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The Perils of the Budget-Focused Organisation

The Perils of the Budget-Focused Organisation

Jonathan Chocqueel-Mangan
Director, Tyler-Mangan Ltd.

Outline

This article explains how ideas emerging out of the Beyond Budgeting Round Table are proving powerful alternatives to the conventional budgeting approach. Also described are how the Beyond Budgeting principles work well when deployed alongside the Balanced Scorecard. This is illustrated through a case study on the financial services provider Nordea.

The ideas in this article are explored in detail in the report Reinventing the Budgeting Process: How to create an adaptive organization by Jonathan Chocqueel-Mangan and James Creelman published by Business Intelligence, London, Summer 2006.

Introduction

One of the most useful ways to define a Strategy-Focused Organisation is to describe it as the opposite of a Budget-Focused Organisation. Yet the integration between the Balanced Scorecard and the budgeting process has been one of the least developed areas of scorecard implementations.

Since 1997 the Beyond Budgeting Round Table (1) has brought clarity to the debate about the value and validity of the budget and in doing so has shaped a number of practical insights for those involved in implementing and fully exploiting the Balanced Scorecard. As a short descriptor, Beyond Budgeting is not about creating a better budget but is rather about removing the budget altogether and everything that goes with it and putting in its place a more adaptive financial and strategic management process.

The Balanced Scorecard

Many organisations have introduced the Balanced Scorecard as an enhancement to the budgeting and planning processes. Such companies recognise that the Balanced Scorecard offers a more complete picture of performance, going beyond the short term financial limitations of the budget.

In their first book The Balanced Scorecard: Translating strategy into action (2) scorecard co-creators Professor Robert Kaplan and Dr. David Norton recognised that the Balanced Scorecard had to sit at the centre of a ‘Balanced Management System’ and that underpinning that system was the requirement to integrate the Balanced Scorecard with the budgeting and planning processes of the organisation. Moreover, such integration is a sub-component of principle 4, ‘make strategy a continual process’ of Kaplan and Norton’s 5 principles of a Strategy-Focused Organization (3). However, it is only in the last few years that we have begun to truly understand the required conditions for such integration to be successful - which we explain in the report Reinventing the Budgeting Process: How to create an adaptive organization (4) Robert Kaplan recognized the integration problems himself when he said that: “One aspect of the Strategy-Focused Organization that has lagged is the integration with the budgeting system. It’s less developed than the objective setting or the links to incentive systems, human resource systems, or communications systems. I think, however, if we don’t establish the link with budgeting, then the scorecard initiatives may wither” (5).

The limitations of the Budget

There are many who would claim that establishing this link calls for a complete re-evaluation of the value of the conventional budgeting system. More radically, through the Beyond Budgeting Round Table, co-founders Jeremy Hope and Robin Fraser have been looking to answer a deceptively simple question: What would happen if an organisation abandoned the budget altogether? This search for the answer culminated in their seminal work: Beyond Budgeting: How managers can break free from the annual performance contract (6).
What they found was that organizations bold enough to take this step and who create adaptive organizations tend to outperform their sector. For example Svenska Handelsbanken has consistently been Europe’s most profitable bank, despite not having a budget since 1972.

Beyond Budgeting

In Beyond Budgeting, Hope and Fraser have addressed the budgeting issue from two perspectives. Firstly, they have addressed the problems concerned with budgeting as an annual management process that traps firms into short-term actions and dysfunctional behaviour year-on-year.  Secondly, they have sought to resolve the problems concerned with budgeting as a barrier to decentralization and empowerment as it reinforces a culture of contract, compliance, and control. Note that both of these problems hold back the successful implementation of many Balanced Scorecards.

Crucially, Beyond Budgeting is not just a financial solution it is a management intervention combining a leadership vision of empowerment and devolved responsibility with a finance vision for better contending with today’s powerful external change factors. Table 1 shows six external factors of change identified by the Beyond Budgeting Round Table (column 1), with responsive leadership and finance visions shown in columns 2 and 3 respectively.

Table 1: Change Factors and Required Responses

 

 Which External Factors are Driving Our Case for Change? What Should Be Our Response?
The leadership vision 
Which Processes are Needed to Implement Our Leadership Vision?
The finance (CFO) vision 
Shareholders are more demanding and are only loyal to those organizations that are consistently at (or near) the top in their industry sectors. To create a performance climate based on competitive success, not on the fear of failing to meet a performance commitment. The goal setting process should be based on agreeing external benchmarks, not on negotiating fixed targets
Talented people are increasingly scarce. They want freedom, challenge and responsibility. And they care about values and the environment. To motivate people by offering them challenge, responsibility, clear values and shared rewards, rather than relying on mission statements, plans, and financial incentives The motivation and rewards process should be based on recognizing and rewarding team-based competitive success, not on whether people have met negotiated targets
The pace of innovation is increasing and product and strategy life cycles are shrinking. To compete, firms must produce a constant stream of new solutions and strategies To devolve performance responsibility to operating managers and give them the freedom to decide, not to make them dependent on superiors for approving their proposed actions The strategy and action planning process should be devolved to operating managers and made continuous, not managed centrally as an annual event
Prices are falling and quality is rising. Firms must be operationally excellent to compete. To empower operational managers by giving them the capability to act, by removing resource constraints and releasing them from bureaucratic ‘red tape’. The resource utilization process should be based on local access to resources (within agree parameters), not on the basis of allocating them through annual budgets
Customers are in charge and will switch loyalties if not totally satisfied. Firms must keep close to customers and respond rapidly to their changing needs. To organize around customer-oriented teams that are accountable for profitable customer outcomes, not around functions and departments that are accountable for meeting budgets The coordination process should be based on making cross-company interactions through “market-like” forces, not through predetermined detailed actions set down in central plans
Demands for higher standards of ethical and social responsibility. Investors and regulators are demanding more open and honest performance reporting To support transparent and open information systems that provide “one truth” throughout the organization, not to restrict the flow of information to those that “need to know”. The measurement and control process should provide fast, open, and distributed information for multi-level control, not budget-based variances for central control

 

Beyond Budgeting and the Balanced Scorecard

This article argues that the Beyond Budgeting philosophy can bring considerable benefits to the implementation of Balanced Scorecards. It has been clear for some time that the Balanced Scorecard is far more than a management tool – if it to be implemented successfully it must be seen as a way of working, and as such treated as a change programme rather than a metrics project. Best practice Balanced Scorecard implementations support all of the Beyond Budgeting principles.

For example a leadership vision is also present in best practice Balanced Scorecard implementations. In Table 2 we show the leadership vision of ‘Beyond Budgeting’ and delineate best practice approaches, which takes it into the realm of the Balanced Scorecard.

Table 2: The Leadership Vision and Best Practice Approaches

 

 

The Leadership Vision Best Practice Approach 
To create a performance climate based on competitive success, not on the fear of failing to meet a performance commitment. By publishing performance data across the company, a competitive climate is introduced. With rewards linked to overall performance, such competition is seen as ‘healthy’.
To motivate people by offering them challenge, responsibility, clear values and shared rewards, rather than relying on mission statements, plans, and financial incentives With reward linked not only to financial performance but to the other three perspectives as well, managers are encouraged to set ‘baseline bonuses’ where staff can be under or over the baseline. Risk taking (within specified limits) is encouraged and rewarded.
To devolve performance responsibility to operating managers and give them the freedom to decide, not to make them dependent on superiors for approving their proposed actions Responsibility rests with operating managers who are given a few key parameters within which they must operate (e.g. ROCE, Cost to income ratio). Cascaded Balanced Scorecards are developed at the operating level as a tool to help operating managers not as a reporting tool for the centre. Planning and reporting is informal and focused on helping the operating manager improve.
To empower operational managers by giving them the capability to act, by removing resource constraints and releasing them from bureaucratic ‘red tape’. With absolute responsibility for performance operating managers are able to ‘purchase resources’ from the most appropriate source. Support functions develop Balanced Scorecards to focus on the needs of their customers, and ensure that the ‘internal market’ is effective.
To organize around customer-oriented teams that are accountable for profitable customer outcomes, not around functions and departments that are accountable for meeting budgets Balanced Scorecard design often results in changes to the organizational structure. Themes emerge from the ‘Strategy Map’, which drive a focus not only on customers in general but on specific segments.
To support transparent and open information systems that provide “one truth” throughout the organization, not to restrict the flow of information to those that “need to know”. Is implemented to enable performance analysis at the point of need. Reports are shared across business units and staff are able to provide input on performance and opportunities for improvement.

 

Similarly, the finance vision is typically present in best practice scorecard implementations, as shown in Table 3.

Table 3: The Finance Vision and Best Practice Approaches (to be added)

 

The finance (CFO) vision Best Practice Approach 
The goal setting process should be based on agreeing external benchmarks, not on negotiating fixed targets The setting, and reviewing, of targets is seen as a means to debate within the hierarchy of the business, opportunities for improvement and so can be changed as the year progresses. Typically there are only 20-25 measures per organisation, only 30% of which may be financial.
The motivation and rewards process should be based on recognizing and rewarding team-based competitive success, not on whether people have met negotiated targets Rewards are based on performance in every perspective. Up to 70% of bonus could be paid even if financial results fall below target. In addition, rewards are dependent upon on ‘team you’re in, and team you lead’.
The strategy and action planning process should be devolved to operating managers and made continuous, not managed centrally as an annual event Dialogue between each level is based on the Balanced Scorecard, where the focus is on content and the opportunities to improve. Ownership of objectives, measures and targets rests at the operating level.
The resource utilization process should be based on local access to resources, not on the basis of allocating them through annual budgets (within agree parameters) Balanced Scorecards drive rolling forecasts, and debate focuses on what the effect on output would be if the input were altered. Forecasts can be revised upwards if a case for adequate ‘return’ can be provided. Operating managers have the freedom to change resource allocation during the year, as long as the ROI (return on investment) or ROCE (return on capital employed) or other agreed parameters are maintained.
The coordination process should be based on making cross-company interactions through “market-like” forces, not through predetermined detailed actions set down in central plans Co-ordination is achieved through regular and informal communication between centre and operating units. Formal mechanisms focus on the whole picture and enable the CEO to challenge plans and actions within a supportive, yet focused, environment
The measurement and control process should provide fast, open, and distributed information for multi-level control, not budget-based variances for central control Balanced Scorecard performance is shared across the entire organisation. A description of performance may include subjective analysis.

 


Case Example: Nordea

Stockholm, Sweden, Nordea, a leading financial services group in the Nordic and Baltic Sea region with about €284.2 billion in total assets, is an exemplar scorecard user (it has been inducted into BSCol’s prestigious Hall of Fame) and is a budget-less organization. Nordea’s performance management system essentially comprises the Balanced Scorecard, rolling financial forecasts and a quarterly strategic review process. Nordea is a major case study in the report: Reinventing the Budgeting Process: How to create the adaptive organization (7).

Balanced Scorecard

The Balanced Scorecard is Nordea’s core tool to drive strategy into business targets and actions.

the perils of the budget-focused organisation-figure 1 


As demonstrated in Figure 1, Nordea’s Strategy Map and Balanced Scorecard comprise the four perspectives of financial, customer, internal process and learning. These perspectives set out to deliver to the ultimate objective of ‘sustainable growth in economic profit’ through the three themes of:

• Ensure growth of income
• Ensure operational excellence, strict cost management and reduced complexity
• Ensure capital efficiency and high credit portfolio quality
 
Within the Balanced Scorecard system each focus area (as Nordea calls strategic objectives) is supported by a focus area description, key performance indicator (KPI), target and strategic initiative.

So, as an example, the focus area: ‘reduce complexity’ has the description: ‘We need to simplify, unify and consolidate internal processes in all service and support units in order to reduce complexity and become One Bank.’ The KPI is ‘percentage of transformation and structural cost initiatives on track’. A percentage target is supported by a strategic initiative to ‘identify major processes for best practice implementation’.

The Balanced Scorecard is the only process for annual target setting within Nordea. Targets are top-down, non-negotiable and set during an annual strategic review and scorecard update.

Sven Edvinsson, Nordea’s senior vice president, head of group planning explains that the Balanced Scorecard is a logical process for target setting. “It is based on a thorough assessment of what is possible in the markets we serve, and is much more scientific than just picking numbers out of your head based on last year’s figures,” he says.

The targets are also aligned to a three-year planning horizon, which forms a better linkage between longer-term goals with shorter-term strategic objectives.

Nordea’s confidence in the Balanced Scorecard is demonstrated through the fact that it has about 1700 scorecards organization-wide, with about 1200 almost identical scorecards within the essentially homogenous retail banking branches.

Rolling Financial Forecasts

Edvinsson believes that to get the best out of the Balanced Scorecard process requires the adoption of a rolling financial forecast (RFF). The RFF, he says, serves as a powerful mechanism to regularly review how Balanced Scorecard initiatives and objectives are impacting financial performance.

Nordea works to a five quarter RFF. The forecast is updated each quarter and is based on the latest possible information from the business. This information includes performance to the Balanced Scorecard, the impact of corrective actions taken in the previous quarters and managers’ assessment of the market and trading conditions. RFFs are created at division, business area and group levels.

Crucially, the RFF is remarkably simple. It is essentially an income statement including specifications tailored to business area specific characteristics. The RFF typically comprises less than 10 line items that cover the critical drivers of revenues, costs and volumes. The forecast also includes KPIs that are aligned to the KPIs within the financial perspective of the Balanced Scorecard.

Quarterly Strategy Reviews

Pulling the scorecard and the REFF together as a dynamic process is facilitated through the quarterly strategy review meeting. Within this forum business area leaders make presentations to the CEO and CFO that begin with the Balanced Scorecard quarterly strategy report.

The top page of the report is an executive summary which shows the business area’s Strategy Map with a commentary on performance based on traffic lights (performance is assessed base on a traffic light system of green (on or ahead of target), amber (slightly below target) and red (below target).

The report also includes an overview of the progress of strategic initiatives and an assessment of market, competitive and internal challenges. Then presented is the updated rolling forecast, which is based on the data and commentary presented in the strategy review.

Says Edvinsson:

“Through the quarterly meeting we are managing strategy as a continual process and not just a one-off annual event.”

Conclusion

The Beyond Budgeting idea has emerged at a time when businesses and organisations are fundamentally re-evaluating their approach to planning and managing performance. Many of us have already identified the Balanced Scorecard as a potential route to more sustained performance improvement. Beyond Budgeting adds to our understanding and enables us to develop a more adaptive performance management model, as organizations such as Nordea and others are demonstrating.

References

  1. See www.bbrt.org
  2. Robert S. Kaplan and David P. Norton: The Balanced Scorecard – Translating Strategy into Action, Harvard Business School Press, 1996.
  3. Robert S. Kaplan and David P. Norton: The Strategy-Focused Organization: How balanced scorecard companies thrive in the new business environment, Harvard Business School Press, 2000.
  4. Jonathan Chocqueel-Mangan and James Creelman: Reinventing the Budgeting Process: How to create an adaptive organization, published by Business Intelligence, London, Summer, 2006.
  5. Lori Calabro, On Balance - an interview with Robert Kaplan and David Norton in CFO Magazine, February 2001
  6. Jeremy Hope and Robin Frazer, Beyond Budgeting: How managers can break free from the annual performance contract, Harvard Business School Press, 2003
  7. As 4

Jonathan Chocqueel-Mangan is Director and Founder of Tyler-Mangan Ltd., a consulting firm that specialises in Business Performance Management, Strategic Planning, and Change Management. Previously Jonathan was Vice President, Europe, Balanced Scorecard Collaborative (BSCol), and was a member of BSCol's Global Executive Committee.

Jonathan may be contacted via Email on This e-mail address is being protected from spam bots, you need JavaScript enabled to view it or see http://www.tylermangan.com