Is it time to replace traditional budgeting?

A method to make a budget more useful to management is proposed. large company, frustrated by years of continual growth in real operating costs (despite severe margin pressures), decided to examine the effectiveness of its budgeting process. It was stunned by its findings:

* Budgeting consumed the better part of the year and involved several hundred staff and line people.

* Budgeting weakened strategic resolve. Staff became preoccupied with budgeting mechanics rather than with strategic issues. Senior management confessed it could not relate budgeted expenses to the strategic plan.

* Participants tended to focus on incremental costs, taking for granted costs embedded in the previous year's budget.

* The budget structure did not reflect changes in the company's organization and processes, and people were budgeting many costs largely under someone else's control.

* Budgets were not credible.

Research done by my consulting firm supports this company's experience. In a study of 10 large energy, transportation and banking companies, we found that, on average, the equivalent of 5% of all staff employees were devoted full-time to budgeting activities.

THE REAL COST OF BUDGETING

For a better idea of the real cost of budget preparation, consider this: At one of those 10 companies, which has a staff-support team of 3,000 employees, 160 employees devote time to some aspect of budgeting. At an average cost of approximately $105,000 per employee, the company s annual cost of budgeting is nearly $17 million--which does not include costs of services supporting the budgeting activity: computer operations, software maintenance and benefits administration for these employees. The full cost of budgeting may exceed $20 million a year.

For that kind of money, budgeting should yield accurate expense forecasts, provide effective support for decision making and control and employ efficient development and reporting processes. In fact, in most cases it fails to do those things.

Conventional budgeting fails to prevent the growth of uncompetitive cost structures in many companies. Evidence for that failure is sweeping corporate America--massive capital restructuring, organizational consolidations and staff cutbacks. This article describes one way to achieve effective resource allocation and control by replacing conventional budgeting processes. The technique is called multidimensional budgeting (MDB), which converts conventional budgets into formats that are more relevant to management. For the purposes of this article, that conversion is called a transformation, in which the data is reformatted into four separate but related budgets: an activity budget, a product budget, a customer budget and a strategic budget.

Properly applied, MDB yields tremendous insights into resource use effectiveness and enables management to align resources with corporate strategies and customer needs. MDB translates into higher profitability and an improved competitive position.

MDB can supplement conventional budgeting with a powerful new set of resource-allocation and decision*support tools. It focuses on the relationships between spending and the underlying value created, rather than on merely how budgeted funds are spent.

The outline for a typical multidimensional budget is illustrated in exhibit 1, page 106. As the reader will see, once the new budget is developed, management can assess resource allocations by working down from the strategic budget to the base conventional budget. At each level, management can test the correct alignment of resources against its priorities, and the budget can be adjusted, as necessary, until an optimal statement is achieved.

FIRST TRANSFORMATION: ACTIVITY BUDGET

The first step is to convert, or transform, the conventional budget into an activity budget, which discloses how much the company spends on specific tasks and the types of resources it devotes to them. An activity budget is created by mapping the line items in the conventional budget to a list of activities (responding to customer complaints, requisitioning new parts, etc.).

Mapping is easiest if costs are first divided into two categories: personnel costs and all others. Costs associated with personnel (including facility and personal computing expenses) should be allocated to activities on the basis of the ways employees actually spend their time.

To allocate personnel costs, the company usually needs to conduct an employee survey-to determine exactly what each person does. This adds a step to the budgeting process, but the survey is always enlightening. Most companies are surprised to learn, for example, how extensively line personnel are involved in such staff activities as budgeting, financial reporting and employee evaluation. Often, two-thirds of the costs associated with these processes are borne outside the departments that administer them. To reduce costs (and budgets) effectively, a company must cut overhead activities along with department manpower. Activity surveys, and the activity budget, address this problem directly.

Nonpersonnel costs such as mainframe computer costs should be allocated to activities after analyzing their cost drivers (activities or factors that generate work and-- by association--cost). [For more on this subject, see "Improving Performance with Cost Drivers," by Frank Collins and Michael L. Werner, JofA, June90, page 131.]

If each mainframe application is tied to a specific activity, costs can be allocated on the basis of the computer time each application consumes. Alternatively, they can be allocated on the basis of the number of report pages generated to support each activity or according to the way people spend their time, as shown in the following example:

Workers using the computer
for processing payables            23
Total workers using the computer   634
% of workers processing payables   3.6%
      x
Computer cost               $1,000,000
Computer costs allocated to
processing payables            $36,000

Once created, the activity budget enables management to look beyond the general ledger and probe the underlying work the organization performs. Questions like the following now can be answered:

* How well do the processes and activities each unit performs conform to its mission?

* Could resources devoted to low-value processes or activities be scaled back or eliminated?

* Can the company reduce costs by reengineering processes or activities?

* Could some activities be performed more effectively or efficiently outside the company?

The insights developed in creating an activity budget also can help improve the accuracy of cost estimates and future budgets, especially for new programs.

SECOND TRANSFORMATION: PRODUCT BUDJET PRODUCT BUDGET

The next step is to create a product budget. This budget holds that each activity adds some value to a product--for an internal or an external customer. More than one activity may be associated with a product.

The relationships between activities and products constitute the mapping procedures-typically called algorithms--for creating a product budget. But first the budget preparers must understand the supplier-customer networks that describe the business.

Business processes-such as product development, manufacturing and order taking-add value directly or indirectly in terms of a delivered product or customer service. Skills training is an example of an indirect business process. Support processes (employee benefits administration and strategic planning) don't add value to products but sustain the organization.

The activity budget then is aligned with products. Mapping of this kind calls for considerable ingenuity because it may not always be easy to identify activities with products. Also, if a logical allocation of some nonpersonnel costs cannot be found in creating the activity budget, an understanding of products and services might provide the necessary insights. For example, in a manufacturing environment, indirect productsupport expenses such as engineering might vary, not by activity, but by product, batch or product line. Therefore, engineering expenses might be allocated using the appropriate cost driver.

Once this mapping is complete, the product budget has been created. Each budgeting entity can review its budget in terms of the accounting line items that form the original master budget as well as in terms of activities and products. The product budget helps address such questions as

* Does the resource allocation to business and support processes make sense?

* Should the manufacture or assembly of certain products or their parts and components be supplied by outsiders?

* How do customer support costs compare with those of peers and competitors?

THIRD TRANSFORMATION: CUSTOMER BUDGET

The third transformation produces a budget showing the total spending proposed for each customer or customer category served by budgeting entities. Products are matched with their internal or external customers. In some cases, fractions of a product may need to be attributed to individual customers or customer categories.

Any residual nonpersonnel costs also should be allocated to an appropriate customer or customer category. For example, certain types of marketing and promotion expenses might be assigned at this point.

The insights provided through this transformation help management ensure that resources are allocated properly with respect to customers' priorities. The latter are usually determined through a customer value survey. Any gaps between customer requirements and current performance then can be corrected.

The customer budget can be used to answer such questions as

* What is the true financial contribution of major customers or business segments?

* Does the proposed spending for each customer or customer category justify the returns it generates?

* What specific actions would reduce the cost of doing business with customer segments while maintaining or enhancing the value provided?

* How attractive is customer retention compared with customer acquisition?

FOURTH TRANSFORMATION: STRATEGY BUDGET

The final transformation re-sorts budget information by major strategy. This is done by describing the strategies associated with each business segment and then matching the strategies with major customers or customer categories. If the company does not have discrete business strategies for its major customer categories, the matching requires multiple steps. For example, enduse market strategies might be matched initially with distribution channels and then mapped from these channels to specific customers (see exhibit 2, page 107).

The process for creating this budget repeats the earlier steps. If a strategy applies to more than one customer or customer category, a description must be assigned to each. All remaining unallocated costs in the master budget--if any--must be assigned to their appropriate strategies.

The strategy budget provides a basis for determining whether proposed expenditures are aligned correctly with corporate, business and supporting strategies. Budgets misaligned with strategic priorities then can be adjusted. Obviously, any adjustments made to the strategy budget need to be carried down through the previous budget conversions. Exhibit 1 depicts this bottom-up development and top-down validation process.

FUTURE PROSPECTS

The most important advantage of multidimensional budgeting is that it offers a better way to direct and control resources. That translates into healthier growth and better operating margins. These benefits are possible because MDB

* Creates an explicit and clear relationship between budgets and the business strategies they fund.

* Permits comparisons of detailed expense information across organizations.

* Provides a powerful framework for measuring customer value, internally and externally.

* Helps a company understand the costs of operating its organization.

* Sets the stage for ongoing performance improvements by presenting managers with detailed budget information in formats that readily lend themselves to comparative analysis and that relate more directly to the logic of management decisions.

* Can be revised to reflect changes in the organization's strategy and structure.

What this adds up to is that multidimensional budgeting systems are a natural complement to computerized executive information systems. The power of such computerized executive information systems, especially when they contain MDB data, is that managers can analyze information from several different angles and ask any number of never-before-asked questions about performance.

As companies break with traditional accounting systems in favor of activity-based costing, MDB is likely to be adopted in some form by a steadily growing number of companies. The database and mapping technologies to create multidimensional budgets are available today, but there are, as yet, no large-scale MDB systems in operation. Once established, however, MDB will require neither more time than conventional budgeting nor major changes to normal accounting or control procedures.

An effective MDB system could be maintained today at a relatively low cost outside of a company's mainframe financial system. To avoid jeopardizing the current general ledger application used for accounting and budgeting, the MDB application could be established separately, either by downloading the general ledger or budget file to a personal computer or workstation or by creating a separate partition in the mainframe system. Today's database technology can provide the necessary support tools.

Whether multidimensional budgeting fulfills its promise will depend on the willingness of management to act on the insights it provides. For lack of such commitment, zero-based budgeting failed in numerous applications. The urgent threat of global competition, capital availability and inflation would seem to create an environment in which MDB can succeed.

EXECUTIVE SUMMARY

* CONVENTIONAL BUDGETING techniques are proving to be wasteful and ineffective. One solution to this is to replace conventional budgeting with a technique called multidimensional budgeting (MDB), which is more relevant to management.

* MDB YIELDS tremendous insights into current resource use effectiveness and enables management to align resources with corporate strategies and customer needs more effectively: That translates into higher profitability and an improved competitive position.

* TRANSFORMING a conventional budget into an MDB requires the following steps:

1. Creating an activity budget, which enables management to look beyond the general ledger and probe the underlying work the organization performs.

2. Creating a product budget, which holds that each activity adds some value to a product--for either an internal or an external customer.

3. Creating a customer budget by matching products with their internal or external customers, which shows the total spending proposed for each customer or customer category served by budgeting entities.

4. Creating a strategy budget, which provides a basis for determining whether proposed expenditures are aligned correctly with corporate, business and supporting strategies.

JEFFREY A. SCHMIDT is a vice-president and a director of Towers Perrin, a management consulting firm, and .region manager of the firm's general management division. He is a member of the committee on corporate development of the University of Chicago Graduate School of Business.