Historical Budgeting kills Business Agility

Ever been on a project where everyone (including the project sponsor) has come to the realisation that the project will never deliver the value that was promised? And despite this common understanding, the project just carries on regardless?

Blame historical budgeting.

Traditional (historical) budgeting, whether bottom-up or top-down, typically involves taking last year’s revenue and expenses and adding a growth factor to each side of the ledger (usually a higher growth factor on the revenue side than the expense side).  This then sets the playing field for the year ahead (i.e. the revenue that the business needs to bring in and the expense that it is permitted to spend, with the planned profit as the remainder).

The expense is further broken down into capital expenditure (capex) and operating expenditure (opex).  Capital expenditure, in particular, may span over multiple years.  Further complicating matters is that both types of expenditure have rules that dictate what can be categorised as capex or opex (as the categorisation can have a significant impact on financial performance reporting and tax liabilities).

While I understand that many of you reading this article will know most of this already, where I’m heading to is the adverse behaviour that this budgeting approach results in, and what can be done to change it.

So, what are the problems with this approach to budgeting?

The major drawbacks include:

  • Internal Focus
  • Budget Hoarding by Silos
  • “Use It or Lose It”
  • Annual Planning Mindset

Internal Focus: as the key determinant of the size of the budget is “what we did last year”, the plan is almost totally determined by the organisation’s past performance (an internal measure), not market dynamics (e.g. changing preferences, entry/exit of major competitors, substitution, innovation, etc.).  To be fair, most organisations do a “reality check” on the numbers, by comparing with sales forecasts and other leading indicators, but the key driver of this year’s plan is nonetheless last year’s performance.

Budget Hoarding by Silos: given the self-reinforcing nature of the historical budgeting cycle, departments/divisions/teams hold on dearly to any expenditure budget they are allocated.  By way of example: if my division gets $1m to spend this year, and we then find that $0.5m can be invested elsewhere for a higher ROI, that should be seriously considered, right?  The problem for me is that then means I only ‘spent’ $0.5m this year (which becomes the baseline for next year’s plan – $0.5m less than the year before!).  Which also leads to…

“Use It or Lose It”: Similar to the example above, if I underspend my expenditure budget this year, I am actually penalised under the historical budgeting model for saving money! For example, underspending $200K on a $1m budget this year means that $800K becomes the new baseline for next year.

Annual Planning Mindset: Perhaps worst of all, historical budgeting means revenue and expenditure plans are reviewed and agreed only once a year.  Given that the process often begins 6 months before the start of the new financial year, this means that the impact can stretch over 18 months!  This effectively creates a huge damper to business agility, with organisations unable to move quickly to adapt to new opportunities and rapid changes in the business environment.

So what to do about it?

Beyond Budgeting is a good place to start.  The Beyond Budgeting Roundtable articulated 12 principles underpinning an alternative management model, including making “planning a continuous and inclusive process; not a top-down annual event” and making “resources available just-in-time; not just-in-case”.  (A full list of the principles can be found at: http://www.bbrt.org/beyond-budgeting/bb-principles.html).

Ultimately, the key to Business Agility from a financial perspective is flexibility in implementation.  It’s not that the original plan is necessarily wrong, but more that the plan itself becomes “the written word”, instead of being a starting point that is continually adapted as new information becomes available.  The greater the flexibility in implementation, the more responsive the business can be to market shifts and (often fleeting) opportunities in the marketplace.

© Eric Jansen 2012. All rights reserved.
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Business Agility Defined

The term ‘Business Agility’ gets a lot of airplay these days – but what does it actually mean?

Much as the term agile has been increasingly used (abused?) in the IT industry to describe a high-performing software development team, Business Agility is now also becoming a term that is increasingly heard in business circles.  Like the term agile, however, people often find it difficult to be specific when describing what business agility actually means.  Responses are usually of the kind: “being flexible”, “capitalising quickly on new opportunities”, etc. – which is fine, but how does an organisation actually do this?

The following diagram depicts six key components of an organisation that exhibits Business Agility:

  • Adaptive Planning: Above all, the organisation needs to be able to plan and execute simultaneously.  Sequential planning leads to a very rigid implementation approach, whereas adaptive planning allows (indeed, encourages) many course-corrections along the way.
  • Focus on Time to Value: There is an almost obsessive focus on getting new products/services/features to market as soon as possible.  This enables a shorter feedback cycle and, equally importantly, an quicker timeframe to earn a return on the investment made.
  • Decoupling: This is where a lot of businesses (particularly larger enterprises) find it very difficult to move quickly to exploit new opportunities.  The more each business process is intertwined (coupled) with others, the harder it is to implement change quickly.
  • Low Latency: While this attribute could be consider an underlying theme, it is worth calling out as a specific component.  The quicker a decision can be acted upon, the sooner the business knows whether the decision was right and what else needs to be done to achieve the underlying goal.
  • Economic Efficiency: A lazy, bureaucratic organisation will protect its turf at the cost of progress and innovation.  Lean operations that minimise waste have the added incentive of promoting new and innovative ways of doing things, and being able to implement them quickly.
  • Rapid Adaptation: While similar to Adaptive Planning, this component really refers to the mindset of continual monitoring of, and adaptation to, changing market conditions.  It is the ultimate feedback mechanism that ensures the product/service offering is continually refined to best meet the needs/constraints of customers, suppliers and partners.

Focusing on how you can introduce/expand the above disciplines in your organisation will bring real meaning to the term Business Agility.  As a result, the business will be better placed to exploit new business opportunities in today’s rapidly-changing competitive marketplace.

© Eric Jansen 2012. All rights reserved.