Budgeting--an action unnecessary evil: A European idea to drop budgeting altogether is starting to find receptive ears in North America. In this two-part series, we consider what's wrong with the present model and how some are suggesting we fix it.

In a very short period, the budget has gone from playing centre stage in most organizations' control systems to being the subject of considerable criticism--to the extent that some people are calling budgeting "broken," "a thing of the past" or an "unnecessary evil." Moreover, recent surveys corroborate such criticism by reporting a growing dissatisfaction among organizations with their budgeting systems.

The case against traditional budgeting has been systematically investigated and reported upon by a European think tank known as the Beyond Budgeting Roundtable (BBRT)--a program of the Consortium for Advanced Manufacturing International (Europe). They argue that firms today need to be more flexible and responsive to deal with unpredictable change, hyper-competition, and increasingly fickle customers. They argue that this requires more effective strategic management and the replacement of the command and control design of most organizations with the dispersion of more authority to the front line.

The BBRT's movement is gaining momentum. Several European companies including Handelsbanken, Volvo, Ericsson, Boots, SKF, Borealis and Schlumberger have either abandoned budgeting or are in the process of doing so. Moreover, the BBRT now has North American companies in their sights and have started pushing their message to these companies' executives.

This is quite a turn of events for such a cherished practice. It's not the first time the budgeting process has been criticized. But there's a big difference this time. In the past, criticisms were leveled at poor practices within the budgeting tradition. Improvements could be made or problems avoided. The BBRT's message is different: in today's environment, where companies are increasingly adopting new management models, the answer isn't to improve the budget process. Instead, the budget has got to go. It is an unnecessary evil. The clarity and cogency of the BBRT's argument suggests that it deserves serious consideration.

The traditional model

Before tackling the case against traditional budgeting practices, it's important to define the traditional budgeting (and control) model. This is depicted in Figure 1. When one sees all the roles that budgets are asked to play, it's not a stretch to argue that, historically, budgets were the control mechanism in most firms. Thus, dismantling them appears tantamount to abdicating control. Note that the budgeting process operates within the traditional top down (hierarchical) "command and control" model. Decisions, resources, and rewards flow down, while information, often in the form of exceptions, flows back up. The role of line management is simply to operate the established facilities, systems, and personnel according to senior management's rules, regulations and pre-determined targets. Valued rewards then follow from doing so.

The problems with traditional budgets

Budget as a fixed performance contract

Budgets often serve as a commitment or "performance contract" between a subordinate and a superior. Implicitly or explicitly the nature of this contract is that if you make this target, your performance will be deemed satisfactory (or better). As such, subordinates can expect to receive a good performance evaluation and valued organizational rewards (in addition to intrinsic satisfaction from making the target).

However, the use of the fixed performance contract can lead to budgetary gaming, including:

a. Providing lowball estimates for sales and/or building fat into the budget for expenses to make the budget target easier to attain;

b. Spending the entire budget at the end of the budgetary period so as not to lose your "entitlement" when the next budget is set;

c. Undertaking behaviour that leads to attaining the budget at the expense of long-term goals--e.g., reducing discretionary expenses such as advertising, R&D, and employee training;

d. Getting customers to take delivery of goods before the current period expires by offering discounts in order to make the budget.

e. Holding profits back when you know that you aren't going to make the budget (essentially incurring next year's expenses in this year's budget or deferring next year's revenues by getting customers to delay delivery);

f. Holding back profits when you are going to exceed the target so that it'll be easier to make next year's budget.

The problem, as Michael Jensen of the Harvard Business School explains, is that budget targets are negotiated annually and fueled by the use of "kinked" reward structures, which produce cut-offs encouraging such gaming behaviour. In this way, the budgeting system essentially pays people to lie.

The problems with fixed budget targets at the individual level seem to translate to the organizational level as well. The approved budget becomes the basis on which senior management makes commitments to Bay Street. With the penalty for falling to meet the numbers playing out in the newspapers almost every day, and generous incentive compensation to fuel the fire, all too often these ambitious goals lead to corporations "managing" earnings in ways that destroy long term corporate value. And, more recently, as the Enron and Worldcom debacles suggest, it could lead to outright fraud. With senior management providing the lead, the culture is established: make your numbers. The game becomes known and accepted. It's simply how business is done.

Adaptability

A changing business environment can render a fixed budget hopelessly out of date, resulting in coordination problems and/or inefficiencies; moreover, the use of a fixed budget can act as a constraint, decreasing the firm's flexibility and ability to deal with new opportunities, threats or changes in customers' requirements. This situation is perhaps best exemplified by the all-too-often heard phrase, "If it's not in the budget...." The truth of this is clear in statistics from The Hackett Group, which reports that 78% of companies don't change their budgets within the fiscal year.

Strategic Alignment and Focus

Budgets, as financial representations of operational details of the firm's costs and revenues, are not explicitly linked to the long-term implementation of strategy (which often deals with non-financial value drivers). As a consequence, people at lower levels don't know how their work fits in with achieving corporate strategy. Nor are their goals linked to achieving strategy. In addition, companies typically have separate processes for longer term strategic planning and annual budgeting. This can result in the neglect of human and financial resources in the budget to permit discretionary activities designed to accomplish strategic initiatives. Robert Kaplan and David Norton, developers of the balanced scorecard, report that 60% of organizations don't link strategy and budgeting. And the focus and commitment to the budgeting process leaves little time for the discussion of strategy. Kaplan and Norton report that 85% of management teams spend less than one hour per month discussing strategy.

Hierarchy versus process

Budgets inevitably mirror the organizational structure of the firm and thus its focus is on the performance of functions, departments, cost centres and divisions. It results in a focus on managing by the numbers. However, this contrasts sharply with the emphasis companies now place on managing processes as the cornerstone of value creation. Leading-edge companies take a horizontal (with the customer interests in the centre) rather than a vertical (pleasing your boss) view of the enterprise. The TQM era has taught that costs and performance are a consequence of doing some activity/process well or poorly, and that unless you change the process, nothing will permanently change.

The expense

Budgets take around four to five months to complete. They occupy up to 20 to 30% of senior executives' and financial managers' time. One can only ask whether companies are receiving value from the budgeting process commensurate with such significant expenditures.

The conflicting roles of budgets

As Figure 1 illustrates, budgets are asked to play many roles. The problem is that a different type of budget is often required for each of the primary roles.

Motivation

A large body of evidence in the psychological goal-setting literature indicates that setting specific, difficult goals generates higher performance than setting specific moderate or easy goals or "do your best" goals. This has lead to the accounting textbook prescription of setting "challenging, but attainable goals" (less than 50 % chance of success).

Evaluation

A person's motivation can be reduced by the rigid use of a fixed standard to evaluate performance. A manager who is held strictly accountable is likely to lose enthusiasm if faced with continued, large negative variances month after month that are a result of uncontrollable events. Three ways to lessen this concern is for the superior manager to adjust the budget ex post by: i) subjectively evaluating the subordinate, ii) objectively adjusting the budget for known changes to key variables in a pre-determined manner agreed to at the start of the year, or iii) segregating controllable from uncontrollable variances. This approach attempts to measure performance that should be expected given actual exogenous conditions--basically, setting the budget with hindsight.

The problem with this model is that it suggests that the budget is no longer a commitment. Few subordinates will complain if the budget target is lowered in their favour, but it would be a different matter if the bar were raised. Moreover, both the evaluator and the evaluated typically prefer objective to subjective evaluations. The evaluator prefers objective evaluations because no justification for the outcome is required and there is less chance of people claiming that decisions are being made based on favouritism or how good people's explanations are. Subordinates prefer them because they appear equitable. The notion of politics within the budgeting process also shouldn't be overlooked. Surveys indicate that managers believe the budgeting process is influenced more by politics than by strategy.

Planning and coordination

This approach requires the budget to be realistic--i.e., the most likely outcome. Making operating decisions (how much to purchase, how many people to hire), coordinating integration, allocating resources efficiently, and managing cash flow requires management's best estimate of what revenues and costs will be. Large performance variances between actual events and the budget can lead to higher costs. Obtaining a realistic budget may require revising the budget, but this conflicts with the motivational and performance evaluation roles.

In summary, the three major roles of budgets--motivation, planning and coordination, and performance evaluation--require that budgets be set at different levels: challenging but attainable, most likely outcome, and evaluating performance with hindsight, respectively. Unfortunately, there is surprisingly little advice in the literature or textbooks on how to deal with these conflicts.

Empowerment

The underlying theme of the traditional model is one of centralized control. The budget target lays out expectations, and deviations are frowned upon. One of the BBRT's key arguments is that the budgeting process undermines employee empowerment because it reaffirms the model of centralized control and drastically compromises empowerment by limiting lower management levels from acting entrepreneurially.

North American research--the next step

The case against traditional budgeting made by the BBRT is compelling, and its new management model will be the subject of the second part of this two-part series in the April issue of Management.

We believe the budgeting issue requires systematic examination with empirical evidence, especially in a North American context. The underlying culture of North American firms may be considerably different from European firms and, thus, it's by no means certain that the BBRT prescription will work in North America. Moreover, there are examples of extremely successful firms in North America whose budgeting system lies at the heart of their management control system.

Over the next several months, we will be involved in a comprehensive study of the current state of budgeting and control in North American companies, starting with a look at Canada. Our objective is to gain insight into the validity of claims made by the BBRT in the North American context. We will investigate the following broad research questions:

* What is the extent of dissatisfaction with budgeting systems in North American companies? Are companies planning to abandon their budgeting systems or radically modify them? If so, how?

* What role does the budgeting system play in today's organization? How do managers deal with the conflicting roles of budgets?

* If the budget is no longer playing some (or all) of its traditional roles, what processes are organizations using to achieve the roles that budgets traditionally played?

* Are organizations beginning to adopt some of the basic components of the BBRT's empowerment and performance management model? If so, which elements are being adopted and what type of organizations are doing so?

* Are any patterns evident in the control elements of high performance companies or companies that are satisfied with their budgeting systems?

We invite you to visit www.budget-reconsidered.com to find out more about participating in this study. Your participation is extremely valuable in obtaining a representative sample of organizational practices and views in Canada.

Theresa Libby, CA, is an associate professor in the School of Business and Economics, Wilfred Laurier University. Murray Lindsay, CMA, is an associate professor at the Richard Ivey School of Business, University of Western Ontario.