Many organisations approach corporate budgeting with a “going through the motions” mindset, and end up with a budget that meets the needs of no one other than those charged with preparing it. Budgets of this nature are subsequently used as meaningless benchmarks against virtually everything, and are as useless for planning as they were expensive to produce. The function they perform most effectively is as instruments of torture for the rest of the organisation.
Corporate budgeting is not supposed to be an agonising annual routine. It's supposed to be a central component of a coordinated planning process. A budget that has no link to planning processes will have no meaningful objective, and possibly no objective at all. If you encounter someone unfortunate enough to be producing a budget under these circumstances and ask them why they are bothering, the answer will probably fall along the lines of "because we always do". I can't fault this answer. It’s absolutely correct.
In many ways, the corporate budget has become a victim of its own success. Few would dispute that it adds value, and virtually every finance department incorporates budget preparation into its annual routine. But routine can create a sense of drudgery, and a sense of drudgery can cause people to lose sight of the reasons for preparing a budget in the first place. An organisation that allows this to happen is unlikely to realise the potential benefits of budgeting, and may end up with a budget pulls it in a direction other than the one it wants to go. The purpose of this article is to list the advantages to be gained from a well-organised budget, and to warn of the risks that come with a disorganised one.
The Benefits of Budgeting
A budget sets goals and prioritises them to align with strategic objectives. A budget advances understanding between people in different parts of the organisation and promotes cooperation. A well-executed budget can identify opportunities, minimize inefficiencies and identify risks. In short, a budget is the financial part of an organisation’s plans.
When a budget process has a clear and well-defined purpose, the budget it produces will build confidence by demonstrating that a well organised plan is in place. Nonetheless, too many organisations don’t set explicit budget objectives, and the aimless process that follows ends up being dominated by the needs of the Finance Department. These may be as narrow as getting the budget submitted for approval, and using it as the basis for variance analysis. As far as objectives go, those two aren't very strategic.
A budget produced in these circumstance can be toxic. It can cause acrimony and confusion, and thus lead the firm away from its strategic objectives instead of towards them. Following are some of the ways this can happen.
One of the tell-tale signs of a disorganised budget process is a preoccupation with the profit and loss statement, with the role of the other financial statements relegated to secondary status and tacked on as an afterthought. In these cases, the cash flow and balance sheet tend to be inconsistent or nonsensical to such a degree that they may as well not exist, which they sometimes don’t. Hence the firm’s financial planning efforts revolve around the P&L, which provides only a partial and short-term view of financial performance.
The balance sheet is where the impacts of all other planning inputs collide, and where any inconsistency between capital, labour, revenue and operational planning will appear to the trained eye as an anomaly. The balance sheet also combines with the P&L to solve the cash flow. In fact, instead of writing this article about why a budget process must have a clear set of objectives, I could just as well have explained why your budget outputs must include a balance sheet and cash flow, and why you should pay close attention to them.
I shall never understand how a firm’s anticipated cash flow and financial position end up being relegated to an afterthought, but I see it all the time. Such budgets set the firm on an erratic path to a destination that can’t be reached, and one you wouldn’t want to arrive at if you could. Planning in these circumstances is like setting out on a road trip to an unknown (possibly fictitious) location, and only consulting a road map for the first hundred metres.
The Materiality Mind-Trick
A budget that doesn’t give due consideration to aligning the segments that comprise the organisation will be prone to the “materiality” trap, whereby attention is focused on the organisation as a whole and little regard is given to the parts that make it up. A corporate budget caught in the materiality trap will have paid insufficient attention to any lower level detail deemed “immaterial”. This is a mind-trick used to justify shortcuts, and will lead only to inaccuracy and omission.
“Materiality” is a concept used in statutory accounting and auditing to determine whether an omission or misstatement in a financial statement is likely to influence the decisions of a person reading it. The materiality concept allows for a very high margin of error and is not suitable for managing a business. A budget may be free of material misstatement, and yet lack the controls and precision necessary to guide an organisation towards its goals. But I’m not saying we need to get pernickety about insignificant details, because insignificant does not mean the same thing as immaterial. An error that is insignificant can be ignored. But an error that is immaterial can be disregarded only in a particular set of (high level) circumstances. For planning purposes, materiality is not a thing.
A budget that has fallen victim to the materiality trap might seem comprehensible at the highest levels, but won’t make sense to the parts of the business that are expected to execute it. The managers who are accountable to the budget will soon realise that it’s easier to discredit it than to meet its performance targets. And once they’ve discredited the budget (which will be easy to do) there will be no targets, and probably not much performance either.
Budgets are not Forecasts. Seriously ... they're not.
In the absence of clearly defined objectives, a budget might be inappropriately used as a predictive tool. In fact, many a so-called “rolling-forecast” is nothing more than the YTD actuals plus the budget for the rest of the year. I’ve written in a previous article that budgets and forecasts are entirely different animals and need to stay well out of each other’s way, but if we don’t state our budget objectives up front, who’s to know if the thing we are working on is aimed at target setting or predictive accuracy, especially if the organisational culture doesn’t appreciate the difference?
Without objectives, we can’t have a clear and unambiguous intention for what we are going to use the budget for, and it can end up becoming a meaningless benchmark for everything. The ensuing comparisons often degenerate into investigations into how the budgeted number was arrived at. But is the performance of the whatever-it-is we are trying to measure up to scratch? Who knows?
Corporate Budgeting has many potential benefits. Nevertheless, each year many firms embark on time-consuming and expensive budgeting processes without setting clear objectives. Budgets that result from these processes tend to lead the organisation away from its objectives rather than towards them. Carefully planned and well organised budgets set targets and let people know what is to be expected of them. Budgets facilitate organisational alignment and set priorities in the use of the firm’s resources. They identify opportunities and risks, and provide effective internal control mechanisms. Maximising the benefits of budgeting should be primary goal of every budget cycle.