made more flexible? Who are the people who should be involved in drawing them up? What should be included and what should be left out? How often should information be revised or updated? These are just some of the questions that arise when faced with the need for financial planning systems that are able to respond to rapidly changing marketplaces.
Many companies are obsessed with drawing up precise, detailed budgets, but the recession and recent economic problems have led them to realize this is virtually a waste of time, because there isn’t enough relevant information at their disposal to make reliable forecasts.
Some concepts that are often used in financial planning and the drawing up of budgets include:
Budget
The quantitative expression of a plan of action proposed by management to help coordinate what is required in the implementation of said plan and that covers a specific timeframe (Horngren, 2004).
Financial Planning
A process that traditionally contains detailed plans and budgets expressed in financial terms (Aberdeen, 2010).
Master Budget
An annual process that typically begins with information from the previous year and includes the drawing up of detailed operating and financial budgets that are indicative of the future performance of the organization as a whole (Aberdeen, 2010).
Rolling Forecasting
In a rolling forecast, the organization adapts to future expectations based on recent performance, resulting in an updated forecast. Predictions, re-forecasts or rolling forecasts may be made at different moments throughout the budget scenario (Bogsnes, 2009).
The traditional budget emerged in the 1920s as a tool for managing costs and cash flows at large industrial companies like Dupont, General Motors and Siemens. It has since become an invaluable tool for the planning and control of organizations.
The traditional budget operates hierarchically from top to bottom. Decisions, resources and rewards are directed downwards, while information flows back (Libby & Murray, 2007). This is a fixed, rigid type of budget that is generally linked to a compensations system (Figure 1).
Figure 1. Traditional Control Process. Adapted from Libby & Murray (2007)
Companies use budgets for several purposes, mainly to: make forecasts, help maximize profits, promote communication, assess performance, calculate compensation, motivate employees, control performance by researching budget variations and make pricing decisions.
The traditional budget has come under criticism because too much time is invested in its drawing up and it doesn’t respond well to changing, volatile environments. This is why it is only occasionally linked to an organization’s strategy (Figure 2).
Figure 2. Time Required to Draw Up a Traditional Budget. Adapted from Uyar.
Likewise, budgets can be conceived as a commitment or ‘performance contract’ between a subordinate and a superior, which can open the door to manipulating or ‘gaming’ the system to facilitate the reaching of targets. This is why there is some doubt as to whether budgets can be used to simultaneously assess administrative and financial performance.
Another interesting problem associated with the traditional budget is its inability to gauge the key success factors of an organization. The reason for this is that traditional budgets focus exclusively on operating and financial performance, but not on strategic performance, which means they have a hard time assessing the creation of shareholder value, customer loyalty and satisfaction, the quality of services and products, and intangible assets like brand equity and customer portfolios.
New Approaches to Budgeting
These days, organizations need to be able to respond quickly to changing market conditions and make effective snap decisions. Consequently, calendar-based planning has to give way to a more adaptive form of budgeting, in which a new financial performance benchmark is more important than number crunching. This approach seeks to link the budget, forecasts and strategic goals, resulting in a financial planning process that gives general managers and CFOs a competitive advantage and allows them to look beyond their reporting and budgeting duties.
In light of the limitations of the traditional budget, both academics and professionals have sought new methods to help improve budget planning and processes. The fruits of their efforts can be seen in alternatives like Better Budgeting -which consists of incremental improvements to traditional budgets- and Beyond Budgeting -which implies radical budgeting changes.
Better Budgeting
There are five main approaches to better budgeting (Neely, 2003):
Activity-based budgeting
Zero-based budgeting
Value-based management
Profit planning
Rolling forecasting
Of these, the rolling forecast is among the most popular. This approach favors a revision of the budget instead of doing away with it completely and usually covers a forecast period of 15 months or five quarters, with monthly or quarterly updates. The advantage of the rolling forecast is that it affords managers the chance to rethink the process and incorporate relevant changes. In zero-based budgeting – another common approach- each cycle begins as if it were the first.
Beyond Budgeting
Created in 1997 in response to growing dissatisfaction with the traditional budget, the origins of the Beyond Budgeting Round Table (BBRT) are in the UK, but it has since welcomed members from Belgium, France, Germany, the United States and other countries. Borealis, Unilever, Ikea, American Express, Southwest Airlines, Charles Schwab, Wachovia and the World Bank are just some of the entities that have implemented this approach.
The creators of the Beyond Budgeting movement argue that today’s companies need to be more flexible and adaptable on a strategic level, as well as being able to respond more quickly to rapid, unpredictable and intermittent change on the markets where they operate. This translates into the need for more effective strategic management.
Budgets can still aid planning, coordination and resource allocation, but should not be used as motivational or performance evaluation mechanisms, since this would hold back an organization operating on today’s hyper-competitive marketplaces that are subject to constantly changing economic conditions.
Linking the Strategy with the Budget
The first step in the search for greater flexibility and strategic adaptability was to separate performance management and financial planning and budgeting systems – simultaneously encouraging managers to reach for “stretch” targets and at the same time presenting an accurate picture of the company’s financial scenario. Companies like Borealis rose to the challenge and came up with a new, four-pillar budget-less management system (Boesen, 2000):
Rolling Forecast
Balanced Scorecard
Activity-Based Cost Management
Investment Management
Rolling Forecast
In this case, the sole objective of the rolling forecast is to provide as clear a picture as possible of the company’s expected financial performance. Since this forecast doesn’t affect managers’ compensation, there is little incentive to ‘game’ the system. Objectivity is the key here.
Objective data on prices, corporate planning, sales volumes, fixed costs, investment, depreciation, interest, inflation and financing rates is combined to come up with a fiver-quarter rolling forecast, which is revised quarterly to allow management to envisage a horizon of at least one year and in which performance in one period is measured against that of the previous. A good test of performance is a comparison with the company’s closest competitor every six months.
Balanced Scorecard
Directors who have experienced difficulties articulating the company’s strategic goals in a manner that can be easily grasped by employees have resorted to the Balanced Scorecard. This tool helps explain and measure corporate performance vis-à-vis established targets and key performance indicators (KPIs) instead of comparing it against, say, budgetary line items. In other words, the scorecard focuses on the drivers behind the numbers as opposed to the financial data, giving senior management much more leverage over the company’s future.
Activity-Based Cost Management
It may sound contradictory to talk about cost management in the absence of a budget, but in this case, expenses are tracked using the 12-month moving averages of activity-based costs, which allows a company to monitor costs in terms of activities instead of budgetary line items, making it easier to talk to employees about how and why to control costs. It is also easier to understand product and client profitability levels when costs have been broken down by activity.
Investment Management
The last pillar of a budget-less company is decentralized investment management, which puts control in the hands of people closest to the marketplace and customers. Although it is unusual to allocate this much control over capital spending decisions to front-line mangers, these employees tend to have a clearer picture of strategic priorities thanks to the Balanced Scorecard and decentralized profit accountability.
Figure 3. Breaking the Budget at Borealis: The Four Pillars of a Budget-less Organization. Adapted from Boesen (2000).
Conclusion
There can be no denying traditional budgets are becoming less and less useful and while there is still a lot to be done in terms of perfecting these new approaches, their efficient application will leave managers more time for analysis – time that would otherwise be fruitlessly invested in drawing up a detailed budget that will probably be obsolete before the ink has a chance to dry on its pages.
References
Boesen, T. (2000). Creating budget-less organizations with the Balanced Scorecard. Harvard Business Publishing Newsletters (pp. 1-3).
Bogsnes, B. (2009). Implementing beyond budgeting. New Jersey: John Wiley & Sons, Inc.
Libby, T., y Murray, L. (2007). Beyond budgeting or better budgeting?. Strategic Finance, 89(2), 46-51.
Loeb, M., y Martin, T. (1995, 05 29). “Jack welch lets fly on budgets, bonuses, and buddy boards”. Consultado en http://money.cnn.com/magazines/fortune/fortune_archive/1995/05/29/203152/index.htm
Neely, A., Bourne, M., y Adams, C. (2003). “Better budgeting or beyond budgeting?”. Measuring Business Excellence, 7(3), 22.
Orlando, J. (2009). “Turning Budgeting Pain into Budgeting Gain”. Strategic Finance, 90(9), 47-51.
Quibria, N., y Jutras, C. (2010). Financial Planning, budgeting, and Forecasting. (2010). Aberdeen Group.
Uyar, A. (2009). “An evaluation of budgeting approaches: traditional budgeting, better budgeting, and beyond budgeting”. Journal of Academic Studies, 11(42), 113-130.
(2007). Harvard Business Essentials: Manager’s Toolkit–The 13 Skills Managers Need to Succeed (Hardcover). Harvard Business School Press Books.
Where is the Budget Headed?
“The budget is the ruin of Corporate America. It should never have existed.”
Jack Welch, CEO of General Electric
Budgets are one of the accounting tools most widely used in the planning and control of organizations. However, there is ongoing debate as to the usefulness of the traditional budget. How can budgets be made more flexible? Who are the people who should be involved in drawing them up? What should be included and what should be left out? How often should information be revised or updated? These are just some of the questions that arise when faced with the need for financial planning systems that are able to respond to rapidly changing marketplaces.
Many companies are obsessed with drawing up precise, detailed budgets, but the recession and recent economic problems have led them to realize this is virtually a waste of time, because there isn’t enough relevant information at their disposal to make reliable forecasts.
Some concepts that are often used in financial planning and the drawing up of budgets include:
Budget
The quantitative expression of a plan of action proposed by management to help coordinate what is required in the implementation of said plan and that covers a specific timeframe (Horngren, 2004).
Financial Planning
A process that traditionally contains detailed plans and budgets expressed in financial terms (Aberdeen, 2010).
Master Budget
An annual process that typically begins with information from the previous year and includes the drawing up of detailed operating and financial budgets that are indicative of the future performance of the organization as a whole (Aberdeen, 2010).
Rolling Forecasting
In a rolling forecast, the organization adapts to future expectations based on recent performance, resulting in an updated forecast. Predictions, re-forecasts or rolling forecasts may be made at different moments throughout the budget scenario (Bogsnes, 2009).
The traditional budget emerged in the 1920s as a tool for managing costs and cash flows at large industrial companies like Dupont, General Motors and Siemens. It has since become an invaluable tool for the planning and control of organizations.
The traditional budget operates hierarchically from top to bottom. Decisions, resources and rewards are directed downwards, while information flows back (Libby & Murray, 2007). This is a fixed, rigid type of budget that is generally linked to a compensations system (Figure 1).
Figure 1. Traditional Control Process. Adapted from Libby & Murray (2007)
Companies use budgets for several purposes, mainly to: make forecasts, help maximize profits, promote communication, assess performance, calculate compensation, motivate employees, control performance by researching budget variations and make pricing decisions.
The traditional budget has come under criticism because too much time is invested in its drawing up and it doesn’t respond well to changing, volatile environments. This is why it is only occasionally linked to an organization’s strategy (Figure 2).
Figure 2. Time Required to Draw Up a Traditional Budget. Adapted from Uyar.
Likewise, budgets can be conceived as a commitment or ‘performance contract’ between a subordinate and a superior, which can open the door to manipulating or ‘gaming’ the system to facilitate the reaching of targets. This is why there is some doubt as to whether budgets can be used to simultaneously assess administrative and financial performance.
Another interesting problem associated with the traditional budget is its inability to gauge the key success factors of an organization. The reason for this is that traditional budgets focus exclusively on operating and financial performance, but not on strategic performance, which means they have a hard time assessing the creation of shareholder value, customer loyalty and satisfaction, the quality of services and products, and intangible assets like brand equity and customer portfolios.
New Approaches to Budgeting
These days, organizations need to be able to respond quickly to changing market conditions and make effective snap decisions. Consequently, calendar-based planning has to give way to a more adaptive form of budgeting, in which a new financial performance benchmark is more important than number crunching. This approach seeks to link the budget, forecasts and strategic goals, resulting in a financial planning process that gives general managers and CFOs a competitive advantage and allows them to look beyond their reporting and budgeting duties.
In light of the limitations of the traditional budget, both academics and professionals have sought new methods to help improve budget planning and processes. The fruits of their efforts can be seen in alternatives like Better Budgeting -which consists of incremental improvements to traditional budgets- and Beyond Budgeting -which implies radical budgeting changes.
Better Budgeting
There are five main approaches to better budgeting (Neely, 2003):
Of these, the rolling forecast is among the most popular. This approach favors a revision of the budget instead of doing away with it completely and usually covers a forecast period of 15 months or five quarters, with monthly or quarterly updates. The advantage of the rolling forecast is that it affords managers the chance to rethink the process and incorporate relevant changes. In zero-based budgeting – another common approach- each cycle begins as if it were the first.
Beyond Budgeting
Created in 1997 in response to growing dissatisfaction with the traditional budget, the origins of the Beyond Budgeting Round Table (BBRT) are in the UK, but it has since welcomed members from Belgium, France, Germany, the United States and other countries. Borealis, Unilever, Ikea, American Express, Southwest Airlines, Charles Schwab, Wachovia and the World Bank are just some of the entities that have implemented this approach.
The creators of the Beyond Budgeting movement argue that today’s companies need to be more flexible and adaptable on a strategic level, as well as being able to respond more quickly to rapid, unpredictable and intermittent change on the markets where they operate. This translates into the need for more effective strategic management.
Budgets can still aid planning, coordination and resource allocation, but should not be used as motivational or performance evaluation mechanisms, since this would hold back an organization operating on today’s hyper-competitive marketplaces that are subject to constantly changing economic conditions.
Linking the Strategy with the Budget
The first step in the search for greater flexibility and strategic adaptability was to separate performance management and financial planning and budgeting systems – simultaneously encouraging managers to reach for “stretch” targets and at the same time presenting an accurate picture of the company’s financial scenario. Companies like Borealis rose to the challenge and came up with a new, four-pillar budget-less management system (Boesen, 2000):
Rolling Forecast
In this case, the sole objective of the rolling forecast is to provide as clear a picture as possible of the company’s expected financial performance. Since this forecast doesn’t affect managers’ compensation, there is little incentive to ‘game’ the system. Objectivity is the key here.
Objective data on prices, corporate planning, sales volumes, fixed costs, investment, depreciation, interest, inflation and financing rates is combined to come up with a fiver-quarter rolling forecast, which is revised quarterly to allow management to envisage a horizon of at least one year and in which performance in one period is measured against that of the previous. A good test of performance is a comparison with the company’s closest competitor every six months.
Balanced Scorecard
Directors who have experienced difficulties articulating the company’s strategic goals in a manner that can be easily grasped by employees have resorted to the Balanced Scorecard. This tool helps explain and measure corporate performance vis-à-vis established targets and key performance indicators (KPIs) instead of comparing it against, say, budgetary line items. In other words, the scorecard focuses on the drivers behind the numbers as opposed to the financial data, giving senior management much more leverage over the company’s future.
Activity-Based Cost Management
It may sound contradictory to talk about cost management in the absence of a budget, but in this case, expenses are tracked using the 12-month moving averages of activity-based costs, which allows a company to monitor costs in terms of activities instead of budgetary line items, making it easier to talk to employees about how and why to control costs. It is also easier to understand product and client profitability levels when costs have been broken down by activity.
Investment Management
The last pillar of a budget-less company is decentralized investment management, which puts control in the hands of people closest to the marketplace and customers. Although it is unusual to allocate this much control over capital spending decisions to front-line mangers, these employees tend to have a clearer picture of strategic priorities thanks to the Balanced Scorecard and decentralized profit accountability.
Figure 3. Breaking the Budget at Borealis: The Four Pillars of a Budget-less Organization. Adapted from Boesen (2000).
Conclusion
There can be no denying traditional budgets are becoming less and less useful and while there is still a lot to be done in terms of perfecting these new approaches, their efficient application will leave managers more time for analysis – time that would otherwise be fruitlessly invested in drawing up a detailed budget that will probably be obsolete before the ink has a chance to dry on its pages.
References
Boesen, T. (2000). Creating budget-less organizations with the Balanced Scorecard. Harvard Business Publishing Newsletters (pp. 1-3).
Bogsnes, B. (2009). Implementing beyond budgeting. New Jersey: John Wiley & Sons, Inc.
Horngren, C.T., Stratton, W.L., Sutton, W.O., y Teall, H.D. (2004). Management Accounting. Toronto: Prentice Hall.
Libby, T., y Murray, L. (2007). Beyond budgeting or better budgeting?. Strategic Finance, 89(2), 46-51.
Loeb, M., y Martin, T. (1995, 05 29). “Jack welch lets fly on budgets, bonuses, and buddy boards”. Consultado en http://money.cnn.com/magazines/fortune/fortune_archive/1995/05/29/203152/index.htm
Neely, A., Bourne, M., y Adams, C. (2003). “Better budgeting or beyond budgeting?”. Measuring Business Excellence, 7(3), 22.
Orlando, J. (2009). “Turning Budgeting Pain into Budgeting Gain”. Strategic Finance, 90(9), 47-51.
Quibria, N., y Jutras, C. (2010). Financial Planning, budgeting, and Forecasting. (2010). Aberdeen Group.
Uyar, A. (2009). “An evaluation of budgeting approaches: traditional budgeting, better budgeting, and beyond budgeting”. Journal of Academic Studies, 11(42), 113-130.
(2007). Harvard Business Essentials: Manager’s Toolkit–The 13 Skills Managers Need to Succeed (Hardcover). Harvard Business School Press Books.