November 5, 2013

Annual Budget – Friend or Foe?

A few days before last Christmas, I was at the mall shopping when I got a phone call from my best friend Ella, a graphic designer for a manufacturer and distributor of home furnishings.  “What are you up to?” she asked.  “Last minute Christmas shopping”, I answered. “So am I”, said Ella.  “My boss told me to hurry up and order a new drafting table.  He said we have money left in the budget and we need to spend it before the year is over.”

“Don’t you need one?” I asked.  “Not really”, she answered, “but my boss says we need to spend the money now or we won’t see it next year”.  She joked “I haven’t yet found out anything expensive enough to use up the leftover money.  Our business development manager has an even longer shopping list. She didn’t spend her money earlier this year either”.

My first thought was “sounds like Ella’s company needs to hire people with better ethics.” But Ella always praises her boss for being an exceptional manager, and their company is growing fast – so the business development manager must be doing something right, after all.  Chances are Ella and her coworker are not the only ones at their company in a hurry to spend the budget allocations before the end of the year.

Does Ella’s Company Have a “People Problem” or a “Numbers Problem”?
The answer is probably “both”.  Any company is only as good as its employees.  But good employees who get the wrong message – “here’s your budget, stick to it” – can be very easily steered in the wrong direction.  Like in Ella’s company, many managers are afraid that their department will lose their budget allocation next year if they under spend in the current year so “use it or lose it” mentality replaces good judgment.

Are Budgets a Bad Thing for Business?
Not necessarily.  But there are budget pitfalls that the company leadership should be aware of:

  • First, it’s hard to plan a year ahead.  Nobody has a crystal ball to predict what the future will be a year, a few months, or a few days from today.  Will the company lose a key customer?  Will the market crash?  Will the pending RPF double the company’s revenues?  Nobody knows for sure.  While it’s definitely important to think and plan for the future, the planning process needs to be more flexible and responsive to the changes in the internal and external environment.
  • Second, human nature should not be underestimated.  The traditional budget creates an opportunity for “gaming” the system.  Managers are much more inclined to set lower revenue targets or overstate their future spending needs so as not to be at fault if they underperform on revenue side or if expenses end up higher.  Budgets also foster a conflict of interest if the company’s incentive compensation is tied to reaching the budget goals.  Managers are incented to negotiate the lowest acceptable level of revenues or highest expenses they possibly can to maximize their bonuses.   If the company leadership doesn’t recognize the importance of these factors and what role they plan in the company’s performance, than the company is very likely to end up like Ella’s company – with good people making bad choices.

Rolling Forecasting vs. Budgeting
While budgets are probably not going to disappear from the management’s toolset, there are definitely good alternative (or at least complimentary) tools to consider.   One of them is called “rolling forecasting”.

If you are not familiar with it, you are not alone.  While this concept has been around for years, it is adopted only by a handful companies.  And here are a few reasons they are transitioning from budgets to forecasting:

  •  Traditional budgets are becoming too “stiff” to effectively navigate in the rapidly changing economy;
  • “Millennials” have a much more flexible mindset compared to older generations which helps them to be more effective in working with models that require continuous adjustments;
  • And finally, the technology has caught up with the needs of the marketplace – more and more of the modern accounting systems have advanced forecasting tools built in that feed from the data in the general ledger and generate various scenarios based on user-defined parameters and forecasting models.

So for many companies, the time to rethink if an annual budget is the best tool for them is now.

Are you a “Budget Believer?”
Can’t think of not having a budget? Then please look into your company’s spending in the last few days or weeks of the year and see if you see any spikes in revenues or expenses.  If the answer is “yes” – you probably need to shred that budget, after all, and look for other solutions.

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