In this series of interviews recognized experts describe how to create an adaptive enterprise.
The expert in the chair this time is John McMahan, Senior Business Advisor, The Hackett Group.
Please summarize what you perceive as the main strengths of the conventional budgeting process?
That’s difficult. I guess one strength it has is that it marshals the resources of the organization in a similar direction. Because you translate activities into a budget, or into a number, then people have a sense that they have to achieve that number.
Based on your benchmarks and observations please summarize what you perceive as the main weaknesses of the conventional budgeting process?
There are many weaknesses, but the main ones are that it takes way too long to get accomplished and it doesn’t marry well with the speed of change and business volatility that most companies have to deal with today.
The other glaring weakness is that often the budget is dissociated from the strategic objectives of the company.
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?
There’s a significant misalignment between the annual performance contract and the way companies do business today. For many organizations the underlying components of performance are changing daily due to market and competitive reasons. This makes it very difficult to objectively measure someone’s performance at the end of the year. There’s just too many change variables in the course of a 12-month period.
Based on your data how satisfied are finance professionals with the conventional budgeting approach?
Unfortunately many finance professionals are by and large satisfied with the budgeting process. Many are satisfied because it’s comfortable – like a pair of old shoes. They wonder what they would do if they didn’t have an annual budget season to go through with all these iterations and all that number crunching. They know how to do it and are comfortable with it.
Really there are two things that really drive companies to maintain the status quo. One is that many organizations are very control focused, and so instead of creating incentives to get people to behave the way they should, they try to control behaviour through budget targets. So employees are told “you are not going to spend more than X on travel and you have to sell a certain amount”, so it’s a control issue.
Also people really haven’t gotten beyond how to incentivize people – how do you pay incentive compensation if you don’t have an annual budget target. There are one or two companies that we know of that have gotten over this problem predominantly by using rolling forecasts with quarterly targets that change over the course of time.
The more forward-thinking finance professionals that we talk to are very dissatisfied with the budgeting process. They recognize that it doesn’t given them the leverage they need to be strategic partners to the business. They are also aware that they don’t get the insights required to understand why targets aren’t hit and which levers they should pull to change performance.
What we see many companies do is create the annual plan and then rely on the monthly or quarterly forecast as their guide for running the business. This is clear evidence that the plan that comes out of this annual process is a ritual that often time is discarded in the heat of managing the business and companies begin to rely on a periodic forecast. For some companies it’s a daily flash report of what’s going on.
And how satisfied are line managers with the conventional budgeting approach?
By and large line managers are dissatisfied with the conventional budgeting process. They see it as extremely burdensome. Often time they don’t believe there’s a clear line of sight between the things that go into the budget and how they run the business. I also hear line managers complain that the budget is determined for them, is thrown over the wall to them and they’re now told to run the business this way. Often time that budget doesn’t have any resemblance to reality.
How effective is the budgeting process for goal setting? And what (if at all) would you suggest as better alternatives?
The budget is used by most companies as a way to set goals and companies are comfortable with this. They understand budget goals. Often though these goals are not aligned with the overall strategic objectives of the firm.
The weakness in the conventional process is its too detailed and you really have to be adaptive to meet the strategic goals of the organization. The conventional budget doesn’t allow for flexibility. So the goals may be relevant during the period of time that they are set but become less valid in time, and for that reason it’s probably not the best mechanism for goal setting.
How effective is the budgeting process for resource allocation? And what (if at all) would you suggest as better alternatives?
Again there’s a time horizon over which it is fairly effective for resource allocation, but as things change over time it becomes an impediment. For example if you’re building a new manufacturing plant and you’re only doing a 12 months budget, does this mean that the plant is only half way completed and then you have to re-budget for next year’s capital expenditure? Well that’s what happens in a lot of companies. So you’re faced with a building that’s half way built and the manager’s back in front of the capital budgeting committee arguing for the funds for the next phase.
So the actual annual plan in many organizations is actually unaligned with the way that capital is actually deployed and it creates a lot of impediments to the efficient deployment of resources.
How effective is the budgeting process for performance evaluation and reward? And what (if at all) would you suggest as better alternatives?
It’s very atypical for organizations to decouple incentive-compensation from the budget. A few years ago we did a joint study with Stern-Stewart (the creators of the Economic Value Added management approach) that indicated that companies that provide the best financial results had decoupled incentive-compensation from budgets.
This was because tying incentive compensation to budgets has some unintended consequences. Because compensation is typically capped, once you’ve achieved your budget what’s the incentive to continue to seek additional gains. The other side of the coin is that if you get half way through the year and realize that you’re not going to hit the budget, the consequence is the same, what motivation have you got to continue to work hard to hit targets that you know you’re not going to make.
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?
By and large companies are trying to better align the measurement tools that they use, the things they use to marshal resources, with the objectives they are trying to achieve. And they are trying to ensure that as the business environment changes they are able to acknowledge that and build those shifts back into their plan so that it becomes a dynamic, living document. The problem is that plans are typically staid. Once they’re done most organizations do not have a good mechanism to change, or adapt those plans as the business climate changes.
The most glaring example would be the September 11 disaster in the US. Whereas no company could’ve foreseen the event, most companies did not have the mechanisms in place to change their plan once it had occurred. Where companies are trying to get to, it’s a bit like a pebble hitting a pond, you may not be able to predict when the pebble hits the pond, but you’ll be able to understand the impact of the ripples once the pebble has hit the pond. Most companies today do not have the ability to understand the impact of the ripples.
Organizations are trying to accomplish two things. One is to better predict, or understand the impact of events and to do that quickly so it allows them to act before the window has passed. And the other is to clearly align employee behavior with that new understanding though an incentive scheme.
What are the favored alternative frameworks being used to replace the conventional budget?
I think there’s a lot of experimentation going on. We see that by and large companies still do a 12 month budget and they use their forecast, whether it’s weekly, monthly or quarterly as the tool they manage by going forward. The budget’s still out there and it’s still tied to compensation but quarter to quarter they do a new budget.
We have seen some companies use the rolling forecast approach very well. We know of one company in the US that has been using rolling forecasts for about five years and in that time they’ve seen dramatic improvements in the accuracy of their forecasts. As a result, the line managers feel they have a much stronger linkage with the forecast and so there’s greater buy-in. They no longer do an annual plan. And they’ve adapted their incentive compensation plan to be geared toward quarterly targets. There’s still some long-term targets, but they’re not annual, they’re two to three year targets.
How would organizations decide on the content of the ‘new’ performance contract and the process for agreeing that content?
It requires some heavy lifting, but to me it’s illogical to think that your strategic objectives can be achieved in a year’s time. Most companies when they build a strategic plan they’re going on 5, 6, 7 years. We do see companies moving to broader targets such as by the end of year three we need to have achieved a market share of X. or unit sales need to be at X and it’s up to the line managers and senior executives to decide how much of that is achieved in a year. But the incentive compensation is tied to the three year target rather than an annual number.
If people believe that nothing they do is going to impact the ultimate number then they have less incentive to focus on it and work toward it, regardless of the incentive compensation plan. By improving the methods we use in planning or budgeting we also increase the ownership of line managers and other employees in that plan. The other main benefit is that it makes companies more nimble and more flexible. At the end of the day the budget is just a way to quantify how we think about our business. And so an alternative way of thinking about your business that provides more flexibility, more alignment with the overall strategic goals is going to help the organization be more successful over the longer term.
In the absence of annual targets how will organizations communicate financial projections and ongoing performance to the investment community?
Most companies don’t communicate their budget. They communicate a sales growth rate, a revenue growth rate, an EPS target. So the companies that have replaced an annual plan with a rolling forecast or with some other means still generate targets on a quarterly basis, or a monthly basis, that they then can communicate with the investment community. Just because you move away from the conventional method of budgeting to something that is timelier and flexible doesn’t change the type of measures that are communicated externally.
Do you believe the annual performance contract will lessen in importance within most organizations over the next three years? If yes, what will drive this change? If no, what will ensure the status quo?
The budget as we know it today will lessen in importance. The rate of change in the environment that we do business in today is not going to slow down, it’s going to get faster. So the conventional way we do budgeting, which is very inflexible and unadaptive and not aligned well with strategic objectives is going to become less important over time. Companies are going to find better ways to align their human resources with their capital resources to achieve their strategic objectives.