Going Beyond "The Budget"

Most companies that prepare an annual budget have been frustrated over the past couple of years as extreme volatility in markets and the economy has rendered their carefully prepared budgets increasingly obsolete. Frustration has even grown so extreme as to lead some to consider alternatives.

Widespread corporate budgeting emerged with the growth of corporations in the Industrial Age. These large organizations designed their budgeting processes by copying the fiscal management and planning processes of the only other institutions of comparable size and complexity: governments.

Why do governments "budget"? (The term comes from the Latin word for a small leather purse.) In agrarian societies, governments collected their tax revenues when they knew that they were available, once a year after the harvest. These collections constituted the only resources that feudal lords such as kings and dukes had available until the next harvest, so they had to be careful to put aside enough to pay for knights, for maintaining the castle and roads, for feasts, and so on. Despite all the years that have passed, this is why we budget on an annual cycle and use fixed amounts just like they did.

Almost all modern corporations have a radically different business model, however. Revenues come in continuously over the course of a year, and expectations for these revenues also change continuously -- in response to internal events, competitive gambits, regulatory changes, and the evolution of the business cycle. Why, then, does management try to run a 21st-century corporation using a financial technique better suited to a pre-industrial, feudal state?

There are aspects of budgeting that serve real business needs. However, budgeting should not be confused with planning. Even though people use the words interchangeably, these are two different processes with two different aims.

Budgeting is indeed a type of planning, but it's essentially financial planning -- it's about creating a blueprint for financial administration for a period of time based on what an organization expects to spend and how it expects to finance these expenditures. Planning, on the other hand, is a much broader undertaking. It's about creating a detailed program of action consistent with the organization's strategy and objectives. In other words, budgeting is about money, while planning is about things -- units sold, head count required, truckload shipments, and so on. Budgeting sets limits; planning figures out what's possible.

Budgeting is about not failing, while planning is about succeeding.

We assert that companies need to put more emphasis on planning and less on budgeting. Companies think that they are planning when in fact they are mostly budgeting because they conflate the two processes into something we call "budgetingandplanning." Unfortunately, this process typically obscures the planning part of it. "Budgetingandplanning" also substantially limits the usefulness of the annual budget process as a true performance management tool -- a key role it has acquired over the past half-century.

Information technology plays an important role in shaping corporations' planning and budgeting processes. Our research shows that a majority of companies still use desktop spreadsheets as their main planning tool, not realizing that these spreadsheets severely limit the accuracy and effectiveness of their plans. Dedicated planning software is a necessary first step to go beyond "budgetingandplanning," but just buying software is not enough. Organizations that want to be more agile also must adopt a rolling quarters planning process, one that continuously looks ahead five or six quarters at a time.

To do this, they must improve the efficiency and shorten the duration of their planning process, which is impossible to do with desktop spreadsheets; spreadsheets are too cumbersome, error-prone, and difficult to manage at a deep enough level of detail or sufficiently wide breadth of participation to allow plans to serve as a useful management tool.

Rapid replanning also requires embracing driver-based modeling, a way of creating models that capture the key factors that drive your business. Using driver-based models focuses people on the most important determinants of how well the business performs, and enables companies to quickly reallocate resources as business conditions change.

To be a useful financial control tool, the driver-based operating models used to create the operating plans also must drive pro-forma balance sheets and cash flow statements. In other words, changes to the operating assumptions must be directly linked so that it's possible to determine their impact on working capital levels -- so that it's possible, for example, for the finance department to understand the impact of projected capital spending, future interest rates, and debt repayments on the structure of the balance sheet, cash flows, and borrowing requirements.

Effective planning also means considering a broad range of contingencies and determining the most appropriate response to each. Again, dedicated software facilitates this process. For example, if short-term interest rates were to double over the next year, how should your company respond? While it's easy to see the threat in this scenario, what options do you have today that can mitigate the risks and give you a leg up on the competition? What are the implications of the various response options for all parts of the company? If you have the right software and the right process, it's much easier to find these answers.

To be sure, corporations may still need to prepare an annual budget for lenders or the board of directors. But that's not a problem: Using dedicated software, they can quickly and easily derive from the fourth fiscal quarter plan a budget with an income statement and balance sheets.

Planning well is essential to business success. So is the ability to quickly adapt to change. Now is the right time to stop "budgetingandplanning" and make fundamental changes to your planning process.