Budgets have been described as “a financial blueprint of management’s expected plan of action.”  As such, they serve at least six key functions.

• Setting targets
• Aligning incentives
• Developing action plans
• Allocating resources
• Coordinating across all functions
• Monitoring and controlling finances

Many see these budget functions as keys to successful management. Yet numerous studies have identified criticisms and complaints. One well-documented issue is that traditional budgeting often creates a fixed performance contract that limits an organization’s ability to be responsive in today’s ever-changing environment.

The ills of traditional budgeting in large corporations are detailed in a chapter of Jack Welch’s, (former Chief Executive of General Electric)  book  – Winning.

Jack’s view  on “Budgeting: Reinventing the Ritual” is:

Not to beat around the bush, but the budgeting process at most companies has to be the most ineffective practice in management. It sucks the energy, time, fun, and big dreams out of an organization. It hides opportunity and stunts growth. It brings out the most unproductive behaviors in an organization, from sandbagging to settling for mediocrity. In fact when companies win, in most cases it is despite their budgets, not because of them.

The pain areas for traditional budgeting are:

• Costs too much
• Takes too long (budgets are out-of-date when published)
• Does not add value in managing the business
• Requires a crystal ball to predict the future
• Slows response time, limiting discussion of innovative ideas to narrow budget preparation window
• Leads to gaming where managers try to negotiate low targets to reach maximum bonuses
• Sub-optimizes results

Some common pitfalls that organizations face are:

1. Forecasting to the wall

Many companies forecast to the end of a period – usually the end of the financial year. When this approach is taken, the purpose of forecasting shifts dramatically. Instead of being a discussion about organizational direction and the risks and potential opportunities in getting there, the conversation quickly turns to one of performance evaluation and a revalidation of whether managers still agree to earnings commitments. The conversation cannot be about the future if the future magically ends when the period ends.

Some organizations try to make the shift by extending their forecast period into subsequent periods. This effort is also ineffective if all management review questions continue to focus on the period end. Rather than coordinating activities for the future, this process is about performance evaluation. In essence, senior management is asking whether each operating manager can be trusted to deliver her/his share of the earnings target. This tends to garner cautious responses, particularly for those lagging in performance who want to project confidence in their ability to catch up, while those running ahead project high future costs to avoid having their targets raised at mid-year.

A rolling forecast is very useful here as it shows a consistent period for each forecast. The objective is of course is visibility across the business cycle.

2. Confusing Forecasts to targets

Simply stated, targets are where a company wants to go. They are typically medium-term aspirations or goals that often get converted into quantified annual targets. Forecasts, on the other hand, highlight a company’s strategic direction.

The problem occurs when the two points are different. Many organizations use the forecast to “close the gap.” Managers who are behind on an actual basis can show their organizations catching up in the forecasts. The problem with this approach is that it blends both current trends with expected results of future action plans. It obscures the details of what needs to happen and limits discussion of the risks of achieving these action plans.

3. Insisting on forecast accuracy in an unpredictable world

Many believe forecasting is about both predicting and controlling the future. Some organizations have a goal of forecast accuracy even to the point of providing incentives to achieve forecast accuracy. While motivated by attempts to control the world, such efforts seem highly irrational in today’s volatile and chaotic business environment.

To accurately predict the future, any business would need to forecast the price and availability of key business inputs such as labour, transportation (which is likely influenced by oil prices), and interest rates or other capital costs. Strategic planning also requires forecasting the success of planned improvement actions, the response of current and future customers, as well as the countering actions of current and future competitors.

However, a major problem with forecasting, when used in a predict-and-control environment, is the natural tendency to make sure forecast numbers are achieved. Companies typically forecast a conservative net income that minimizes revenue expectations while it maximizes future expenses, so long as the net total is acceptable. While considered prudent from a financial management point of view, this approach results in constant minimizations of opportunities and timid approaches to growth.

Budgeting expert Jeremy Hope notes, “The purpose of forecasting is to inform decision makers to help shape outcomes, not to predict the future. In reality, forecasting is necessary only because organizations cannot react instantly to changing events.” The focus should be on understanding how to react more quickly and understanding both causes and effects. The winds will change, how quickly can you trim your sails?

4. Forecasting with spreadsheets

For most organizations, forecasting is performed using spreadsheets. Well known as a powerful personal productivity tool, the spreadsheet is ill-suited for integrated cross-company communication and collaboration. While it is possible to do a single pass with spreadsheets, multiple iterations with changing budget assumptions are a nightmare to control. Security of key financial data is difficult. Consolidation of results is cumbersome. The risk of error is high, with user reviews often the only control mechanisms.

In conjunction with the use of a proven technology, many organizations have  found key levers to improve the success in using rolling forecasts. These approaches  include:

• Using today’s tools to visualize results
• Focusing on critical drivers and avoiding excessive detail
• Matching your forecast with your ability to see
• Using different time horizons for different decisions, but integrating systems
• Moving to advanced planning approaches

I am keen to seek your valuable views and comments

Data Source/References/Quotes:

Cognos white paper – Managing through change – the power of rolling forecasts: Copyright IBM Corporation 2009

Jack Welch’s book  – Winning

Disclaimer
The views and opinions mentioned in this blog are strictly my own and in no way reflect those of IBM or any other corporation or individual in any manner