Why budgeting kills your company

The same school that asked if IT matters anymore now asks -- do budgets matter?Harvard business experts think your company may be better off booting budgets entirely.

The average billion-dollar company spends as many as 25,000 person-days per year putting together the budget. If this all paid off in shareholder return, that would be fine. But few organizations can make that claim. In fact, many firms now question the ROI of traditional budgeting altogether and are looking for alternatives that reduce time and better align spending with strategy.

Look at your own company's budget process: Has it really helped you do a better job of belt tightening during the current slowdown? Many companies have reverted to more centralized command-and-control procedures to keep a tight rein on costs -- but the dynamics of the budgeting process often undermine this effort.

"In tough times like these, any significant real cost growth feels imprudent and is hard to justify for most businesses," writes Mike Baxter, a partner in the New York-based consulting firm Marakon Associates, in a recent company publication. "Business units have used their budgets as a bargaining chip, bidding high to get a larger slice of the pie while keeping their cards close to their chest.

"The CEO has had no choice but to get them back into shape, though he lacks any clear line of sight for identifying and challenging the least valuable resources," Baxter continues. All too often, the CEO must opt for across-the-board cuts -- even though he knows that this approach penalizes the high-performing units and props up the underperforming ones. The result is a decoupling of the company's resource allocation process from the highest-value strategic opportunities.

The answer, some experts say, is to dispense with budgets entirely and replace them with a system of rolling forecasts and key performance indicators that shifts strategic decision making to customer-facing edges of the organization. Others advocate less sweeping but still significant changes: Housing the budgeting and strategic planning functions in one office, establishing top-down goals three to four years out, and requiring all business units to explore the budget implications of several strategic alternatives.

The following discussion will help stimulate your thinking about how your own company's budgeting process can be transformed from an exasperating exercise in pork barreling and interdepartmental brinksmanship to a tool for achieving strategic alignment.

How fixed-performance contracts ensure underperformance

At its simplest, a company's budget process consists of each unit producing a sales forecast (assuming it's a profit center) and a capital needs forecast. "I've seen some annual budget processes that didn't take any time at all," says William J. Bruns Jr., Henry R. Byers Professor of Business Administration, Emeritus, at Harvard Business School and a visiting professor at Northeastern University. After each unit's sales and capital needs forecasts are complete, "senior management holds a three-day meeting to discuss them and then makes its decisions. Of course, at the other end of the spectrum, you have these 200-page budget books that get produced, requiring months of meetings."

In some instances, the budget process consumes up to six months and 20% of management's time.

Most companies' approach to budgeting increases the chances that the process will be arduous, expensive, and frustrating, says Jeremy Hope, coauthor with Robin Fraser of Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap (Harvard Business School Press, 2003). The culprit is what he calls the fixed-performance contract. "The targets for sales, costs and key ratios that are spelled out in the budget become an implicit contract," he says. A recent Hackett survey found between 60% and 90% of the top 2,000 global companies have this sort of contract. "And there are usually financial incentives attached: Career prospects and bonuses ride on this contract —- incentives for hitting the targets amount to as much as 97% of a U.S. manager's annual salary.

"There's terrific pressure on everyone to make those targets; hence the distortion, misrepresentation and gaming that can happen in even the most ethical companies," Hope continues. "If you're a manager trying to increase spending or get a capital project approved, you put in for 50% more than you need, knowing you'll get argued down by senior management to what you originally wanted."

At the same time, the fixed-performance contract fosters the fear in managers that if they don't spend what's left over in their budgets at the end of the year, then their funding for the next year will be reduced. Cost discipline thus takes a back seat to turf protection. The budget process may help establish a ceiling on costs, but the internal politics of the fixed-performance contract ensure that there is also a cost floor -- in other words, that the cost savings aren't as sizable as they might be.

As long as budgeting, a vestige of the old command-and-control approach to management, remains in place, the newer tools designed to decentralize strategic decision making will never achieve their full potential, Hope and Fraser argue. The solution is not better budgeting "but rather abandoning budgeting entirely and building an alternative management model," they write.

Among the features of the approach they recommend, which is currently being used by organizations in a range of industries and countries, are the following:

Goals based on longer-term external benchmarks instead of internally negotiated annual targets. Adopt benchmark goals based on "industry best-in-class performance measures or direct competitors," Hope and Fraser write; and give teams "an extended period of time to reach them" -- two to three years. Atlanta-based eye-care company CIBA Vision found that the move to competitor and market performance benchmarks -- chief among them sales growth, return on sales, and economic value-added (EVA) growth -- not only helped it shorten and simplify its budgeting process, it also reduced the amount of budget gaming.

Evaluation and rewards based on relative-improvement contracts. Such contracts involve "a whole team... setting and meeting a range of performance benchmarks over a period of time," write Hope and Fraser. "Performance is then evaluated by a peer review group (using relative measures) with the benefit of hindsight." At the Swedish bank Svenska Handelsbanken, the company's 11 regions compete like teams in a league, trying to beat one another's return on equity. Similarly, the 550 branches compete on two other key performance indicators: Cost to income and profit per employee. The relative standings are publicized throughout the company. The uncertainty of this relative-performance approach drives success. Each manager knows from the outset "what has to be done to improve his or her usual performance," Hope and Fraser write. But it is only in hindsight that they know how well they have performed relative to the other managers. This leads them to focus on "maximizing profits at all times rather than playing games with the numbers" to meet artificial annual targets.

Continuous and inclusive action planning. A five-quarter rolling forecast that provides projections for each of the five subsequent quarters can help eliminate the distortion caused by having financial incentives to meet a fixed target for a single fiscal year. A typical rolling forecast may have only a few line items: Orders, sales projections, costs, profitability, cash flow, and capital investment. But this information is enough to enable managers to focus on long-term issues that are fundamental to the business' success—for example, why customers are leaving or what's wrong with a particular product.

Resources that are made available as needed, instead of allocated in advance. Handelsbanken gives its branch managers the freedom to decide which products to sell and to set their own prices and discounts. (Branch managers know that whatever decisions they make about prices and products, their costs must be about 40% of income.) Similarly, each branch manager gets to decide what resources the unit needs.

To make its central services more responsive to market demands, Handelsbanken conducts an annual round of negotiations in which cost estimates and the services underpinning them are discussed by all involved. Regional and branch managers can challenge the prices and even choose to go with outside vendors. Since the early 1990s, branch managers have had the authority to determine staffing levels and set staff salaries. At first, senior managers predicted that it would lead to an increase in the number of workers. But the opposite has occurred; Hope cites this as evidence that the further out toward the customer-facing nodes of an organization you push the profit responsibility, the more cost-conscious and innovative the employee behavior you get. Indeed, since Handelsbanken abandoned budgeting in the early 1970s, it has bested its Scandinavian rivals on return on equity, total shareholder return, cost-to-income ratio, and customer satisfaction.

The budget as an agent of strategic alignment

Other experts are not as eager for a complete overhaul. Harvard's Bruns suggests keeping budgets but restructuring compensation programs so that managers no longer have an incentive to favor short-term goals over the longer-term health of the company. By getting rid of the inflexible approach to short-term targets, you answer the problem that lies at the heart of Hope and Fraser's critique of budgeting.

Although Marakon's Baxter also doesn't advocate the wholesale replacement of traditional budgeting, he does believe that changes must be made to reforge the link between a company's strategic planning and resource allocation.

"Budgeting and performance are typically overseen by the finance department," he says, "whereas planning is coordinated by a strategy department. Often, the two processes aren't well integrated, resulting in strategies that are often dictated by the budget process instead of vice versa. When it comes time for senior management to review the units' investment proposals, their decisions are often blind to their impact on long-term value.

"Resource allocation should be about putting funds behind the right high-value opportunities," Baxter continues. He recommends creating an all-in-one process in which the CEO takes the lead in setting the strategic planning goals for all units, reviewing alternative strategies with business units, and linking resources to delivery of the alternatives with the highest value and best performance characteristics. With this approach, you're more likely to get not only the level of performance you're seeking, but also the particular implementation path that you're after.

Although you want to encourage bottom-up thinking about how best to achieve the desired performance, you also need to create some discipline. "Many business unit managers are overly optimistic about the long-run performance potential of their strategies, leading them to overinvest in the near term," says Baxter. Senior management can provide valuable top-down guidance here by using three- to five-year strategic plans to define the boundaries of these discussions and then making sure they're clearly communicated at the outset of the resource allocation process. Next, charge each business unit with developing several alternatives as a way of helping the corporate center understand the highest-value, highest near-term profit, and lowest-cost options that exist in each unit. This helps create a genuine dialogue between the corporate center and the units about the resource and performance tradeoffs involved in choosing a particular alternative.

When you're clear on your strategic goals and have a process that integrates strategic planning with resource allocation and performance management, budgeting can actually work, Baxter says. It becomes a mechanism for ensuring not only that funds flow first to the strongest opportunities, but also that those opportunities actually deliver on their promise.


To read more articles like this one, visit HBS Working Knowledge, an online source for business analysis, information and research.

© 2003 President and Fellows of Harvard College

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