By Andy Burrows
[First published 9 February 2017]
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This is part of a series of articles looking at Finance activities, and basically asking 'why?' The premise is that understanding why we do things helps us to do them better. It may even fundamentally change the way that we do them. If you haven't seen it already, take a look at the introductory article that explains the approach I'm taking: The Purpose-Driven CFO Part 1: Introduction
In this second article in my series on Purpose-Driven Finance, I want to focus on one of the most widespread headaches that the CFO has to manage – the budget.
Of all the energy-sapping, life-draining, activities in Finance, the annual budget process seems to be the most hated. In almost every big business I’ve worked with, anyone involved in the annual budget process has had complaints about it. And the accountants, by the end of the process, are left cynical, usually saying that the numbers either don’t make any sense or they’re out of date.
Where would a purpose-driven approach take us in trying to make the budget process less of a pain?
So, let’s try to answer the question, “what is the purpose of the budget?”
To do that, first, it may be helpful to define what a budget is. And in doing so, we should distinguish between a ‘financial plan’ and a budget. A budget is normally associated with spending, but financial planning involves projections of all types of financial flows – income, costs, capital, cash, etc. In normal usage, we don’t normally make a distinction - ‘budgeting’ and ‘financial planning’ are practically synonymous. But, if we examine why we do them, they come down to slightly different things. Let me explain.
Why do we feel the need to do projections of future financial flows? Why do we predict income and costs to get a predicted profit? The answer is so that we know whether the business is going to make enough money to achieve the business owners’ aspirations. Or more to the point, it helps us to know what actions we need to take to try to achieve the business owners’ financial aspirations. That’s why it’s a plan and not just a forecast.
On the income side, the outcome of our actions is not possible to predict with 100% accuracy. Whilst there are lots of factors we can control (price, quality, sales outlets, etc) that will be influential in customers’ buying decisions, we can’t force them to buy from us. Revenue is not directly under the control of the business. On the other hand, expenditure is entirely under the control of the business.
That means that if we are committed to trying to make an amount of money that the owners of the business will find acceptable, then we must limit expenditure based on prudent revenue projections. Hence part of the purpose of financial planning is to work out how much the business can afford to spend. The budget allocates that amount to the various business functions as a limit to their spending.
And that, in turn, means that plans and budgets have different purposes. A financial plan is done to derive how much we can afford to spend. A budget is done to put limits on what managers within the business can do. So, a financial plan is about prudent financial management. Whereas a budget is about controlling or limiting the actions of people within the business.
And let’s be clear. When I talk about a budget being about controlling or limiting actions, I’m not saying that’s because we don’t trust managers. It’s just that none of them has the full picture on how much expenditure the business can afford.
But let’s not miss this: The purpose of a budget is to control or limit the actions of people within the business. The purpose is not to encourage or enable optimal spending decisions. The purpose isn’t to enable prudent financial management. Here are two illustrations of what I mean.
First, as Steve Player, of the Beyond Budgeting Round Table, said, “You put a ceiling on cost, and I guarantee they won’t spend a penny more. The problem is they rarely spend a penny less.”
Once managers have the budget to spend the money, they needn’t think much deeper about whether they’re getting value for money, or whether the benefits outweigh the costs. They spend just because they can sometimes.
The same happens with the people budget. After someone leaves, they are automatically replaced. Very little thought goes into whether the department could make do without that role. And with no cost-benefit analysis, a manager may decide to cut out that role and recruit a different one, because they’ve “got the headcount budget”.
The budget is not going to ensure that the business is cost efficient, keeping spending as low as possible and spending on value adding stuff. That’s not the purpose of the budget. The purpose of the budget is to control or limit people. If you think that a budget is there to control costs, think again.
Second, the other implication of this purpose-drive approach is that it leads us to question why we would ever do a “bottom up” budget process. The purpose of financial planning is to work out how much the business can afford to spend. That leads on to questions of resource allocation and expenditure prioritisation. The budget is effectively a way of allocating resources and expenditure across the business, to ensure that all functions continue to be effective.
But allocation and prioritisation is not something that individual managers can do. They don’t have the full picture. All they can consider is what they think they should be doing and the grand plans for their area of responsibility. Doing the “bottom up” part first is unfair on managers, and it wastes a lot of time when it gets to the “horse trading” part. And, as has been well documented, it leads to some managers “padding” their budget submissions because they know they are probably going to be cut back.
This has two dangers. On the one hand, some managers “get away with it” and end up being able to spend more than would be optimal for the business. But on the other hand, the “horse trading” doesn’t often result in an optimal answer for the business, because it’s influenced by managers’ different strengths in negotiation, the timing of meetings, personalities, etc. I’ve seen so many budgeting processes end with the Finance team looking at the end product with exasperation because it just doesn’t make sense for the business.
The prioritisation of expenditure, which leads to the allocation of resources to the various functions of the business, is something that must at least start as a central activity with support from Finance. This allows Finance to propose a basis of prioritisation/allocation based on business value, which can go towards making the consideration more objective. That is to say, if we have to do budgeting it should always start “top down”.
And then finally, going back to the revenue part of the equation, I made the point earlier that the amount the business can afford to spend must be based on prudent projections of revenue, because revenue is less controllable. That means that we cannot use the revenue figures from the financial plan (or budget) as our sales targets. They would not be stretching at all, and would probably lead to complacency in the sales team.
So, by being clear about the purpose of financial planning and budgeting we find that:
But what’s the alternative?
I’ve been fascinated over the years by the discussions about how life is possible in business without budgets. The Beyond Budgeting Round Table is dedicated to those discussions. But as far as I can see, only a small number of businesses have adopted a Beyond Budgeting approach. I have yet to work in a business that has ditched the annual budget completely, or even one that has suggested doing that. There are case studies out there – Svenska Handelsbanken, who gave up on traditional budgeting in 1972, being the most well-known.
Some have suggested using rolling forecasts without a budget process. This is, in fact, the way that I manage my own business and personal finances, without putting much thought to it. I revise my forecast every month, plotting my expected income and costs, which tells me if and when we can afford the holiday, the new car, the kids’ music lessons, etc. Others have observed that this can involve a big increase in workload for the Finance team.
The main thing, I think, if we’re being purpose-driven, is to work out what it might mean for our own businesses. If our goal is to ensure that the business gets as much value as possible out of its expenditure, then we will start to think about what processes and actions, policies and procedures, might help with that. A top down financial plan? Having different target setting processes for sales revenue and expenditure? Better cost analysis, and cost/benefit analysis? Using overlays?
What we have to acknowledge is that budgeting is something that is done to address a management problem, not a finance problem. And therefore, the budget is just one element of a management system. And management systems are rooted in particular assumptions about psychology and group dynamics. And the effectiveness of those systems changes as cultures change (either across geography or through time).
Perhaps that’s why budgeting, despised as it is, is so difficult to change. It has so many implications into other areas of performance management that improving budgeting is not like any other continuous improvement project. It requires something of a seismic shift in thinking about management itself.
To save you looking, here are the links to all the articles in this series:
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