UK: BUDGET IN THE BALANCE.

UK: BUDGET IN THE BALANCE. - Should it be based on objective forecasts, or set tough targets?

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Last Updated: 31 Aug 2010

Should it be based on objective forecasts, or set tough targets?

The budgeting process demands that assumptions be made about the future. But how should these be presented in the budget? Should figures for future sales and profits be based on forecasts, which are taken to be reliable and 'objective'? Or should the budget present a tough target for managers to aim at, even if the forecasts suggest they might not get there?

Adrian Martin, managing partner of accountants BDO Stoy Hayward, argues that, whatever the enterprise, its budget must be based on realistic assumptions.

'Don't kid yourself,' he warns. 'An over-pessimistic forecast is just as bad as an over-optimistic one. Do a budget for the year and stick to it, but record the outcome against the original budget, tracking progress.

Don't confuse a budget with a target.' Considerations such as cash flow will depend on the realism of a forecast.

It's possible to cause serious trouble by committing a business to more sales than resources allow - because the budget is too pessimistic.

Professor Andrew Likierman of London Business School teaches much the same lesson. Likierman is currently on loan to H M Treasury as chief accountancy adviser. Government too has to budget for its spending, he points out.

'Funds are voted for specific purposes, so they must be based on a realistic forecast of spending needs. By definition, you should not build in an over-cautious contingency as that would deprive other areas of resources, and if you set targets too tightly you risk running out of resources.'

Within a commercial operation, however, isn't there a danger that a budget negotiated with local management might dilute corporate objectives? Len Collinson of management consultants Collinson Grant believes there is.

'The question is whether the budget-setting is top-down or bottom-up.

If the latter, it is likely to be cautious and relatively easily achieved.

If it is top-down, it is more likely to be based on what the company wants in order to meet its objectives.' Collinson considers that budgets should stretch managements, but warns that the targets should not be so tough as to lack credibility.

David Allen, visiting professor at Loughborough University Business School and former finance director at Cadbury-Schweppes, thinks that the 'tough target' approach is used by fewer businesses these days. 'If you trust your people to do what's right, you will give them more latitude,' he says. Yet it's clear that a company's approach has everything to do with its corporate culture. Budgeting, says Professor Roger Hussey of Bristol Business School, is 'a psychological and political process more than an accounting process'.

There are two kinds of individual in Hussey's view: the 'immediate gratifier' like the sales executive who sets a high target to impress the boss - hoping it will soon be forgotten - and the 'deferred gratifier' who will be pessimistic now in the hope of winning praise later. A bottom-up process is a form of negotiation, Hussey says. It works 'as long as you are aware of the psychological processes'. Most businesses understand this intuitively.

At brewing and leisure group Whitbread, according to finance director Alan Perelman, 'We try to make it an open process - it removes the element of game-playing which is not productive'.

As the pace of change quickens, companies are revising their forecasts more frequently. That in itself makes it harder to impose a top-down annual budget. Whether the trend leads to sound planning or just 'game-playing' with local management will depend, like so much else, on the strength of the corporate culture.

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