In this series of interviews recognized experts describe how to create an adaptive enterprise.
The expert in the chair this time is Dr. Fritz Roemer, Senior Business Advisor, The Hackett Group.
How would you define an adaptive organization?
An adaptive organization is very much a proactive organization. This means that the organization is proactively thinking about the future. It is focusing on what is really important and not just doing forward accounting based on historical data and many line items. Forward accounting is the wrong approach. Organizations should “continuously” think about the future and consider expected developments in the market and competition and from this process derive the budget.
As for what’s happening out there to move companies towards being more adaptive let’s look at trends. And I will start with what is not a trend.
A lot of people are talking about beyond budgeting but this is not a trend. Basically beyond budgeting is a very good idea because it is pointing out the faults of the traditional budgeting approach. The problem is that they recommend abandoning the budget, which is rarely happening as research by The Hackett Group has shown over a number of years. This is because if you want to change the budgeting process, whether you redesign it, reinvent it or abandon it, it’s not only a methodology piece it’s a cultural piece. It’s very difficult to change the process. Hackett defines 25 finance processes and the process with the biggest cost saving potential is the budgeting process, but it’s also the most difficult to change. If you want to change this process, it’s not just about doing some work in finance. You have to convince the whole executive board to change this process.
I don’t know many companies that have abandoned the budget. Handelsbanken everyone knows about. There are about 10 examples in the whole of Europe, out of how many companies?
Please summarize what you perceive as the main strengths of the conventional budgeting process?
It provides a stick in the ground. Borealis was famed for abandoning the budget but it was reintroduced as it has been within other companies. At Borealis they believed they needed a stick in the ground – any stick in the ground.
Please summarize what you perceive as the main weaknesses of the conventional budgeting process?
Conventionally there are a lot of iterations in this process. It is a bottom-up approach. It takes a lot of time, it is a waste of resources and it is non value-added. A good starting point for a redesign of the budgeting process is to put away this bottom-up approach and introduce a top-down target setting approach. This is derived from the strategy and comparison with peer groups, taking into account the competitiveness of your own organization.
Another weakness is the complexity. As a comparator there are companies that budget only around six items at the corporate level, yet a lot of the companies that follow a traditional approach end up with budgets with 100s or even 1000s of line items. This is a typical indication of a highly complex budgeting operation. If you take two influences together – the bottom-up approach with say five iterations and the complexity in the line items that takes 5-6 months for the process, you’re talking about a lot of wasted resource and effort.
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 do think you need an annual stick in the ground, in line with the early milestones of the strategic development as an outcome of the strategic plan. The three year to five year planning process should be important and ideally the key targets for the budget should be derived from this plan, which itself will be based on the strategy.
During the budget year you also have forecasts, quarterly or whatever.
The ideal picture is having a lean budgeting process, taking about two months and then a (rolling) forecasting process. And a best practice forecasting process is e.g., a middle-up process, so it doesn’t involve the whole organization, as the cycle time for a new forecast needs to be very short (1 week). The budgeting process involves the whole organization.
I think the advantage of rolling forecasts is that you get more frequent data (matching with the business cycle) on the future and you get it beyond the fiscal year.
How satisfied are finance professionals with the conventional budgeting approach?
We find that finance people in operations are suffering the most, not the corporate people. The corporate guys are just setting guidelines and sending out letters at the start of the process. Then they wait and get the data, which they consolidate and report. It is the people in the legal entities, countries and plants that are working out this data. They very often have to make a lot of iterations, and maybe liaise with different business units and maybe through different systems.
How effective is the budgeting process for goal setting? And what (if at all) would you suggest as better alternatives?
If you have a traditional approach it is not effective. It is just gaming. If a manager knows they can deliver 100 next year he’ll probably start the negotiation at 85, hoping that by the end of the iterations his required performance will be 95.
It is effective when it is a top-down target setting. The executive board decides on the key targets for the businesses/regions and this is devolved down through the organization.
Of course the challenge is to set ambitious but realistic goals. The board members must convince the organization that the targets are achievable. This should be based on external benchmarks and knowing what your peer group (for each business) is doing. So talk to external analysts who may know comparative targets. This type of information is available and one reason why the benchmarking business is doing well is that there are clear performance data for end-to-end processes. You can derive targets from that.
How effective is the budgeting process for resource allocation? And what (if at all) would you suggest as better alternatives?
When we talk about investment planning, there should be some independence from the budgeting process. You should review the capex plan on a quarterly basis. If you have a great idea to invest in a new technology you should not have to wait for the next budgeting process.
How effective is the budgeting process for performance evaluation and reward? And what (if at all) would you suggest as better alternatives?
When it’s a traditional budget it’s not effective, due to gaming. But it is very effective when it’s a top-down approach as it’s not only an absolute target it’s a relative target, because the targets coming down from top management should be relative. At the end of the year we can measure and say “we expected our peer group to grow at 10% but actually it was 9%. So although 9%, which we achieve, is less than the 10% we aimed for, it still beats the competition, so the reward is based on beating the competition and not beating the budget.”
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?
Basically it is extremely difficult to change the process. We have a best practices database and we explain that long cycle time and high cost is by not using best practices. We may be able to show that a large company can save, say $5 million. They then have to decide whether it’s worth changing the process, as you need a lot of discussions internally and willpower to do it. You need to involve the finance people and the line management. It’s a process that may take six months to change (without technology improvement) and is a lot of work. And if you do not get the sponsorship of the CEO and CFO there’s no way you can change the process.
The corporate guys are aware that the process is criticized in the company but find it hard to change it.
For those organizations planning to move away from a conventional budgeting approach, are they typically reengineering or simplifying the budget, but keeping its basic structure in place or are they moving towards something much more radical, such as working without budgets?
We are seeing much more interest in de-emphasizing the budget. You cannot 100% predict the future. There are people who believe that by the 5th or 6th iteration they can improve the outcome of the budget. That’s nonsense, so you have to de-emphasize the budget. So the trend is to redesign, reengineer, and is focused mainly on the reduction of the cycle time and reduction of line items.
A de-emphasized budget is top-down, and is a stick-in-the-ground which is supported by rolling forecasts.
Unfortunately I am not seeing many companies use the balanced scorecard well alongside the budget. An exception is Novo Nordisk in Denmark and they use the scorecard comprehensively.
I am a fan of the scorecard but it’s not being effectively used alongside the budget.