Appearing on In The Black Digital website, September 2019
New thinking for budgeting
It was Churchill who said that the future is just one damn thing after another. Anyone in business who has the job of looking ahead knows how true this is, but there are methods that can provide a road-map of the path ahead and help finance professionals avoid the dead-ends and pot-holes.
The place to start, according to Dr Prabhu Sivabalan, a Professor of Accounting and Associate Dean – External Engagement, at the UTS Business School, is to re-think the process of budgeting. He believes that most organisations struggle with budgeting because the future is always hard to predict, and managers generally do not want to make firm, on-the record forecasts.
“There are two intrinsic weaknesses,” he says. “First, there is the inherent difficulty in predicting how the real world will impact the organisation in the future. Second, there is the issue of getting managers and employees to engage with this process in an authentic way. Usually, it is a bit of both.”
The most common form of budgeting in Australia is the annual budget, usually structured in a traditional way and broken down through divisions, business units and even teams. Monthly and quarterly rolling budgets are often used alongside annual budgets in larger organisations.
By and large, a budget is the expected financial quantification of a company’s goals, hopefully based on a considered reflection of an organisation’s circumstances. It is then used as a tool to hold managers accountable for a level of performance. In being used to evaluate performance, however, it sets off a chain of incentives that lowers its utility for planning and resource allocation.
“The main weakness is the unyielding focus that managers and staff have on over-specifying the use of a budget as a performance evaluation device, while missing its value as a planning and management device,” says Professor Sivabalan. “These are related, but by over-emphasising the evaluation we ruin planning. Emphasise planning, and you reduce the negativity associated to evaluation.”
Telling employees at any level that their performance assessment, including bonuses, will be judged on an adherence to a set of numbers can induce pressure. If targets are too difficult, they naturally discourage creativity and innovation. But the same budget that constrains can also enable. If a looser, more generous R&D budget is given, for example, it emboldens the creativity of staff.
Getting ahead of the curve
“It is just human nature to stay with the safe and the known if you are rewarded for doing so,” Professor Sivabalan notes. “What we need is a wider range of performance incentives to take the pressure off budgets as the sole determinant of performance evaluation. My research shows that a lot of companies have a range of financial and non-financial KPIs but they do not actually walk the walk when bonus determination time arrives. Inevitably, staff are rewarded if they hit a financial number, with a cursory acknowledgement of their non-financial outcomes.”
At the same time the organisation’s executive team needs to be able to look at the larger picture on the forecasting side. This means developing an understanding of trends within the industry and the broader economy, emerging technologies, and social issues so that the longer term objectives of the organisation is met, and not only its annual profit target. Resources can then be allocated through the budget process to those areas of the organisation most likely to face challenges, or to where there are opportunities to get ahead of the curve.
This can be disruptive, compared to the steady-as-it-goes mentality often associated with traditional budgeting.
“It requires bold leadership, a special kind of executive,” Professor Sivabalan says. “You can’t blame most C-suite executives for not taking this on. You initially rock the boat when you incentivise staff based on factors other than budget adherence.”
Forecasting methods are sure to vary across industry sectors and the team responsible for looking ahead has to choose the right metrics and the most appropriate time-frame. Financial institutions, for example, will need to look at future interest rates and the economic framework with a long horizon. In the retail sector, forecasts are better made on a weekly or monthly basis. But the fundamental principles of taking a broad view, considering a range of data, and acknowledging uncertainty are universal.
Professor Sivabalan notes that there are some software tools that can help with forecasting but they are no substitute for a strategic mind.
“No software explains uncertainty,” he says. “We have all the technology we need. What is in short supply is a willingness to embrace uncertainty. When you determine budget numbers at the start of a period, you know they’re likely to be wrong. If you are able to accept this and work with it, you’re ready to start thinking about smarter ways of benefitting from a budget.”
Professor Sivabalan argues for a pragmatic, planning-based perspective.
“We need to turn budgeting into a forward-looking process where managers adapt to uncertainty when it arises, and not game around it before a period starts by arguing for easy numbers so they get a larger bonus later.”