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.