A new look at planning and budgeting
by Dr Mike Bourne

For many organisations, planning and budgeting is an annual ritual. A letter goes out from head office describing the company's expectations, shortly followed by a budget pack. When the packs are completed and returned, the annual negotiations begin in earnest. Eventually negotiations conclude and the budget is set for the next 12 months. This may be typical of traditional budgeting but in many larger organisations planning and budgeting is not seen as adding value. It is slow, time consuming and often does not produce a result that is significantly better than they started with. And all this time is spent on planning and budgeting rather than running the business.

Part of the problem is that companies use the budgeting system to integrate everything. A budget is supposed to be a plan, but we complicate this by using it not only as a forecast but also as a motivational target for management. With such incompatible requirements it is no wonder many companies have problems with their planning and budgeting systems.

More complication
With the increase in global competition companies can no longer rely on their markets and competitors remaining unchanged for many years. The growth of China as a manufacturing base has hit many companies around the world. For those in services, the Internet has disrupted some markets and created huge opportunities in others. These rapid changes can quickly make a budget out of date, particularly when it is only updated once a year.

As if dealing with external market changes is not enough, there are new management, reporting and regulatory requirements to deal with. Many companies' planning and budgeting systems simply aren't fast enough to respond to this new requirement.

The stakes for getting the budget wrong are higher than ever. PricewaterhouseCoopers found in a 2001 study that, on average, a profit warning reduces a company's share price by approximately 20 per cent. In 2002, Ernst & Young found the average reduction in share price after profit warnings had increased to nearly 25 per cent.

Then there is the move towards quarterly reporting, putting pressure on companies to meet financial results, and re-forecast, more frequently. All these issues raise an important question. How do we improve our planning and budgeting processes so that we can plan, re-forecast and motivate management within the short time frames required?

Some solutions
Some have suggested phasing out the budgeting process but few have taken this route. A much more widespread and practical approach is not to depend on the budget for everything. The answer to the problem lies in understanding the strengths and weaknesses of budgeting and using other mechanisms to deliver those things for which budgeting is unsuitable. For example, Borealis (the Danish-based international plastics business) split its management requirements into four distinct agendas: to forecast, set direction, manage costs and control capital expenditure. It then set up four distinct systems to deliver each of these requirements.

Forecasting was done centrally using a financial model that collected basic data from key points within and outside the company. As a result accurate re-forecasts could be produced in one-and-a-half days without disrupting the whole of management. Direction setting was delivered through interlinked Balanced Scorecards which set financial and non-financial targets across the business. Cost control for the support functions, such as HR and financial management, came from extensive benchmarking against competitors. This resulted in targets being set by comparison with others, rather than being based on the previous year's performance. As a consequence, the company focused the cost reduction efforts on achieving competitive advantage. Finally capital expenditure planning was managed by a central committee, which met monthly and juggled priorities with income flows.

Not all companies are able to completely re-engineer their planning and budgeting systems. There are, however, things that they can do to help improve the process:

• Decouple the achievement of the budget from the compensation process. In our survey of some 200 companies attending a series of conferences run by the ICAEW and ALG Software last year, nearly half were paying management a bonus on achieving the financial budget. This link immediately creates an issue when setting targets, as employees want to ensure they achieve their bonus while the employer wants to set goals. One solution is to pay bonuses directly related to the level of profitability, thus avoiding the issue of target setting. Another is to adopt the approach taken by BP where some bonuses are based on performance compared with its direct competitors, again removing the problem of target negotiation.
• Decouple the budgeting and forecasting process. Budgets are, ultimately, concerned with resource allocation and so require management input and negotiation. Forecasts, on the other hand, can be done using financial models. These can easily be rerun on a monthly or quarterly basis or when circumstances change.
• Use external benchmarking to set cost control targets. This avoids negotiating improvements over last year and creates realistic targets that take into account the improvements being made by the competition.
• Set direction using both financial and non-financial performance measures. Improving the financial position can be done in the short term by reducing service levels and competitiveness. One classic example was Marks & Spencer which was making record profits in the mid 1990s while its customer satisfaction was falling. Eventually the situation caught up with it and its profitability fell. Tracking leading non-financial indicators can avoid this.
• Build explicit links between the major non-financial activities and resulting financial performance and manage the change in these relationships. Many budget improvements are delivered by shaving cost from individual lines of the budget without any consideration of the impact of these changes. It is then not surprising that the budgeted savings are not delivered. However, if we create an understanding of process capability using statistical control techniques, we can judge with reasonable certainty what the performance will be. Planned improvements to the process will, in time, deliver performance improvements to the organisation but these improvements have to be planned and executed. Linking the activities, improvement plans and the financial plan enables improvements to be tracked and budgets properly validated. Software now exists to do this.

Separate running costs from investments. This may be a fundamental concept for accountants, but most organisations ignore the fact that the business has to make small, incremental improvements each year just to keep up with the competition. When business is going well, these small items of expenditure are simply absorbed in running costs and are probably not even noticed. Unfortunately, when budgets become tight, this discretionary spend is easy to cut. Businesses look profitable but can lose their competitive edge.

Dr Mike Bourne is the Director, Centre for Business Performance, Cranfield School of Management, United Kingdom. This article is contributed by CIMA (The Chartered Institute of Management Accountants) and it first appeared in Insight, CIMA’s on-line newsletter for accountants in business. Insight is accessible at www.cimaglobal.com/insight