Escape from the budget straitjacket

Annual plans are a drain on resources, a pain to prepare, entirely fictional and a hostage to fortune. So why do companies bother with this yearly pantomime? Because there's no other way. Oh yes there is, says Simon Caulkin.

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Last Updated: 31 Aug 2010

The finance director of a big, well-regarded multinational had a headache. For the second time in a year, he'd had to cut the group's profit forecast to the markets. This was more than embarrassing: the point of instituting better communications with the markets, as decided by the board, was to build investor confidence. This was doing the reverse.

Ironically, his department had never had more data to hand. As a result of attempts to make the group more responsive, the centre was collecting more information than ever before. It was drowning in data. The annual budget and plan - which was supposed to avoid these surprises - had reached 600 pages and more than a million numbers.

Preparing it required armies of people at HQ and in the subsidiaries to supply detailed figures, answer queries and then 'correct' the numbers to fit the plan. Despite 14-hour days and weekend working, the document took six months to prepare. The monitoring process was just as nightmarish.

Yet the forecasts based on these laboriously assembled figures seemed to be getting less, not more, reliable. 'We were going mad with the amounts of data people couldn't use,' says a weary finance manager.

Sounds familiar? Although almost everyone uses budgets, nobody loves them. Ninety per cent of US companies and 88% of European firms view the process as cumbersome and unreliable. Computers don't seem to make it better or faster, either: budgeting absorbs up to 30% of top management time and generates equivalent cost, research has found. When Ford added up the figures, it found the numbers fest was costing it $1.2 billion a year.

And for what? 'You have to ask yourself what all the grief is for,' sighs the finance manager. As the above example shows, budgets often provide neither short-term predictability nor control. Being internally focused, 'budgets serve the interests of neither shareholders nor operations managers', says Jeremy Hope, research director of research group Beyond Budgeting Round Table and co-author of Beyond Budgeting (Harvard Business School Press). 'They prevent change and protect cost.'

Faith in the budget is responsible for the disastrous belief that a sharp enough numbers person can manage anything ('When I've finished with it, a monkey will be able to run this company,' ITT's accountant CEO once boasted) - which is why the corporate graveyard is full of the corpses of companies that imagined they could manage by budget alone: alongside ITT, Westinghouse, Enron and WorldCom are just a few of them. The budget, according to Jack Welch, former CEO of GE, is 'the bane of corporate America'.

And not just in the private sector. In the public and voluntary sectors, running the business around the needs of the accounting rather than investment cycle is as counter-productive as in companies, argues Hope. The tyranny of the budget is the spur every year in February and March for an orgy of unnecessary road resurfacing, while other council services are at a standstill. Meanwhile, charities struggle to reconcile the requirements of the annual financial accounting schedule with the needs of two- or three-year projects. Frustratingly, they say, donors increasingly accompany their grants with detailed budgetary controls that actually make it harder for them to respond flexibly to unpredictable events on the ground.

The budget is also the lynchpin of modern management. For most managers, it would be as unthinkable to do without as hierarchy, targets and incentives.

And that's exactly the problem. It's the budget that binds the present system of management together. But as a few adventurous organisations are finding out, there are surprisingly practical alternatives to the budget straitjacket. They involve dismantling some of management's most cherished beliefs - in short, a different way of managing.

To understand why, a bit of history is necessary. The budget is a relatively modern creation; an offshoot of management accounting, it grew up in the 1950s and '60s from the work of accountancy academics striving to show how businesses could be scientifically managed using accounting targets and feedback from accounting information systems. Practitioners who moved into the top corporate offices in the '60s and '70s, such as ITT's Harold Geneen, quickly seized the opportunity to turn it into an instrument of managerial fiat. From figures initially designed to keep score, notes accounting historian Professor Tom Johnson, the budget evolved into today's all-embracing apparatus of planning and control: an earnings promise made by top management to investors, translated into targets and cascaded down in an almost feudal pyramid of performance contracts that managers must sign up to. It is underpinned by sharp incentives and a comprehensive information system to monitor and control costs.

The budget, says John Seddon, MD of Vanguard Consulting, 'is the equivalent of command-style central planning in an economy'. As a management system, it worked - after a fashion - in the post-war seller's market, where next year's sales could reasonably be extrapolated from last year's and the perceived organisational imperative was compliance with the central plan. But where, as now, a buyer's market rules, 'make and sell' - the 'push' model of mass production - is less and less viable.

As departing executives at Marks & Spencer and Sainsbury know only too well, last year's sales are no longer a good guide to this year's. Instead of compliance with a monolithic, internally derived plan, a company needs to respond quickly to the external stimulus of the market. 'Produce to order' is the mantra of the day.

Budgets are no help here. 'They are backward-looking and inflexible,' says Alec Reed, chairman of Reed Executive. 'Budgets are just not an intelligent way to run a company in today's conditions.'

The knee-jerk reaction of managers who feel the figures running away from them is to tighten the controls. But like a driver tugging on the steering wheel and braking in a corner, that just makes the car more likely to leave the road. Says Seddon: 'Like all targets, budgets distort priorities by focusing managers' attention on the wrong things. Setting a financial outcome and deciding what to do to meet it is starting from the wrong end.'

Instead of satisfying customers - a com- pany's real source of livelihood - the budget focuses managers' attention on satisfying the boss. In other words, 'the budget becomes the purpose'. This may flatter the chief executive's ego, but his impression of control is illusory. The more managers try to reassert control through numbers and budgets, the more they put real control - in the sense of rapid responsiveness to a changing market - out of reach.

The reality, says the multinational finance executive, is that today's budget is the opposite of a rational calculation: a political poker game of bluff and counterbluff at all levels. Every operating manager knows the unspoken rules:-

- To make the target easier, underestimate potential sales and overestimate spend (anything over can be hidden away for a rainy day).

- 'Use it or lose it' - never underspend your budget, otherwise it will be reduced next year.

- Never give the real picture if you can help it - at some stage you'll need to find excuses for variances, so the less transparency the better.

- That applies to other teams, too: you're competing for the same resources, so never give away your best tricks.

- Do whatever it takes to make the bonus ... But never exceed it; otherwise, managers will conclude you were bluffing, mark you down and raise the target. Instead, move extra sales to the next period to give it a flying start.

The result of this elaborate charade is a waste of resources on a grand scale - suboptimisation (the parts making their targets at the expense of the whole), opacity, individual burn-out and, not least, a corrosive cynicism. 'The people getting promoted are the skilled political operators who can negotiate favourable targets and hide contingencies for a rainy day - that's the name of the game,' says the finance chief.

Meanwhile, the dead hand of the central budget causes so many corporate change initiatives to be stillborn, stifling attempts to put into practice delegation, decentralisation and customer focus. Not surprising, says Hope: 'that's what it's designed to do.'

Because the budget has for decades been the framework within which managers manage - it is management - many find it hard to envisage anything different.

Yet the pressures for change are building. The example of several consistently outstanding companies is telling: it's no coincidence that the world's most successful carmaker (Toyota), airline (Southwest Airlines) and one of its most successful banks (Svenska Handelsbanken) are run with performance-management systems that challenge the conventional budget head on. This is not lost on a group of big-name US financial services companies (Amex, Wachovia, Charles Schwab), which have set up an active BBRT special-interest group to investigate alternatives. 'US firms in general are the most control-oriented on the planet, but these guys are really running with it,' notes Hope.

Pressures on the public sector to do more with less, particularly in the UK, also favour new budgetary approaches. A growing number of managers and companies, despairing of the stultifying effects of existing methods, are rebelling. The budget just doesn't fit with what they want to do.

For example, conventional accounting approaches are a major obstacle to companies going 'lean' - indeed, the philosophies are diametrically opposed.

'Traditional accounting is actively hostile to lean,' says a spokesman for BMA, a consultancy promoting lean accounting. 'The budget is anathema.'

Or take our multinational, which powerfully illustrates many of the issues and principles involved, including its insistence on anonymity: investors as well as managers need to be educated by results before it can come out, say champions of the new approach. Each organisation has to find its own way to salvation, but this one was feeling the pinch on several fronts. How could it raise its no-better-than-adequate earnings performance, cement better relations with shareholders and ease the intolerable pressures on its finance department?

Clearly, to raise performance, it could no longer behave as the benevolent conglomerate of largely autonomous international subsidiaries of the past; it needed to become a much more dynamic manager of the overall portfolio.

To do that, the centre required accurate information about what was really happening on the ground, which in turn required a relationship based on truth rather than the bluffing of the budget. Paradoxically, to manage better, it had to give up the illusory control of the budget process and make its people face the other way: outwards to the customer, rather than inwards to the plan.

The aim, remember, is to ensure that people do what's best for the business, not for an outdated and arbitrary plan. So the group first cut its detailed planning requirement, then quietly abandoned it as a separate activity altogether - a move likened by one executive to dynamiting Saddam's statue.

'If you don't have a detailed plan, you can't report against it. All you can say is you did better or worse than last time,' he explains. 'This changes the nature of the information that goes to the board.'

It also frees up resources at all levels for more productive activity.

Instead, managers now concentrate on forecasting: initially focused on year-end, then a rolling estimate for a year ahead, updated every month.

'Business doesn't happen in yearly chunks - we need to get people thinking outside the annual time-horizon,' says another finance executive. He notes that a rolling forecast is dynamic rather than static. Over time, the plan that goes to the board falls naturally out of the rolling review, representing a best guess rather than a signed-off commitment - a very different thing.

The next step is anchoring the change with a new pay scheme - since there's no longer a fixed end-year plan target, reward has to be linked to something else. A major goal of the new scheme is to eliminate incentives for damaging games-playing. Bonuses are now awarded after the event against a range of criteria rather than at an automatic trigger, allowing the quality as well as quantity of the result to be assessed.

With planning slashed and a new pay scheme introduced, the architects of the scheme are quietly pleased. They acknowledge that there is still a huge amount of work to be done: some parts of the business have adapted more readily than others, and the implications of the forecasting system are still emerging. Yet for all the caution, the ligatures that obstinately prevented the old structure from adapting have been cut. For the first time, the bureaucratic ratchet has been forced back a notch or two. Movement and energy have been released.

'This place is full of intelligent, good people,' says a manager, 'and for the first time they're being encouraged to live in the real world of risk and uncertainty, and use their skills to make better business decisions rather than play political games. It's a revelation.'

A DESTRUCTIVE SYSTEM THAT MAKES FIDDLERS OF US ALL

What happens when managers are squeezed between the rock of an unachievable budget target and an implacable superior? They 'cheat'. They bring sales forward, or invent them and cancel them later, draw on contingencies hidden from superiors or the group, or borrow from other budgets. This kind of fiddling, says Vanguard Consulting's John Seddon, is endemic in all target regimes (of which the budget is one), and is well documented in Britain's public sector. And the result is always the same. Such systems are, strictly speaking, out of control. Since the centre doesn't know what is really going on, it has no way of acting to avert unpleasant surprises, or indeed of making systematic improvements.

The cause, insists Seddon, 'is not bad people but a bad system that forces them to bend the rules to survive'. Most of the time (as in the NHS and most traditionally run firms), the consequences are fear, inefficiency and waste. This is bad enough. But if the controls are tight enough, they can be worse. It is no coincidence, for instance, that Enron and WorldCom were notoriously tough on managers 'making the numbers'.

A WorldCom executive told the Financial Times: 'You would have a budget, and (CEO Bernie Ebbers) would mandate that you had to be 2% under budget. Nothing else was acceptable.' If managers didn't fulfil their targets, they were out. Enron had a rigorous policy of sacking its lowest decile performers every year.

In both these companies, the pressure to make the numbers was so great that managers didn't just doctor a few figures, they broke the law. Similar pressures may have been at work, although with less extreme consequences, at Shell. As the great statistician and systems thinker W Edwards Deming drily put it half a century ago: 'People with targets and jobs dependent upon meeting them will probably meet the targets - even if they have to destroy the enterprise to do it.'

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