Why It’s Time to Say Goodbye to Traditional Budgeting
Jan 24, 2019
What the Research Says
General Electric Chairman Jack Welch doesn’t think much of budgets. In his best-selling book, Winning, he calls the budgeting process, “the most ineffective practice in management. It sucks the energy, time, fun and big dreams out of an organization…In fact when companies win, in most cases it is despite their budgets, not because of them.”
CEOs in Europe have long shared Mr. Welch’s distaste for traditional budgeting. That’s why the rolling forecast and other methods of continuous planning have replaced the traditional budget at many European companies. Now that trend is slowly making its way across the pond, as more and more American-based companies realize that a more adaptive planning approach is the best way to set their future course.
The Beyond Budgeting Round Table (BBRT) has spent countless hours examining the performance management models of many large organizations and produced dozens of case studies. Its conclusion: the culture of budgeting is the single greatest barrier to change. The average corporation spends four months and 20-30% of senior executives’ and financial managers’ time on the budget (with some organizations taking six to nine months). In 2003, the Hackett Group found that the average billion-dollar company spent as many as 25,000 person-days per billion dollars of revenue putting together the annual budget.
“Budgets, once meaningful control instruments, have become (in today’s dynamic information/knowledge economy and global buyer’s markets) a danger for lasting enterprise success,” says Steve Player, director, BBRT North America. “They prevent fast and flexible adaptation to the market so that full potential is not realized. They often promote mistrust, deception and endanger the external corporate transparency demanded today.”
Specific Problems with Budgets
There are three primary problems with traditional budgeting:
1. It takes a long time, costs too much, and consumes too many corporate resources. For some companies, the process can take as long as six to eight months. Many companies on a calendar fiscal year start the budgeting process in the summer and won’t end until November, December or, in some cases, after the budget period has actually started. Most budgets are very detailed and require the input and back and forth negotiation of many people throughout the organization, which only adds to the amount of corporate resources consumed by traditional budgeting. Moreover, often, internal politics come into play and become more important than the customer—with managers and employees self-occupied as a result.
2. It’s fixed and inflexible, and can quickly become irrelevant. The traditional budget starts top down and then becomes a detailed bottom up building process to meet fixed goals set by management—whether realistic or not. Once the budget is locked down, game over—no more changes. The economy may change, industry or market conditions may change, something specific within the business may change. Regulations may roil the playing field. New entrants or competition may emerge. There may be new concepts, new partnerships, new innovations, or other internal factors with financial repercussions. There are so many things that can (and perhaps should) change, and yet the budget only looks at things as they were back when it was created.
A survey of planning, budgeting, and forecasting practices by APQC and the BBRT found that 55% of respondents felt that the assumptions used in their budgets were so different than actual results that the budgets were useless within the first six months of the year. Player, the lead researcher in the study, noted that this trend is increasing as market conditions become more volatile due to the accelerating speed of business.
3. Most companies tie executive and employee compensation directly to performance against the budget. When this happens, the goal for the employee becomes “How can I minimize performance expectations?” And, the easiest way to control that is to negotiate an overly achievable budget benchmark, so that hitting the goal is easily reached. If you’re managing a cost center responsible for spending, you will likely try to maximize as much as possible the size of the budget spend, because it will give you the most resources to spend regardless of whether these resources are necessary. And, if you come in at what you really think you’re going to spend, you’ll look good, which will impact you positively from an incentive standpoint. Conversely, if you’re a in a revenue producing center, you’re likely going to lowball the budget, so when you exceed it you’ll look good. But, you’ll just barely exceed it so you have plenty of room to do well the next year. Otherwise, management will increase your budget for next year!
So, what happens is that the budget, the very mantle on which the company stands, actually turns into an internal negotiation with management, a gamesmanship of sorts, where rather than developing a budget that realistically reflects a view of where the company is going, ends up being something largely fictitious and arbitrary.
The Remedy: Rolling Forecasts
If the traditional budget has flaws, what should be done? The rolling forecast is a logical adaptation of the fixed budget or forecast—largely addressing the issues raised above with the traditional planning process.
The rolling forecast is a solid first step toward adaptive performance management. To better understand the rolling forecast, picture the 15th century explorer traveling the ocean in pursuit of the New World. He may have maps and charts at his disposal, but what if he has to change course due to unplanned circumstances such as bad weather, sickness or even the occasional pirate ship attack? Without some kind of tool that can help him navigate these unexpected deviations from plan and reset course, our captain may very well end up in Belize rather than Boston.
A rolling forecast can be defined as a projection into the future, partly based on past performance, that is routinely updated to incorporate input and information reflecting changing market, industry and/or business conditions. It is not meant to be a fixed target, but rather a best current prediction as to the organization’s financial and operational performance over a certain time horizon. That time horizon can be 12, 18, 24 or any number of months or quarters ahead from today. It “rolls,” because as time moves forward, so does the time horizon of the forecast, unlike a traditional budget cycle that ends at a fixed point in time. Ideally, you don’t want to look too far into the future or it tends to become too hazy, unrealistic and unpredictable, but you also don’t want to keep the time horizon too short or you’re not seeing the full impact of your decisions.
Rolling forecasts are typically updated on an ongoing basis, rather than quarterly or semi-annually. This means that they are more accurate and require less time to update than a traditional budget/fixed forecast planning model. Unlike traditional budgeting, where you basically start all over and have to redefine the whole process and marshal the resources annually (and have to contend with ongoing negotiations), rolling forecast, involves only minor tweaking as you continually update on a short-term basis. This saves time and resources.
Rolling forecasts solve the third problem outlined above, tying executive and employee compensation directly to performance against the budget, by instead focusing on outperforming the competition and achieving high performing results. For example, a company can use key industry metrics to measure its performance against the top players in its industry, resulting in higher bonuses for executives if the company outpaces its competition. Or, try publicizing peer performance of a sales organization—and see how hard those salespeople work to remain “A” players and come out on top.
Responding to Change
European countries, as earlier indicated, have pioneered the notion of moving away from the traditional budgeting approach. The climate, of course, is different there—one generally marked by an open and less regulated market. In the U.S. we tend to have a shorter term mentality resulting from the influence of Wall Street, which places an undue emphasis on quarterly earnings and its effect on stock prices. This drives companies towards traditional budgeting, which Wall Street closely monitors, leaving little room for flexibility.
As a result, many companies have been resistant to change. As with any trend, there will be a tipping point. In the last couple of years we have seen a willingness by clients to get their toes wet when it comes to rolling forecasts, with many slowly making the transition by establishing some kind of rolling forecast, while not yet eliminating the traditional budget. The goal is that eventually the concept of the calendar year and the stop-and-start budget will become less and less important.
If your business uses an antiquated tool that doesn’t facilitate a rolling forecast, the transition will be an onerous one. Managing the rolling forecast by using spreadsheets is very challenging, and most budgeting software tools are designed for fiscal year cycles. Yet, planning tools now exist that offer flexibility and can handle the transition from the budget to the rolling forecast, or any variation thereof.
But even with the proper tools to facilitate the transition to the new system is the need for a fundamental change in an organization’s culture and management philosophy. The change must be a C-level management decision and then be efficiently communicated down the chain.
Like any significant change, this one won’t be painless. But the return on investment will be great. People will quickly learn to love the rolling forecast if, for no other reason, that it’s not the budget.
For more information on exploring such a change in your organization, visit Beyond Budgeting Round Table.
Switching to a rolling forecast is a big change and could be considered a risky maneuver. See how to utilize risk to benefit your company with this free AMA webcast.