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Beyond Budgeting Round Table

By adopting six key principles, organizations can shift to processes that free managers from the limitations of traditional business practices.

Research has found far more effective ways to plan continuously and adaptively control operations. We’ll look at some of the key principles needed to build adaptive processes. With these processes, managers can break free from the annual performance trap that results from traditional practices.

The Beyond Budgeting Round Table has spent more than five years researching how companies are creating more adaptive processes by moving beyond traditional budgeting approaches. Six key principles of adaptive processes have been defined. These focus on:

1. Goals;
2. Rewards;
3. Planning;
4. Resource availability;
5. Coordination across the company; and
6. Controlling adaptively.

Each of these Beyond Budgeting principles will be explained in the context of how it differs from traditional practices. Examples of best practices will be used to explain the principles along with examples of the practices in action, drawn from the Beyond Budgeting Round Table’s case study library. Understanding how these principles work together is the key step to healing pain inflicted by current practices.

Goals

Traditional budgets are a prime tool used by managers to set and communicate organizational strategy by translating strategic goals into quantitative measures. However, this often becomes a great game of negotiation. Managers seek easily achieved targets and buffer themselves against uncertainty. Experienced managers have learned that delivering on the target commitments begins with negotiating an achievable target.

Senior management and central staff often attempt to counteract these negotiations by leveraging field targets to reach more aggressive goals. This can be potentially dangerous when central operations insists on “improvements” that may not be applicable to that specific division.

Beyond Budgeting companies eliminate the negotiation of incremental targets and introduce a goal-setting process that establishes “stretch goals” aimed at relative improvement.

It does this by enabling local teams to set goals based on maximizing performance potential. The key first step is to disconnect goal setting from evaluation and rewards. This encourages managers to go for a “maximum stretch.” It eliminates any motivation to negotiate lower targets.

To eliminate fixed targets, Beyond Budgeting organizations base goals on achieving better results than peers, competitors, or external benchmarks (i.e., the goal is to be at the top of the league tables). Ownership of the goals is transferred to local teams. Their use of relative metrics allows changes in environmental conditions to be automatically factored into the results.

Changing to relative-improvement goals provides greater inspiration to achieve. It shifts the focus to being better than the competition and to being the best in the world. A national consumer products company that is budgetless has a phenomenal record of growth. After increasing sales 35 percent over the prior year (more than three times the growth of the company’s product category), the management team was proud of its accomplishment. Even so, it asked, “What kept us from growing 40 percent?”

Fixed targets did not limit them; they didn’t worry about stopping. Their speed and adaptability allowed them to dramatically increase market share.

Rewards

Central to the budget process is the mantra of “pay for performance.” To this end, most budgets are tightly linked to compensation and reward systems. These can be explicit, such as tying bonuses to meeting budget targets, or implicit, such as budget management as a key performance evaluation criteria. Some companies use both approaches.

This tying of incentives to fixed budget targets has resulted in numerous instances of gaming as managers manipulate the system to maximize their financial rewards. Use of stock options provides additional motivations to manipulate results. Yet we have seen numerous instances where workers played games with the numbers merely to please their bosses. The need to meet supervisors’ expectations led many to participate in gaming either by negotiation of lower targets or authorized manipulation of reported results. Often the performance being paid for is skillful negotiation of targets rather than hard bottom-line results.

Beyond Budgeting organizations take a different approach by basing evaluation and reward on relative improvement contracts “with hindsight.” There is also a shift to rewarding teams and groups more than individuals.

The bonus pool formulas use a range of key performance indicators consistent with the organization’s goals and strategies. The rewards are selected to balance both short- and medium-term results. Most important, the rewards are selected to be fair and motivate the right actions and behaviors. This last factor helps explain the shift to more team-based measures as results are typically accomplished by group effort rather than by individuals.

A key difference in rewards is setting payouts “with the benefit of hindsight.” Companies publish a known formula defining the relative weight of different measures being used. Actual performance can then be tracked, but the end results are not known until the results are measured against the other relative measures (i.e., “with hindsight”).

For example, an organization can increase sales by 10 percent. Is this good or bad? If the overall market is flat, most would say this growth is good because the share is increasing. On the other hand, if the overall market grew at 25 percent, a nominal 10 percent growth actually represents deteriorating market position. Use of rewards with hindsight keeps everyone striving for improvement.

Planning

Most companies view planning as an annual event driven from the top of the organization. Department teams rush to prepare ideas to meet management’s planning cycle deadlines. The finance staff incorporates the ideas from all departments and aligns the coordinated plan to a financial calendar. Many good ideas fail to be considered if their timing falls outside the planning window.

The financial calendar often becomes the driver for activities. Management focuses on delivering quarterly results that match finance’s view of the world rather than following the natural business cycle. The most visible sign of this approach is found in the number of financial forecasts that merely look to the end of the year.

Operations are driven to support finance rather than finance supporting operations. There is an annual push down to set the budget and a quarterly push up to reach those milestones. As a result, the natural pull from the customer is lost, and attempts to operate as a lean enterprise are pushed aside.

Management still claims the mantra of operating in real time. But, where is the benefit if the objective is to reach budget targets determined more than a year in advance?

Beyond Budgeting changes this approach by making action planning a continuous and inclusive approach. It devolves strategy planning and decision-making to lower-level teams. These teams determine their key value drivers, action plans, and key performance indicators from their goals and strategies.

Performance management cycles use short- and medium-term checkpoints based either on a calendar (such as quarterly) or by event triggers. For example, a large consumer products company that operates without an annual budget manages its advertising expenditures using a continuous approach. On a quarterly basis they allocate a portion of their available advertising or promotional dollars. They hold some reserves for opportunistic programs.

Over time, the company has developed a reputation as a company that is never “out of budget.” It receives many low-cost opportunities for quick turnaround promotions at times when its competition has overspent or previously committed advertising budgets. This approach allowed the company to grow at greater than 30 percent per year for five consecutive years. Management is continuously looking for promotions with the most attractive growth prospects.

Another budgetless company operates factories worldwide. It uses its amount of free cash flow to continuously adjust its funding of incremental projects to improve return on assets. Management is continuously looking for which projects will yield the greatest return on assets.

Beyond Budgeting companies involve the entire team. They are challenged to continuously improve rather than merely to reach a negotiated number. They celebrate success, but continue to ask, “How could we have done better?”

Resource Availability

For many companies, budgeting serves as a chief source of power. Managers believe they either can achieve or are prohibited from achieving merely as a byproduct of budget approval or denial. With the introduction of the Sarbanes-Oxley Act, many cite budget approval as a key internal control technique. But is it really?

Many CFOs cling to budgets as their primary tool for keeping a lid on costs. While budgets can serve as a ceiling for costs, they often create a floor at the same level. The more budgeting is used to cap spending, the more prone managers are to hoard approved budgets. With a “spend it” approach, managers make sure they spend at least 99 percent of their allotment. First, the managers fought hard to get budget approval, so they don’t want to waste it. Second, they know future amounts likely will be based on current usage.

When resource allocation is based on annual budgets, numerous assumptions must be made with regard to satisfying demand from both external customers as well as internal stakeholders.

Demands for end products and services must be translated throughout the organization. Organizational units must often rely on other parts of the organization to deliver products to customers. Numerous requirements must be translated and shared throughout the organization.

Services units convert demands into staffing and other capacity requirements. Traditional budgets push these requirements throughout the organization. The costs of these functions are often allocated back to the consuming units. When actual results differ, some units are over-resourced while others are short. Those units that are short quickly ask for more resources, while those that are over cling to their budget authorizations.

As a result, traditional budgeting leads to hoarding — often on a grand scale. Hoarding is often very difficult to identify. Units have little incentive to optimize their performance or show their excesses.

Beyond Budgeting changes the budgeting approach by making resources available as required. Rather than negotiating fixed amounts, Beyond Budgeting companies set key performance indicator goals that are used to steer the organization.

For example, Handelsbanken, a leading budgetless bank in Sweden, uses the cost-to-income ratio as a guiding metric throughout its branch network. Managers are free to add operational resources as they find necessary, but they realize each person, new equipment, or other resource added will increase costs. Managers must decide if it will also improve income.

Central services are also made available to operating units through internal markets. These shared services sell at an agreed-upon transfer price (usually with no markup). Beyond Budgeting companies also use fast-track approvals for major projects with frequent re-evaluation of priorities.

Coordination

Traditional budgets typically begin with the corporate planning department publishing planning guidelines. Business units and departments translate these guidelines into detailed plans. Multiple iterations are used to coordinate cross-company actions. If it works correctly, plans will be coordinated based on the same assumptions.

In reality, managers adjust the inputs they receive based on their experience. They buffer for peaks and valleys and cushion for uncertainty. Since traditional budgeting is mostly a game of negotiation, they go in high so that when they are negotiated down, the resulting amounts are attainable. This process is repeated over and over both within departments and divisions and across the organization. One manager described this process as “making sausage” — it comes in a tidy wrapper, but it sure is a messy process.

Beyond Budgeting companies coordinate cross-company actions according to prevailing demand rather than relying on annual planning. This begins with a philosophy where teams are seen as suppliers and customers within an internal market. These internal customers have needs and conditions for satisfaction that are needed to meet external customer demands.

Service-level agreements are often used between units to clearly define the services or products being provided. These agreements specify the quality and delivery commitments, as well as the agreed-upon pricing. A key aspect of these agreements is communicating each unit’s responsibility for managing short-term capacity allowing real-time adjustments to respond to customer demand. These agreements allow the organization to understand how quickly its business model can be adjusted.

Controlling Adaptively

Once annual budgets have been set, most performance measurement systems merely compare actual results and compute variances. Explanation of these variances becomes a monthly ritual. Much of what is viewed as management is the perfecting of “elegant excuses” to explain why there are deviations. Jack Welch, former chairman and CEO of General Electric, described this as an “exercise in minimalization.”

The focus is on staying on track. The key driver of this effort is often top management’s commitment to reach the targeted earnings per share. Senior management then translates their external commitment into internal commitments from each division. The divisional management translates the division targets down through each group and department within the division. Everyone locks in to the negotiated targets. If someone falls short, the rest of the organization gets squeezed. If the actual economic and environmental conditions differ, the organization gets squeezed. This traditional budgeting locks managers into an annual performance trap.

To avoid these performance traps, organizations are replacing fixed-budget targets with relative measures. Using relative measures results in the organization continually striving to improve rather than stopping when a certain hurdle is reached. For example, building-product distributor Ahlsell measures sales-branch performance based on return on sales.

Handelsbanken measures its return on equity against other banks in its region with a goal of being in the top quartile. This relative metric is then translated into relative metrics that are meaningful to the components of the organization. For Handelsbanken this means measuring its branch organizations on the cost-to-income ratio.

These relative metrics can be easily displayed in league tables where members of a group, such as a region, can be compared. Each of Handelsbanken’s 10 regions composes a league table. The performance of all branches creates the regional total. Regional performance is also viewed in a league table, which combines to create the bank’s total.

At Ahlsell, branches are split into two leagues. Those that have a return-on-sale of less than the company goal of 13 percent form the qualifiers league. Return-on-sale is the only measure. Those branches performing above 13 percent make up the premier league. This league is judged on both return on sales and profit growth.

Use of relative metrics still allows management by exception — the difference is that exceptions are measured from a relative mark rather than a fixed mark.