I’m about to tell you why a process you probably hate is actually damaging the business you lead. Budgeting. Most businesses go through a budgeting process on an annual basis. And we advocate annual strategic planning cycles and even target setting and scorecards. I hear you ask, “Isn’t budgeting just a form of target setting and scorecarding?” Yes, but, and this is a big but, there are critical differences between target setting and budgeting.

How Budgeting Works

Most firms that utilize a budgeting process begin the process with a bottom-up budget draft, which is submitted up the chain of command and then revised downward and returned to the authoring management team for revision. This continues in an iterative fashion, typically with three total iterations, the first being the rough cut and the last including final decisions regarding allocation of funds for competing improvement initiatives. This process actually has a lot going for it:

It allocates scarce capital resources for competing projects;
It can allocate negative impacts like reductions in force;
It begins with insight from line management where the rubber meets the road; and 4. It can be quick. Yes the author knows it is often not quick… but it can be.

How Budgeting Harms the Business

First, the process is almost never quick. I know some organizations that avoid creating a tremendous time suck out of budget drafting, etc. But I suspect they also heavily sub optimize the process. See below about the conflict between budgeting and profitable growth. I’m not alone in this. An interesting study once determined that the average $1 billion company expended 25,000 person days on budgeting activities including the creation, review, management and reporting of budgets and budget information. The magnitude of that figure is suspect. That means in a $1 billion company, you would have 11 people budgeting full time. I don’t know any firm that bloated. Unless the 25,000 includes activity related to managing to a budget. If that is the case, the portion of the time allocated to managing to a budget is not wasted. Managers NEED to be watching the numbers and we think this is critical. Clients that manage to the numbers and do it in the normal course of business out-perform others. See caveats below.

Second, it encourages empire building. This is probably the most obvious way in which budgeting goes wrong. In order to succeed as a manager or executive, one needs to increase the scope of the job managed. After all, if a manager is doing the same thing this year as last year, the manager should be paid the same as last year. Right? Perhaps with a cost of living adjustment (COLA). A manager or executive wishing to grow their scope can:

Grow the business, and therefore their scope,
Grow the size of their department relative to the size of the business so that it becomes a larger part of the business, or
Grow their scope by being promoted.

We all want to believe that it’s number one that’s happening, but often it’s number two because of the three it is the one the manager has the most influence over. And that influence comes in the guise of the budgeting process. Each manager comes up with creative ways to improve the business that require additional resources to accomplish. Most of the time, this is not even done in a conniving way. Managers genuinely believe in their departments and their ability to contribute improvements to the organization. But most departments shouldn’t grow. And that brings us to our third way in which budgeting harms the business.

It ignores a core tenet of profitable growth – growing revenue faster than costs. The truth is that while each department in a business has a critical role to play, they are not created equal in their ability to grow earnings and value. Take as an example, a business that provides janitorial services to its customers. This is one that everyone can understand and imagine. Everyone knows what a custodian does. In this hypothetical business, labor is 90% or more of the cost structure of the business. If well-managed, customers and contracts are long lived and buy year after year so SG&A costs are a small percentage of the costs of the business. Even direct materials, the stuff the professionals spritz on the floors, windows and tables they are cleaning, is a small fraction of the cost of the business and while necessary to the proper, professional completion of a cleaning contract are a negligible portion of the contract. So even if the purchasing manager was able to get the product for free, there would be no appreciable impact on earnings and therefore value. Of course, the opposite is not true. If the purchasing agent does a terrible job and the company runs out of window cleaner, its lights out on customer experience until more window cleaner is purchased.

In a budgeting situation, the purchasing manager in this business is essentially side-lined and told “Just do what you did last year and avoid stock-outs.” Or, they attempt to take matters in their own hands and add staff to improve on the excellent job they did last year of not running out of window cleaner and negotiating the best price for window cleaner. While this example is overly simple, the principles absolutely apply to larger departments that don’t grow value. Their primary function is to not damage value and to enable the portions of the business that do grow value.

The business should be celebrating departments and functions that year-over-year become a smaller percentage of the revenue of the business. But most of us just don’t think that way and budgets don’t do anything to get us there.

What Works Then?

Strategic planning with financial and other targets can be used to keep the organization focused on the prize, which are earnings that grow faster than revenue. Strategic planning should produce the vision of the business on the planning horizon. Often this is in the form of a Big Hairy Audacious Goal (BHAG). Using the BHAG for clarity and motivation, the planning team should identify capabilities needed by the business to be able to operate as required by the BHAG. It is advancement of the organization’s capabilities that drives the change initiatives that should be undertaken over the course of the planning horizon.

It is this vision-driven process that eliminates the problems of traditional budgeting. During the detailed portion of the strategy process, initiatives are planned out and estimates are developed for the time and resources that will be required for initiatives as well as for the entire financial model of the business. If money is needed to fund critical initiatives, the financial model of the business is examined for opportunities to shift resources or to create resources by gaining efficiencies or reductions in another area. The difference is that this process is very rapid and highly iterative because all the important characters are in the room together, cooperating to determine how to accomplish a single goal, the BHAG. While this doesn’t preclude empire-building, it does give the team a much more compelling focal point. And the open air-environment and shorter time period reduces the opportunity for empire building and scheming. It really just doesn’t happen much during the high-speed strategic planning process.

But Wait…Isn’t This a Budget?

The result of the strategic planning process that we are interested in here, is a set of financial projections for the business, that are aspirational and at the same time, less prescriptive than a budget and more directional. The leadership team will know where it needs to be financially at the end of the planning horizon and can make moves in the intervening years to get there. Perhaps reducing costs in one area, perhaps increasing results and resources in another area. Any changes, such as promotions or hires will be made with an eye to becoming more like the vision and less like the past.

Call to Action

Integrate your financial projection and management process with your strategic planning process:

During the strategic planning workshops, identify the vision and if appropriate, the corresponding BHAG for the organization;
Include detailed initiatives planning in your strategic planning workshops this year to translate from high-level directions to specific financial projections and ratio targets; and
Develop a set of scorecards for the organization coming out of strategic planning and incorporate managing to these scorecards in the daily operating procedures of the business.

Here’s a link to a related article that explores the problems of budgeting from Harvard Business Review.