Cranfield School of Management | Six Steps to Improve Budgeting

Cranfield School of Management

Think: Cranfield
Six Steps to Improve Budgeting
by Mike Bourne

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 breathes 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 working with 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.

Six Steps to Improve Budgeting

1. 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.

2. 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.

3. 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.

4. Set direction using both financial and non-financial performance measures

Since financial targets are too easy to manipulate, so 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.

5. 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.

6. 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 lose 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.

A Revolution is Just Breaking

From our observations of the developments in planning and budgeting over the last few 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.

Mike Bourne is Professor of Business Performance at Cranfield School of Management.



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