Corporations spend too much time budgeting and not enough time planning. As you kick off the budget season, you should be thinking about how to derive more business value from the process.
Most companies that prepare an annual budget have been frustrated in the last few years as extreme volatility in markets and the economy have rendered their carefully prepared budgets increasingly obsolete. Frustration has grown so extreme that some are considering alternatives to the annual ritual.
Alternatives are long overdue because companies need to do more dynamic planning to support agile decision-making in a volatile economic environment. A decade or so ago, a big day on the foreign exchanges markets saw a swing of at most one-tenth of a cent. Today, swings several cents in one day are not uncommon. Commodity prices have changed 20 percent or more in a couple of months. Interest rates are historically low, but for how much longer? It's likely that business volatility will remain historically high while predictability will stay low. In this environment, more effective planning can make a difference between average performance and above-average results.
One reason this is true is that more effective planning enables companies to react to change in a more coordinated fashion. This is an issue most companies face. Our benchmark research finds that fewer than one in 10 companies (9 percent) react to major change in their operating environment in a well-coordinated fashion. More than one-third (36 percent) admitted they are uncoordinated, and more than half (54 percent) say they are somewhat coordinated. Although that might sound innocuous, just like a “somewhat coordinated” juggler, corporations that fall short in coordination wind up dropping a lot of balls, and this has an impact on the bottom line. Indeed, more than one-third (37 percent) of these companies said that lack of coordination occurs frequently and that they spend a lot of time and effort dealing with it.
Budgeting is an essential part of running a company and is a cornerstone of good governance. Yet because it usually takes precedence over planning business operations in an integrated fashion, companies fail to achieve their true potential.
Even though people often use the words planning and budgeting interchangeably, they 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 those 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, headcount 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. People often think 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 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 those 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 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 the 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, especially in today's volatile business environment. The ability to quickly adapt to change has become an essential competitive skill. Now is the right time to stop “budgetingandplanning” and make fundamental changes to your process to emphasize the operational aspects of planning.
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Robert Kugel is a senior vice president at Ventana Research, where heads up the Finance practice. He is a regular contributor to Business Finance.