There was a time when “business” was mainly about farming, hunting, and fishing. The four seasons provided a natural rhythm for everybody involved. But today, the reality is starkly different. We long ago moved from an agrarian society to an industrialised one. And now we are in an information age where companies are trying to keep up with how technology is changing business models in industries from oil to banking.
What all these organisations have in common, however, is that they are still squeezing management of very diverse activities into the same fixed period — the calendar year, where everything starts in January and ends in December (or any other fiscal-year period).
The forecasting rhythm in business is a good example. It can be compared to driving a car with a very peculiar use of the headlights.
During long autumn months we have the high beams on, not because it is a dark time of the year but because it is budget and planning time. They light up next year’s budget and shine into the long-term planning horizon.
Then we turn the high beams off and start driving into next year using only the low beams. As we drive on and the quarters pass, the low beams gradually get covered with mud and become weaker and weaker, covering a shorter and shorter distance. But we don’t mind, we can see until year end!
Then we stop and clean (budget time again). This pattern then repeats itself.
Let’s pause and question: Is this the best way to drive in the dark? Why do so many “business cars” use their lights in the same way, even if some travel on well-lit highways (well-established businesses), others on dark and bumpy gravel roads (volatile businesses), and some off-road in the wilderness where no car has driven before (disruptive startups)?
Calendar-driven planning is similarly strange in resource allocation. Imagine a bank telling its customers: “We are only open one month in autumn. If you want to borrow money to buy new machinery or open a new office, you’d better be here in October. We are closed the rest of the year.” It would be madness! But this is very much what a budget process looks like.
Target-setting is another classic example. Why should all targets have a 31 December deadline? We all know why such is the case — the annual pay review. But that is not a good enough reason. Targets must have natural deadlines, driven by the complexity and urgency of what we are targeting.
Most people both recognise and suffer from the problems described above. Fewer see the solution, but there is one.
It starts with understanding that the budget has three different and conflicting purposes:
- Target-setting: What we want to happen. The budget works as a target for production, sales, and profit.
- Forecasting: What we think will happen. The budget shall provide insights into, for instance, next year’s expected cash flows and financial capacity.
- Resource allocation: What it takes to make it happen. The budget hands out bags of money to the organisation, both operating expenditure and capital expenditure.
Three purposes fulfilled in one process and in one set of numbers might seem very effective. But herein also lies the problem: The three do not go well together.
How can an ambitious sales target also represent expected revenues? How unbiased is a cost forecast that is also a line manager’s only shot at getting access to resources for the next year?
These conflicting purposes can only be solved by separating the three into different processes, allowing for different numbers. The separation opens up exciting improvement opportunities within each process and allows each to run on rhythms better suited for their purposes, as shown in the chart below:
Solving the budget conflict
Targets can be set with varying deadlines — shorter or longer. Performance appraisals for learning and development can also be done on more natural points in time, for instance after the finalisation of a major project. This does not prevent us from running an annual appraisal for reward purposes, if needed. To perform an appraisal, a manager can review targets delivered months ago, those just before the appraisal, and those still in progress.
The forecasting rhythm can be made either rolling or dynamic. A rolling forecast is typically updated every quarter, and it usually looks five quarters ahead. In a dynamic forecasting process, local units update their forecasts when something happens in their own business environment that, in their opinion, justifies a forecast update.
There is no predefined forecasting horizon; the process merges short- and long-term forecasting. If someone further up in the organisation needs data further out than what the numbers in the forecast provide, those asking should “fill the hole” by making a generic forecast based on their business knowledge.
Business units should not be forced to forecast further out than what they need to manage their own business. Upper management should be able to tap into these numbers at any time, ahead of communication with the market, or to check financial capacity ahead of major investments. But dynamic forecasting has higher system requirements, as a common forecasting database is needed.
Resource allocation should also be dynamic. For projects, this means “the bank is always open”. Business teams can always forward projects for approval, at any time. How high up one needs to go is regulated by a mandate structure, which needs to be loose enough to avoid too many decisions going up the chain of command. A yes or no to a project depends on two things:
1. How good is the project (strategically, financially, nonfinancially)?
2. Do we have the capacity (financially, organisationally — as things look today)?
Dynamic forecasting is used to monitor whether new commitments are within current financial constraints — which is also a dynamic picture.
Managing operating cost without a budget is more challenging, but it is absolutely possible. Here, there are fewer big and distinct decision points, so we need other mechanisms. These include alternatives like:
- “Burn rate” guidance: Operate with full autonomy within this approximate activity level;
- Unit cost targets: You can spend more if you produce more;
- Benchmarked targets: For example, unit cost below average of peers;
- Profit targets: Spend so that you maximise your bottom line; or
- No target at all: We’ll monitor cost trends and intervene only if necessary.
What is described above is drawn from the Beyond Budgeting model and its 12 principles. Separating the budget purposes and improving each one must be part of any agile transformation journey.
— Bjarte Bogsnes is active in the Beyond Budgeting movement and heads the implementation of Beyond Budgeting at Equinor (formerly Statoil), Scandinavia’s largest company. He is the author of Implementing Beyond Budgeting: Unlocking the Performance Potential. To comment on this article or to suggest an idea for another article, contact Alexis See Tho, an FM magazine associate editor, at Alexis.SeeTho@aicpa-cima.com.