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Cranfield School of Management

Research shows some companies have exorcised the term ‘budgeting,'' while a group of Scandinavian companies have dispensed with budgeting altogether.

In a recent Economist Intelligence Unit survey, financial directors ranked budgetary reform as their top priority. Other research suggests that 80 percent of companies are dissatisfied with their planning and budgeting processes. There is a phenomenal amount of interest in re-engineering these archaic practices, too. Yet, a survey published by CFO Magazine revealed that, even when firms claim they have re-engineered them, most respondents were still dissatisfied.

Traditional budgeting methods are too time-consuming and costly. They are also too unresponsive to today’s competitive and turbulent environment. Furthermore, they are counterproductive in that they are usually affected by gaming, corporate politics, and horse-trading tactics. Some estimates suggest that planning and budgeting processes use up to 20 percent of all management time. The Hackett Group assesses that a mean of 25,000 work days are used on planning and budgeting per billion dollars of sales.

In 2001, Cranfield School of Management’s Centre for Business Performance in the United Kingdom was commissioned by the Accenture Finance & Performance Management service line to investigate what exactly represents best practice in planning and budgeting.

Weaknesses in Practices

The research team conducted an extensive academic and practitioner literature review (over 100 sources). It then interviewed a selection of 15 companies regarded as among the best practitioners in this aspect of performance management to identify the differences between theory and practice.

The initial literature research identified 12 significant weaknesses of traditional planning and budgeting practices. The factors most frequently criticized by users fall into three principal categories:

• Competitive strategy. Budgets are rarely strategically focused and are often contradictory. They concentrate on cost reduction and not on value creation. They constrain responsiveness and flexibility and are often a barrier to change. Budgets add little value. They tend to be bureaucratic and discourage creative thinking.
  
• Business process. Budgets are time-consuming and costly to put together. They’re developed and updated too infrequently, usually annually. They’re based on unsupported assumptions and guesswork. They encourage gaming and dysfunctional behavior.
  
• Organizational capability. Budgets strengthen vertical command and control. They don’t reflect the emerging network structures that organizations are adopting. Budgets reinforce departmental barriers rather than encourage knowledge sharing. And they make people feel undervalued.

Much of the literature argues that, collectively, weaknesses lead toward underperformance.

Our contention is that, to be effective, budgets must first be aligned with the organization’s strategies, with appropriate strategic planning and performance management processes introduced. Second, they must involve processes that are value-based, consequential, and continuous. That is, processes that are focused on identifying and managing the drivers of shareholder value; that make explicit the links between these value drivers; and that promote a continuous process of questioning and challenging the assumptions inherent in the strategy. In our experience, few meet these effectiveness criteria.

Better Budgeting

The literature research uncovered five principal techniques to generate improvements. These were:

• Activity-based budgeting. Similar to ABC and ABM, this involves planning and controlling along the lines of value-adding activities and processes. Resource and capital allocation decisions are consistent with ABM analysis, which involves structuring the organization’s activities and business processes so that they better meet customers and external needs.
  
• Zero-base budgeting. Expenditures must be rejustified during each budgeting cycle, rather than basing budgets on previous years or periods. This avoids building on the inefficiencies and inaccuracies or previous history. The value of this approach depends on stability of the operating environment.
  
• Value-based management. This is a formal and systematic approach for managing the creation of shareholder value over time. All expenditure plans are evaluated as project appraisals and assessed in terms of the shareholder value they will create. This approach helps to link strategy and shareholder value to planning and budgeting.
  
• Profit planning. This profit-wheel method for planning future financial cash flows of profit centers assesses whether an organization or unit generates sufficient cash, creates economic value, and attracts sufficient financial resources for investment. It ensures consolidation of an organization’s short- and long-term prospects when preparing its financial plans.
  
• Rolling budgets and forecasts. This technique solves problems associated with infrequent budgeting and, hence, results in more accurate forecasts. It’s more responsive to changing circumstances but requires permanent resources to administer. It also overcomes problems linked to budgeting at a fixed point in time (i.e., the year-end) and the often dubious practices that such cut-offs encourage.

Activity-based budgeting and zero-base budgeting undoubtedly help to improve the focus and accuracy of budget outputs. The problem they share, however, is they tend to involve even more work than traditional budgets. So they are best used on a one-off basis rather than a regular one.

Valued-based management and profit planning appear to be more theoretical than broadly adopted approaches. Very few examples of practical applications and related implementation techniques (in a planning and budgeting context) were found to evaluate the efficacy of the approaches. Even so, there’s little evidence to suggest that these will simplify the essential process.

The fifth technique, rolling budgets and forecasts, appears to have the most potential as a better regular budgeting approach. A number of organizations have successfully introduced it to improve their forecast accuracy and overcome the traditional budgeting time-lag problem. Alas, none of these approaches provides a complete solution.

Practitioner Research

To find out if there’s another way, the research team interviewed 15 leading companies, including many of those quoted in literature as exponents of advanced planning and budgeting practices. This research provided insights into which approaches these companies were actually adopting. Not unexpectedly, some turned out to have more mature systems than others. Generally, they tended to fall into three principal categories:

• Those that were trying to adapt their existing planning and budgeting processes, making them less threatening — to avoid gaming — and trying to improve their accuracy with rolling forecasts (BP, for example);
  
• Those that still budgeted but were taking an information technology approach to monitoring real-time data through the application of state-of-the-art financial management systems (Cisco Systems, for example); and
  
• Those that had taken a radical re-engineering approach (Borealis A/S, for example).

By far the most interesting group were those that had gone down the radical re-engineering route. They had simply banished budgeting.

Beyond Budgeting

Very few companies have eliminated budgets altogether. And, curiously, most of those that have are a cluster of Scandinavian companies, including Svenska Handelsbanken, Borealis, and Skandia.

Svenska Handelsbanken, the largest bank in Sweden, eliminated budgets in the 1970s. For 29 consecutive years, it has had a better return on equity than any of its direct competitors, against whom it benchmarks its performance. It also claims to be the most cost-efficient universal bank in Europe in terms of both expenses as a percentage of total assets and its cost-to-income ratio (i.e., margin). It delegates responsibility for all corporate and private customers to its 520 branch office operations and 10 regional banks in the Nordic region. Monthly performance league tables enable the head office to keep track of branch efficiency and effectiveness, while central support operations are benchmarked against alternative external sources. While benchmarking branch offices and, therefore, encouraging them to compete against each other might seem like a recipe for internecine warfare, the internal culture and nature of the market in which it operates prevents this from becoming an issue.

Denmark-based Borealis A/S, the world’s fourth-largest polyolefin plastics producer, created its last budget in 1995. It uses rolling forecasts to manage the future and a balanced scorecard to keep track of its performance and motivate staff through target setting. Today, forecasting is done on a quarterly basis (the company tried monthly, but abandoned the scheme) for a rolling five quarters, using a minimal resource for a process that takes no more than 10 working days. Over the last five years, the corporate balanced scorecard has been cascaded through the organization. Each individual business unit, site, and department now has its own balanced scorecard. Trend reporting, using moving averages, is encouraged. Broad use of external benchmarks is applied in order to get rid of internal negotiation as part of the target-setting process, especially in relation to controlling fixed costs and nonfinancial indicators. Beating the competition is what matters. Arguably, this is the world’s most sophisticated application of beyond budgeting principles.

Skandia, the 7,000-employee Swedish financial services organization, is also seeking to devolve responsibility to its operating companies. It uses a highly slimmed-down budgeting process at the business-unit level as part of its strategic planning process. This process only includes key high-level budget figures. And there it stops. It then applies its own Navigator scorecard framework to manage the business. Quarterly bonuses are awarded based on a combination of financial and nonfinancial measures. Its business units are run autonomously and business planning is undertaken at business-unit levels based on constructive debate with customers and suppliers.

These aren’t the only companies that have abandoned budgets. AB Volvo did so in 1994, favoring quarterly forecast-planning and monthly performance-reporting processes to manage its cyclical business. But, once again, this is a Scandinavian company. Jeremy Hope and Robin Fraser, of the Beyond Budgeting Round Table, identify Ahlsell, a Swedish heating, plumbing, and electrical supplies wholesaler, as yet another Scandinavian example of budget abandonment (in this case, since 1995).

Is the rest of the world oblivious to this Nordic phenomenon? Not entirely. Companies such as Shell, BP, AstraZeneca, and Ford Motor Co. are beginning to move away from traditional budgeting and review processes. Improvements are undoubtedly being made. Indeed, several of these companies, along with a selection of the Scandinavian leaders, were prepared to share experiences from their individual journeys at a conference, attended by over 70 delegates, hosted by Cranfield School of Management and the Chartered Institute of Management Accountants (CIMA) at Cranfield University in January 2002 and again in January 2003.

Best-Practice Principles

Although no single company seemed to encompass the perfect approach, the practitioner research allowed us to develop some essential principles for radical planning and budgeting process re-engineering. The researchers identified “five plus one” critical success factors.

1. Assumptions, Not Opinion-Based

Leading companies are achieving more accurate, faster, and lower-cost forecasts by ceasing the budgeting negotiation process and instead applying explicit forecasting models:

• These are deliberately separated from their financial management systems;
• The models are based on clear assumptions (often lost in the budgeting process); and
• If and when the world changes, the assumptions are changed and a new accurate forecast is generated quickly, with virtually no manual intervention.

2. Lean, Not Mean

Leading companies are reducing the cost of their financial planning and reporting by judicious investment in IT to create integrated and widely accessible cost and revenue databases:

• These are designed to create a single view of the company;
• They reduce duplication of effort in running separate legacy systems; and
• Leaders are also light on their review process, focusing on a few key financial measures and not reviewing every line item.

3. Strategically Managed, Not Financially Managed

Leading companies understand that better financial performance comes from developing and executing good competitive strategies — it does not come from better financial management:

• They plan and manage investments separately from the day-to-day operations of the business;
  
• They focus more on the achievement of nonfinancial targets than they do on the monthly financial results — and so are frequently measured using strategy-related scorecards; and
  
• They understand the concept of action/ performance lag — the time between the initiation of an intervention and the resulting improvement in performance (thus preventing the continual initiation of new projects that are supposed to create short-term benefits but inflict long-term damage, as they consume management time and resources while failing to reach completion before they are taken over by events).

4. Competition-Focused, Not Budget-Focused

Leading companies are extremely externally focused:

• Comparisons are not made with budget but with the competition;
• Targets are set not based on current performance but by reference to external benchmarks; and
• Incentives are disconnected from budget achievement and focused on beating the competition both financially and in terms of achieving externally benchmarked nonfinancial targets.

5. Action-Oriented, Not Explanation-Oriented

Leading companies are far less concerned with explaining past performance than managing future results. This is done by:

• Forecasting and explaining likely variances before the financial variance occurs;
• Managing using the period-end forecast and not the actual results; and
• Focusing on taking the actions that really drive performance, most of which are nonfinancial.

Plus One

All of this represents a radical departure from traditional annual budgeting and performance management mindsets. To succeed in this, however, everyone needs to be singing off the same hymn sheet or it just won’t happen.

There is another fundamental difference between the traditional planning and budgeting processes many companies use and the approach that best-practice companies are taking.

Under traditional budgeting, control was exercised by business units and divisions reporting their actual performance and variances to the head office. The head office virtually was left to use this information to predict the year-end result. Now, forward-thinking companies trust their managers to tell them what they will achieve. You cannot work on management’s year-end forecast, with almost total disregard for the actual monthly result, without trust.

If the right degree of trust is missing, these principles and approaches won’t work.

Thus, on aggregate, a large part of the basic traditional process, and its attendant cost inefficiencies, remains intact, often with an over-layer of more frequent forecasting. Very few companies, the Scandinavian pioneers apart, have truly gone beyond budgeting. Yet.

About the Author

Title: 

Director of the Centre for Business Performance

Cranfield School of Management

Andy Neely is director of the Centre for Business Performance at Cranfield School of Management, professor of operations strategy and performance, and managing partner of The Performance Practice. He has authored over 100 books and articles.