Director, Centre for Business performance, Cranfield School of Management, ... planning and budgeting for every one bill
Six steps to improving your planning and budgeting system Dr Mike Bourne, Director, Centre for Business performance, Cranfield School of Management, Cranfield, MK43 0AL, UK Background For many organisations, planning and budgeting is an annual ritual. Once a year a letter goes out from head office describing the company’s expectations, shortly followed by a budget pack to be completed by a predefined date. Once a year these packs are completed and returned, and then the annual negotiation begins in earnest. Head office wants more and the subsidiaries know this, so they have kept something back. But Head Office know they have kept something back, so are trying even harder to increase the budget. Eventually the negotiations conclude and the budget is set for the next twelve months and everyone breaths a sigh of relief and finally gets back to running the business again. Now I know that this is a bit of a caricature of traditional budgeting and many people are into rolling forecasts and rolling budgets (which hopefully doesn’t mean that the whole budgeting process has to be repeated four times a year), but in many larger organisations planning and budgeting is not seen as adding value. It is slow (Shell for example have a thirteen month budgeting cycle), it is time consuming (according to Hackett group, companies on average are spending 25,000 person days per annum on planning and budgeting for every one billion dollars of sales) and often doesn’t produce a result that is significantly better than we started with. In addition, all the time we are spending on planning and budgeting, we are not spending directly running the business. Part of the problem lies in the fact that companies use the budgeting system to integrate everything. A budget is supposed to be a plan, but we complicate this. It is also used as a forecast of what will be achieved whilst serving at the same time as a stretch target to motivate management. These different needs are incompatible, so it is no wonder many companies have problems with their planning and budgeting systems. Recent complication If the incompatibility of the different roles of planning and budgeting were not enough, more recently these problems have been exacerbated by events. Firstly, the increase in global competition is putting pressure on businesses. Companies can no longer rely on their markets and competitors remaining unchanged for many years. The growth of China as a manufacturing base has hit many companies around the world. For those in services, the internet has disrupted some markets and created huge opportunities in others. These rapid changes can make the budget out of date extremely quickly, especially when it is only updated every twelve months.
Secondly, if dealing with the external market changes is not enough in itself, there are new management, reporting and regulatory requirements to deal with. The Sarbanes Oxley legislation in the USA has a direct impact on all those companies listed on Wall Street. Companies will shortly have to disclose all events that will impact significantly on the performance of the business. The legislation also requires the business to report what the impact will be. Many companies’ current planning and budgeting systems simply aren’t fast enough to respond to this new requirement from Sarbanes Oxley. Thirdly, the stakes from getting the budget wrong are getting higher. Price WaterhouseCoopers found in their 2001 study that, on average, a profit warning reduces the company’s share price by approximately 20%. In 2002, Ernst & Young found the average reduction in share price after profit warns had increased to nearly 25%. Finally, there is the move towards quarterly reporting, putting pressure on companies to meet financial results on a quarterly basis and to reforecast more frequently. All these issues raise an important question, “How do we improve our planning and budgeting processes so that we can plan, reforecast and motivate management within the short time frames required?” Some solutions Some have suggested discontinuing the budgeting process (Hope & Fraser, 2004). They cite organisations such as Svenska-Handelsbanken who mange and thrive without a budget. But few organisations have truly taken this route. A much more widespread and practical answer is not to depend on the budget for everything. The answer to the problem lies in understanding the strengths and weaknesses of budgeting and then using other mechanisms to deliver those things for which budgeting is unsuitable. For example, Borealis (the Danish based international plastics business) split their management requirements into four distinct agendas. They had a need to forecast, set direction, manage costs and control capital expenditure. They then set up four distinct systems to deliver each of these requirements. Forecasting was done centrally using a financial model that collected basic data from key points within and outside the company. As a result accurate reforecasts could be produced in one and a half days without disrupting the whole of the organisation’s management. Direction setting was delivered through a set of interlinked Balanced Scorecards, which set financial and non-financial targets right across the business. Cost control came from extensive benchmarking against competitors in the industry and best in class companies for the support functions such as HR and financial management. This resulted in targets being set by comparison with others, rather than on the previous year’s performance. As a consequence, the company focused the cost reduction efforts on achieving competitive advantage. Finally capital expenditure planning was managed by a central committee, who met monthly and juggled priorities with income flows. Borealis have performed well over a number of years and this approach stood them in good stead. However, not all companies have the opportunity to completely
reengineer their planning and budgeting system. From researching the practices adopted by Borealis and others, I would suggest the following series of actions to improve the planning and budgeting process. Firstly, decouple the achievement of the budget from the compensation process. From our survey of companies attending events last year, nearly half the respondents were paying management bonus on achieving the financial budget. This link immediately creates an issue when setting targets, as employees want to ensure they achieve their bonus whilst the employer wants to create stretch goals. This doesn’t mean that bonuses can’t be paid based on financial performance. One way of avoiding the issue is to pay bonus directly related to the level of profitability avoiding the issue of target setting. Another is to adopt the approach taken by BP where some bonuses are based on performance compared to their direct competitors, again removing the problem of target negotiation. Secondly, decouple the budgeting and forecasting process. Budgets are ultimately concerned with resource allocation and so require management input and negotiation. Forecasts on the other hand can be done using financial models. These can be rapidly rerun on a monthly or quarterly basis and when circumstances change. Thirdly, use external benchmarking to set cost control targets. This avoids negotiating improvements over last year and creates realistic targets, which take into account the improvements being made by the competition. Borealis were initially surprised by their poor cost position when they started using the approach and now there are a whole range of organisations and clubs that can provide the necessary data. Fourthly, financial targets are too easy to manipulate, so set direction using both financial and non-financial performance measures. Improving the financial position can be done in the short term by reducing service levels and competitiveness. One classic example was Marks & Spencer who were making record profit in the mid 1990s whilst their customer satisfaction was falling. Eventually the situation caught up with them and their profitability fell. Tracking leading non-financial indicators can deter this behaviour. Fifthly, build explicit links between the major non-financial activities and resulting financial performance and manage the change in these relationships. Many budget improvements are delivered by shaving cost from individual lines of the budget without any consideration of the physical impact of these changes. It is then not surprising that the budgeted savings are not delivered. However, if we create an understanding of process capability using statistical control techniques, we can judge with reasonable certainty what the performance will be. Planned improvements to the process will, in time, deliver performance improvements to the organisation; but these improvements have to be planned and executed. Linking the activities, improvement plans and the financial plan enables improvements to be tracked and budgets properly validated. Software now exists to allow this to happen and to be coordinated across a large organisation. Finally, separate running costs from investments. This may seem an obvious comment and a fundamental concept for accountants, but most organisations ignore the fact that just to stay competitive the business has to make small incremental improvements
each year just to keep up with the competition. When business is going well, these small items of expenditure are simply absorbed in running costs and are probably not even noticed. Unfortunately, when budgets become tight, this discretionary spend is easy to cut. Businesses can look profitable but loose their competitive edge and the approach adopted by companies such as ABB, is to make these different types of investment explicit so that they can be tracked and monitored. From our observations of the developments in planning and budgeting over the last four to five years a revolution is just breaking. A number of major leading companies are in the process of revolutionising their approach. They are taking the time and effort to review this critical process and develop planning and budgeting systems that suit their needs and circumstances. They also believe that they are getting a competitive advantage from this. Here I have suggested some initial steps you might take to move forward, but at some stage you will probably need to take the plunge and will need to conduct a complete review. On the 27th of January, The Centre for Business Performance is running a conference in collaboration with CIMA around the theme of planning and budgeting bring together speakers from the School of Management and organisations such as Unilever, Statoil International Exploration and Production, Nuaire Group, Fifth Third Bank and the National Blood Service (for information see http://www.som.cranfield.ac.uk/som/cbp/courses/conferences.asp). Reference Hope, J. & Fraser, R., (2004), “Beyond budgeting: how managers can break free from the annual performance trap”, Harvard Business School Press, Boston, MA, USA.
