Creating an Adaptive Organization
James Creelman and Jonathan Chocqueel-Mangan are co-authors of the Report: Reinventing Planning and Budgeting for the Adaptive Enterprise, Business Intelligence, 2006. This is a transcript of the initial conversation that shaped the content and key arguments of the Report.
Jonathan Chocqueel-Mangan is a UK-based Partner with Heidrick and Struggles, the world's premier provider of senior-level executive search and leadership consulting services, including talent management, board building, executive on-boarding and M&A effectiveness (www.heidrick.com). Jonathan was previously an Executive Vice President for the Balanced Scorecard Collaborative and sat on its Global Executive Committee. He worked closely with Drs. Kaplan and Norton in shaping their first two books.
James Creelman asked the questions. Jonathan Chocqueel-Mangan provided the answers.
How would you define an adaptive organization?
An adaptive organization is one where authority, accountability and responsibility are at the appropriate level in the organization – the level that has the best impact for customers and the other associated stakeholders.
An adaptive organization is devolved by definition. It is flexible and quickly reacts to customer needs. What’s more, an adaptive organization can react to learning at both operational and strategic levels and pass insights up and down the command and control structure. And that’s an important point. In an adaptive organization there’s still a command and control structure. It’s not a free for all. But there is much clearer accountability.
The other point about an adaptive organization is that it strikes the balance between flexibility and alignment. In a typical conventional and hierarchical organization alignment is seen as a benefit because it’s fixed – it’s management by algorithm if you like: budgets are cascaded down and will always mathematically add up, as will targets.
So there’s this dynamic tension between alignments, in that everybody’s activities are directly supporting the organization’s stated goals and the flexibility that allows looseness in that alignment. If there’s too much flexibility it’s chaos. Adaptability is a form of flexibility that balances that tension. It’s constantly realigning itself, but the alignment isn’t fixed.
Please summarize what you perceive as the main strengths of the conventional budgeting process?
To be honest I can’t think of any. There are apparent strengths, which are in fact illusionary. The most common one that people quote is the illusion of control. Because I’ve given you a target and a budget I know you won’t spend more than that. This isn’t true because people do and become very creative at hiding spending. It also has the illusion of predictability, which also isn’t true. Companies rarely get anywhere near their budgeted figures, which isn’t surprising as budgets are typically put together up to 18 months before the end of the financial year the budget relates to.
The other quoted strength of the conventional budget is that the allocation of resources is more transparent. Again that is an illusion because budgets are allocated on a strength of argument basis rather than the value of that investment. So you may argue for a very large budget but your contribution to economic profit may be very small. Also the budget becomes an entitlement to spend. If I give you £100 you’ve got no incentive to spend £90. You may as well spend £100; especially as if you do spend £90 it will influence your budget for the next year.
Please summarize what you perceive as the main weaknesses of the conventional budgeting process?
There are many other weaknesses of the budget. Not least it encourages managers to deliver to the budget rather than delivering value. Managers should be encouraged to be creative and use their judgment and experience to create value, rather than just hit a budget. Delivering value is relative, delivering the budget is absolute.
The other obvious weakness is the gaming that goes on. People argue about budgets and no-one’s honest in the process. My first experience of the budget was putting a budget forward for a small design team. So I costed it all up and thought about what we could do better. I put the number to the chief engineer. He said this budget couldn’t be submitted because it probably accurately reflected what I needed. Somewhat surprised, I said that I thought that was the point of the exercise. He said ‘no, the production manager always thinks we ask for twice what we need. So whatever number we put in, he’ll halve. So take the budget and double it.’ I said ‘so if I double it and he halves it - what’s the point of that?’ And the chief engineer said ‘that’s just the way it works.’
The other weakness is the budget takes a vast amount of time and is of very questionable value. You can be seen as a success by hitting your budget even if you’ve come bottom of your sector and are losing market share.
In short, the budget allows you to spend a lot of time doing the wrong things.
Typically, the budgeting process is deployed as an annual performance contract. How relevant do you consider annual performance contracts to be in the knowledge-era?
I’m not sure the knowledge-era makes any difference. The budget doesn’t make any sense irrespective of the era.
The annual cycle is completely arbitrary. You have to have a cycle that enables you to pay taxes to the government, although I’m not sure why that couldn’t be done quarterly. And throughout our lives we respond to a yearly calendar.
But running organizations to an annual cycle leads to performance comparisons that may not be sensible. For instance if last year we sold 100 units and this year we sold 90, this is apparently bad - but it may not be due to extenuating circumstances. In fact, we may have done better than our competitors this year at 90 and worse last year at 100. I think the cycle should be much more event-driven. It should be rolling and continuous; relative as opposed to absolute.
For example if I work for a pharmaceutical company and I discover a drug that may potentially cure AIDS, to be told that you can’t run trials because there’s no money in the budget is clearly nonsense. This is clearly an event that would trigger a revaluation of the budget.
Also, what struck me as amazing around 9/11 was that people used that as an excuse for not hitting their budgets. But this was an event that hit everyone, so the questions should have been did they do relatively better or worse than their competitors? Many companies stuck to their old budgets. Airlines being a stunning example. They stuck with their budgets because of the annual cycle, which didn’t make any sense.
As another example of the stupidity of the annual cycle, I had an experience recently with a bank that said it was very risk averse so they didn’t change their budget in the middle of the year. I asked whether they thought their budget was achievable and they said that they didn’t think it was. I don’t think that is risk averse. I think it’s risky to have a budget that you know is unachievable and you won’t change it. In fact it’s irresponsible.
How satisfied are finance professionals with the conventional budgeting approach?
It is the view of many in finance that you can’t change the budget. The budget is the budget. But the budget isn’t real life. The budget should be a response to real life.
Also telling many in finance to abandon the budget is a waste of time as it forces them to question the purpose of their job. For many in finance it gives an illusion that finance is in control of the business. But finance is a long way from the business, which most people in the line will tell you. I don’t think finance has ever been in control.
However, views do vary. A lot of finance professionals know that the budget isn’t perfect. But they can’t think of how to replace it. And there are a lot of enlightened professionals who are coming through now who believe that that isn’t their job anyway, believing that budgets can be done as an algorithm and that organizations don’t need a highly qualified finance professional to do it.
How satisfied are line managers with the conventional budgeting approach?
Most line managers are unhappy with the budget because it consumes a vast amount of their time on pointless activities. It doesn’t tell them how they are doing. It tends to be lag information. It tells them what they have spent but it doesn’t tell them how they could spend it better or what their expenses will be in the future.
Line managers see it as finance involving themselves in the real world, but the budget actually keeps finance and the line apart. Most line managers would argue that the cost of the budgeting process is a waste, that the cost of finance for doing the budget, which typically sits on their P&L, is a waste.
How effective is the budgeting process for goal setting?
It almost goes back to why we set budgets in the first place. There is a need for setting goals, so we have a rough idea of where we are going and how much inputs we need to achieve certain outputs.
We need goals and the budget can do that. What it does though is set goals via a contract, rather than a means of understanding what it is we should be doing. It sets this over a fixed term, a year.
Also, if I ask you for a forecast, a target and a budget, what’s the chance of you giving me the same number?
Too often if you have a budget that’s 100 and I ask you what your forecast is you’re going to want to say 100. If I then ask you what is your goal, you’re going to look at me blankly because you’re goal is 100.
Yet that isn’t what I want. You may have a budget in sense of a minimum sales number for example, and a forecast, what you actually think you will achieve and a target, which with a fair wind behind you, may be reached. So there’s three different numbers. I’ve seen people reprimanded for not forecasting to hit budget. A forecast is a forecast; you can’t tell me what my forecast should be as this takes away my responsibilities for being a manager. If you want my forecast to be the same as my budget then I’ll make my forecast the budget every time. And then when I miss my budget you’ll be surprised. But I won’t be because I never thought I could hit it.
So why not have a goal of hitting 120 and a forecast of 105. There’s a lot more information there. If my forecast is to come under budget then I have to rethink how I reallocate my capital in the short term accordingly. Clearly you then work with the individual to find out why it’s under budget. Is it an execution failure or is it a market failure? We can then start to have useful and grown-up conversations.
Also we have to be clear as to the implication of not meeting a goal. If I set a target for you and if you hit it you’ll get a big bonus and if you don’t then you won’t, then that completely determines my behavior. If I set a target that is aspirational and if you miss it you’ll still get a bonus then you’ll behave completely differently. I think it can be useful to set goals that are lofty and idealistic with a low chance of hitting them. If I have these goals as my targets in the budget then I won’t do it, I’ll give you a lower goal and ultimately I will miss the opportunity to create value. A goal should be something we aspire to.
How effective is the budgeting process for resource allocation? And what would you suggest as better alternatives?
Because the budget tries to do so many things it never quite manages any of them. Resource allocation is potentially one of its best uses, as long as the resource allocation doesn’t become a fixed contract and therefore unchangeable in the budget cycle. We need to know the minimum amount of capital that we are going to need and what other resources we require, and the best place to put those resources to create value.
Also, in an adaptive organization you become free to say that your original resource allocations were wrong and so reallocate. Often the budget prevents this happening. It doesn’t allow for adaptiveness. You should be reacting to the market continuously and allocating and reallocating resources continuously based on the best and latest information.
A better alternative, in every instance, is the idea of a relative, continuous contract that allows me, wherever I am in the organization, to reflect what I’ve learnt, either from executing the strategy – such as assumptions I made at the beginning are wrong – or because the market’s changed, and reallocate resources accordingly.
How effective is the budgeting process for performance evaluation and reward? And what (if at all) would you suggest as better alternatives?
This is the killer. The budget and performance evaluation tend to be linked directly. Compensation tends to work on an annual cycle and I can’t really see the case for that. You can take a snapshot whenever you like, which is why I’m seeing lots of organizations giving quarterly bonuses, because it means you can have a horrible quarter and recover in the next.
Also you don’t end up with the situation where you know the bonus is in the bag, and you know there’s little incentive to exceed your budget because it doesn’t increase your bonus, so what you do is delay performance and push into next year so you can start accumulating next year’s bonus.
What we tend to see in organizations is a cycle where performance is flat at the start of the year because everyone’s so relieved last year is over, then there’s a peak of activity in the middle six months, and in the next three people know where they are in terms of the budget. If it’s in the bag then there’s no point doing more and if I’m going to miss the budget and my bonus then I may as well miss it by a long way and build it for next year.
You need to have a serious think about the linear and fixed link between performance and reward. One company I know had been in a market that’s had a terrible year. This company has outperformed the market but hasn’t hit budget. So nobody’s got a bonus and they also got poor ratings because the ratings decided the bonus. Relatively they’ve performed very well so the impact on morale of getting a low rating is terrible. Simply the link between budgets and bonuses typically demotivate people.
However, revaluating compensation is not as difficult as you think if you got a simple reward strategy. It needs to be relative, it needs to be more than just financial and it has to be aligned to creating long-term value. But what this requires is a huge amount of confidence in your strategy, which is not always evident in organizations.
On the plus side I’m now seeing some organizations not budgeting for bonuses. Bonuses all come out of over and above a minimum standard. Handelsbanken is a brilliant example, everything over a minimum standard is shared 50-50 between the staff and shareholders. And it’s uncapped.
One enlightened leader I know said that he’d honor last year’s bonus, as he wasn’t there when it was agreed. He said “right, here’s what you said you would do in the contract. You’ve hit your financials so here’s your bonus. However if you put in the same performance this year as you did last year you’ll get half the bonus. Because client satisfaction is low, your staff hates you and you are not developing capabilities for the longer-term”.
So don’t just hit financials and don’t leave it to the third quarter either. It’s still hitting plan, but the plan is not just the short-term, it is linking the longer-term and short-term together. And it takes a huge amount of courage to do that.
Most leaders are fully cognizant of the shortcomings of the traditional budget, but hesitate to move to a new model. Why do you believe this is the case?
The reason most leaders do not change the budget is because they don’t think the market will like it. They think the market wants companies to tell them exactly what they are going to do and then to do it. However, rather than the first planning question being ‘what does the market want us to do’, it should be ‘what do we think we could do and let the market assess’. It’s too often what does the market want us to say, and then let’s say it and then figure out how we are going to do it and use the budget in a very blunt way to hit that number.
I don’t think that companies should not be going to the city with budgets. It reinforces the idea of fixed contracts. If you go to the market and say that we will do £100 million of business that becomes your budget, you have to go back and force your business to meet it. You shouldn’t do that. You should figure out what makes your business tick and explain that and how you’re going to outperform the competition. It’s for the market to then decide what that means in terms of sales, revenue, market share etc.
Jack Welch spent a lot of time telling the market how his businesses worked. That gave the market confidence. Indeed the share price is actually driven by perception rather than numbers. If you spent a lot of time talking to the market about the management team, the execution capabilities, etc., then that’s what they want to hear. Often companies do not spend time communicating to the market about what makes their business works because often they haven’t spent enough time themselves on doing it. So it becomes a double-sided tragedy. I don’t want to go to the market because they will think I don’t have any control. And actually I believe them. I don’t have control because I really don’t know how my business works.
What are the favored alternative frameworks being used to replace the conventional budget?
There’s no magic formula. It’s the underlying principles. You can’t say ‘If I use the scorecard I will be successful’. It’s about using a tool correctly. It’s about having a clear vision of what an adaptive organization is going to be and how it is devolved to the frontline and how we allow flexibility in resource allocation on an event-driven basis. If such principles are in place then I think you can use the scorecard or other tools successfully.
Adaptive organizations tend to have clear agreements on key performance indicators, which are relative and continuous. As a banking example, I may say to a branch that the cost/income ratio must always be 43% or lower, return on equity must always be 16% or more and your income growth must always be at least 3%. And they are based on the competition. And I can compare across branches, so doing comparative benchmarks internally and, if possible, externally.
When there’s lots of budget lines, the budget is being used not only to control what you do, but how you do it. In a devolved organization I want you to be reactive, and I’m not going to predict that. I will predict some of the outcomes such as cost/income ratios etc. Inside the business unit there’s a lot of freedom. There’s very little mandated across the organization.
Finally, what do you believe a truly adaptive organization will look like three years from now?
They will be much more enjoyable to work in. They will be much more motivating because people are empowered. And they are likely to be more efficient. Adaptive organizations will be better for customers, better for staff and better for shareholders.
Also an adaptive organization will be full of adults. No parents, no children, just adults.
For information on the report: Reinventing Planning and Budgeting for the Adaptive Enterprise: Tools and techniques for reengineering the budgeting process by James Creelman and Jonathan Chocqueel-Mangan, visit www.business-intelligence.co.uk