In this series of interviews recognized experts describe how to create an adaptive enterprise.
The expert in the chair this time is Jeremy Hope, Research Director, Beyond Budgeting Round Table.
How would you define an adaptive organization?
A way I would define it is that a truly adaptive organization is pulled by the customer rather than pushed by the plan.
Particularly an adaptive organization constantly responds to its environment, to emerging competitive threats and opportunities. For example, thinking about resource management, American Express has made a huge change in moving away from annual allocations to a monthly process of constantly looking at rolling forecasts and prioritizing their investment funds on a monthly basis according to the projects that give them the best opportunities.
Please summarize what you perceive as the main strengths of the conventional budgeting process?
There are obvious strengths. The budgeting process wouldn’t be so well entrenched if it hadn’t worked so well for decades. And I guess a strength is that it is a coherent management model. But it’s coherent around the whole idea of central control, which is also its weakness.
It’s also well understood. Every junior manager learns about the budget and its politics within the first 12 months of joining an organization.
The conventional budgeting process looks good and ordered and everything is coordinated at one point in the year. And department and functional budgets all aggregate up to the master budget.
And all of the software vendors are geared to it, which is a big strength.
Some think it’s a big strength that managers know exactly what they have to do in that they’ve got specific numbers and targets. They know what they are accountable for.
In the context of the central control model it sits beautifully. But it’s the model that’s the problem.
Please summarize what you perceive as the main weaknesses of the conventional budgeting process?
The whole idea of central control, of top down control, of bureaucracy, is falling away from favor. There is a whole philosophy moving toward more devolved, more flexible, more organic, more natural systems.
When I talk about budgeting, and use the budgeting word, I don’t just mean the process itself, I’m always talking about a wider performance management model.
I don’t think of budgeting as just a process for putting together income and expenditure forecasts. All of the behavioral elements that go around it are a big part if it and of the problem.
A big problem is that with the budget we think we can predict and control performance over the next year. Therefore it becomes a rigid plan that’s difficult to change. It becomes difficult to respond to unpredictable events. The idea is that prediction and control is the right way to manage the business – it might have been in the 50s and 60s but from 70s onwards it’s got more and more insane.
And think of American Express. Their head-office was opposite the World Trade Center. They lost their head office for a whole year. And they were hit by the Gulf War, the Afghan War, the SARS epidemic. Every plan that they made became inappropriate to the world they found themselves working in. That, more that anything else, gave them the wake-up call to think differently.
Another problem is the lack of integration with strategy. Budgets typically go in the direction of departments and functions and hierarchies. It is about feeding the power bases.
What we are trying to use the budget for is to implement a joined up strategy. And that’s a big issue. And its failure here is one of the reasons why the Balanced Scorecard has taken off.
And let’s consider the behavioral dynamics around budgeting, which are much more pervasive than many people imagine. Look at all of the gaming that goes on at the front-end of the process for setting targets. For the line manager to win the game they have to get away with the lowest target they can and negotiate the highest reward. At the other end of the process, at the period end, you’re absolutely naive if you don’t spend your entire budget.
Also a cost escalator is built into the budget, which is the antithesis of what people believe. There was an article by Simon Caulkin in the UK Sunday newspaper The Observer that talked about how difficult it is to get from A to B on the roads at the end of March. And this is because all local authorities have to spend their highways maintenance budget by the end of the month, the end of the financial year. It’s the numbers driving decisions, and not the other way round.
There are many other issues. It stifles innovation. There’s no reason to be imaginative and take risks. So you get incremental changes to the budget rather than step change or truly stretch targets. It also requires a large bureaucracy to manage the whole budgeting, planning, reporting process.
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 use an expression that some people don’t like and this is that fixed performance contracts are management weapons of mass destruction. If you really look at what happens with companies such as Enron, WorldCom, Tyco, etc. you can trace it back to aggressive targets linked to incentives that drive short-term actions.
A typical life of a CEO in Europe is now 2.5 years. So they come in, set big aggressive targets to make a big statement and get the attention of the analysts and investment community – and then they say they will reward all of their top peoples with bonuses and share options on reaching targets. And when they realize that performance doesn’t come from the boardroom but from the front-line, they end up with all of this dysfunctional, irrational and fraudulent behavior in order to hit the targets.
And that is the top-end of the annual performance contract. But it’s happening at every level in the organization. Companies will admit that fudging goes on deep inside their organizations. So you end up with managing the numbers and not the business or strategy. And this all comes back to this performance contract.
People often don’t like to think that they have a fixed performance contract as they don’t have anything written down. It’s the unwritten, the implicit performance contract. Even when you say that these are the measures but we are not going to hold you accountable for them, people will still believe that they will be. So you end up with people at lower levels interpreting budgets and measures as contracts. That’s what they have to deliver and it’s what they will be evaluated on at the end of the year – bonus, promotion, their future with the organization. That’s the situation we have to get away from.
How satisfied are finance professionals with the conventional budgeting approach?
CFO magazine did a poll of their readers and they came up with a figure of 88% being dissatisfied. I also know of a company I’m working with who did a survey of finance and the wider management community that found that the finance function was more dissatisfied than the rest.
How satisfied are line managers with the conventional budgeting approach?
This is more difficult to say, but we have a diagnostic that is filled in by line managers and they are typically dissatisfied.
How effective is the budgeting process for goal setting? And what (if at all) would you suggest as better alternatives?
I don’t think it’s effective at all. If you think of a WW 2 bomber, only about 10% of bombs dropped hit within seven miles of their target.
Target setting is like that. You’re incredibly lucky if you get near the target and missing them causes huge collateral damage. Setting profit targets 12 months out just doesn’t make any sense. People should be managing their business, their strategy, the continuous improvement of their processes and customer delivery. Focusing on financial targets and metrics – it’s managing by results not by means. Means are the results in the making. If you manage by processes you will get results. Most managers think they are managing results when they set targets. So you end up turning on or off marketing, R&D etc., depending on where you are against an arbitrary target. It doesn’t make sense.
What we’ve seen in all of our best practice case studies is moving away from goal setting more and into performance evaluation. If you look at any fund manager they’re looking at the performance of the investment against similar alternatives. That’s the true test of performance over time – to be at or near the top of the peer group.
How effective is the budgeting process for resource allocation? And what (if at all) would you suggest as better alternatives?
The budget is very ineffective here as there is a huge amount of politicking going on around it. In most large organizations managers usually apply for more than they need, expecting to negotiate backwards to what they do need.
At the other end of the process, you’re looked on as a renegade or a maverick if you don’t spend your entire budget. We’re seeing more organizations managing resources through trends and rolling forecasts. We also see directional trending, so we want to see your cost in the department on a 2% downward trend over the next year, but how the unit does it is up to them rather than micro managing to item lines imposed by the center.
How effective is the budgeting process for planning? And what (if at all) would you suggest as better alternatives?
Ineffective as a result of predict and control. It’s counter-intuitive but true that the more detail you put into a plan, budget or forecast the less accurate it is likely to be. It’s far better to focus onto a key few drivers that are probably no more than 8-12 in any business unit. If you really understand what they are then you will get a better result. So we are seeing a trend away from annual planning and budgeting at the mechanistic level and moving toward rolling forecast of 12-18 months done quarterly.
Sometime we see two cycles. So that within month one you’re forecasting to the end of month three, which is used more for control and is quite effective and the longer-term cycle. And all this linked to quarterly reviews looking at improvement opportunities and whether further action is needed to change.
How effective is the budgeting process for performance evaluation and reward? And what (if at all) would you suggest as better alternatives?
Financial metrics are a very crude way of evaluating people. They’re also not as rich as people think they are because they don’t capture the quality or nuances of performance.
The real test is how well did a management team do over a given period looking back upon it and given the unpredictable events that happened during that period. It’s easy to set a target and beat the target if the market is more favourable than you thought it would be. The only true test is, to use an analogy, use a jury system – the jury is looking at evidence of performance over a period. Part of that evidence is the measure that you agreed but there will be criteria around how well did you execute the strategy and how well did you invest for the future, how will did you improve operational excellence and efficiency, how well did you do against their peers and so. Most performance evaluations and appraisal systems are unfair because they don’t capture the full picture of what actually happened.
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?
I think they find it all a bit scary. Whenever I talk to people there’s usually a knee-jerk reaction around control. There’s this perception that if you move away from budgeting you are giving up controls. Those controls are illusory. The real control is knowing where you are now and having a very clear view of the next 3-6 months.
Also most finance people are not known for their risk taking. They also like to get messages from consultants that this is the right thing to do and I’m not sure they are getting these messages yet from the accounting consulting firms.
There’s also a herd effect. There are quite a number of high-profile names getting linked to this, especially in the USA – American Express, Southwest Airlines, MasterCard, Charles Schwab. When that turns into a tipping point a lot of the nerves and fear will evaporate.
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?
The vision of change is typically incremental change. And this is where most of the consultancies and software vendors are – faster budgeting, quarterly budgeting, rolling forecasts, etc. This doesn’t fundamentally challenge the model and performance contract that is the core problem.
This isn’t just a budgeting problem, it’s a whole performance management problem and that is underpinned by cultural issues in the organization.
What are the favoured alternative frameworks being used to replace the conventional budget?
This is almost back to the philosophy on management. A lot of the literature shows that we’ve inherited a cause and effect, central control from Newtonian physics. This idea of a clockwork mechanism where you have levers within levers. It moves around and you can predict that if you pull a lever in one part of the organization it will have a predictable effect elsewhere. And this is where the idea of cause and effect comes from. And strategy mapping is a reflection of that to some degree.
There’s a lot of evidence now that cause and effect isn’t a model that represents reality. It’s a model that accountants grow up with. The real world is an eco-system and more quantum mechanisms. Things move around and are inter-dependent and more chaotic.
What we’re seeing is a movement away from the Newtonian model to one that is more organic, more devolved, more adaptive and more flexible to change. The barrier to all this happening is the performance management process.
We talk about culture and how to change culture but increasingly what my experience tells me is that culture isn’t a choice, it’s not something that the CEO can stand up and say that we want to go down the empowerment route and a week on Monday all will change. It is how we set targets, how we set incentives, how we handle resources, how we measure performance, how we interact and coordinate plans in the organization. It’s only by changing those that you get a change in behavior. That has to be reinforced by senior management.
This is one of the reasons why lean thinking hasn’t really taken hold within organizations. You have a collision of cultures. You have performance management culture coming from financial targets, numbers etc. and lean thinking coming down the process channels and trying to focus on process improvement and designing processes from the customer back. The two don’t gel. You have to get both in alignment. This is why I say that you start with the word budgeting but it’s much broader than that.
How would organizations decide on the content of the ‘new’ performance contract and the process for agreeing on that content?
Again this is bigger than finance. You can’t do any of this without dealing with the incentive-compensation system. You need HR on side and the CEO. You can do things by stealth, such as putting in rolling forecasts and then seeing the budget eventually roll away. But at some point you hit the wall of incentive-compensation that takes you to a new level.
How would organizations identify controls and parameters for resource allocation when monitoring performance to the ‘new’ performance contract?
Directional spending is a better way of controlling resource allocation.
You’re telling people that you want them to keep their spending within a certain tolerance and that may be a ratio or an increase or decrease on the trend line, which works effectively. We also have other controls without budgets. Some of the typical reporting systems that we see will have actuals versus prior years, trends and rolling forecasts, KPIs and relative measures for an external reality check – a richer array of control mechanisms.
In the absence of annual targets how will organizations communicate financial projections and ongoing performance to the investment community?
There’s quite a movement away from annual promises. In tough trading conditions, especially when there’s poor visibility this happens a lot. What you want is a better dialogue with analysts, about strategy, business segments, etc., telling the fundamentals of what they are doing and looking at how the company is doing against competitors.
What do you believe a truly adaptive organization will look like three years from now?
I always hold up Handelsbanken as the great model of this. Here you have an organization that’s been top of its peer group for 30+ years. A flatter organization, faster information, few and simple KPIs, devolved decision-making, integrated system. And there will be a greater embracement of lean thinking. When the ideas of beyond budgeting and lean thinking come together I think you have an unstoppable formula for change. Because you’re aligning the financial processes with the core business processes of the organization. This will unlock most of the barriers to performance improvement.