The budgeting process is deeply ingrained in corporate culture. However, I believe it is time to adopt a new approach that is more in tune with today’s fast-moving business environment.
Typically, the budgeting process kicks off six to nine months before the financial year starts and a number of assumptions are made at that point. By the time the budget is signed off, it is a historic document with assumptions overtaken by technological or economic developments.
Quarterly forecasting is one way to take a fresh look at the budget assumptions and financial outlook for the year. It also enables reflection on how the internal and external environments have changed and what action needs to be taken to reflect those changes.
It may be the case that more needs to be spent on marketing, less on recruiting or resources need to be re-allocated. The world has moved on and forecasts can highlight these changes, allowing for corrective action to be taken. Budgets create an inward-looking ’point in time‘ framework and cannot dynamically reflect what is happening externally in the market and how the organisation must respond.
Three months into the financial year the world may look very different and a different course of action may be required. However, budget holders are not incentivised to flex resources to beat the competition; only to achieve budget.
I believe this is not only inefficient but also can block effective decision-making and have a harmful effect on an organisation.
Research has shown that sandbagging is not an uncommon practice. This is when budget figures are understated so that an individual or department can comfortably meet or exceed them. That’s not stretching and results in opportunities being ignored or resources mis-allocated.
In all fairness, when the budget is signed off it’s likely to be as good as it can be for the assumptions made then. It is a useful numerical snapshot of the organisation’s aspirations at a specific point in time.
Tellingly, when organisations ask consultants to help them improve their operations’ efficiency and effectiveness, a typical question is “what are the other companies doing?”. Organisations look at consultants to tell them how their competitors are performing and to measure their performance against industry best-in-class benchmarks.
So why do organisations have a system that measures senior management performance against an internal yardstick and not by the same external metrics?
Shouldn’t performance management and reward be anchored into “how are we doing against the competition?”, rather than “have we achieved the number?”
I believe the traditional budget must be phased out and the performance contract changed, especially for senior management. This would mean bonuses match a handful of key performance indicators that better reflect the organisation’s strategic aspirations and allow for benchmarking against their competitors.
Adopting metrics that can be benchmarked externally will create a more flexible attitude to changing market conditions. It will also drive innovation to enhance the long-term profitability of the organisation and boost value for shareholders and clients. Most organisations acknowledge the frustrations created by tying performance contracts to budgets but not many do something about it.
I believe this comes from the political fallout the change would create, which would be a radical departure from the status quo and most likely unpopular.
The secret to success will be a gradual shift, to slowly increase the prominence of forecasting and introduce additional measures to the performance contract. These measures would reflect the organsiation’s strategy but can be benchmarked externally, such as cost of a function as percentage of revenues.
Over time, the budget’s importance would diminish as a quarterly rolling forecasting process is established and individual performance is anchored on metrics that drive value-generating organisational behaviours.
This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG in the UK.