Even without the disruption of COVID-19, budgeting and forecasting for the year ahead are challenging tasks requiring months of back-and-forth negotiations between departments and senior management. Prabhu Sivabalan, professor of accounting at the UTS Business School in Sydney, who has spent years researching budgeting, talks about the problem with using budgets for performance evaluation and suggests quick wins to improve budgeting this planning season.
What you’ll learn from this episode:
- A brief history of modern budgeting.
- Why more than 90% of organisations continue to use traditional annual budgeting approaches.
- The problem with using budgets for performance evaluation.
- How rolling budgets and reforecasting can help in high-uncertainty environments.
- Zero-based budgeting and other budgeting philosophies demystified.
- Small steps to improve the budgeting process.
Play the episode below or read the edited transcript:
To comment on this episode or to suggest an idea for another podcast episode, contact Alexis See Tho, an FM magazine associate editor, at Alexis.SeeTho@aicpa-cima.com.
Alexis See Tho: Even before COVID-19, there has been a general sense amongst some accountants and finance professionals that the traditional way of budgeting — where teams sit down a few months before the start of a fiscal year to plan and decide on what to earn and what to spend the following year — doesn't seem to work. For one, it's difficult to predict what will happen next year, and even more so with the current pandemic, and most budget assumptions end up quite different from reality.
So should organisations rethink the way budgets are done, especially for 2021 when there’s still risk of subsequent waves of (COVID-19) infection?
Joining me for today's discussion is Prabhu Sivabalan, professor of accounting and an associate dean of external engagement at the UTS Business School in Sydney. And here's our conversation.
You've done quite [a lot] of research on budgeting and forecasting. You even told me that budgeting is your passion. Before we get into the details of today's budgeting landscape, if I can call it that, can you share a brief history of how we got to where we are today?
Prabhu Sivabalan: That is an excellent question for us to begin our discussion today. Budgeting was invented really at the coalface of its practice, you know, in organisations. Many would say the idea of financially planning for the future — if you are to broaden the idea of what a budget is, a future financial conceptualisation — budgeting really is a timeless activity that's been around as long as currency has existed.
But it's more traditional form as you and I know it today. The origins of budgeting can probably be traced back to the early 20th century, sort of the 1920s, the 1910s, where through industrialisation, we had the growth of the modern mega corporation
And as companies got bigger and bigger, folks like the DuPonts in Europe and the Sloans — who at the time really were the Warren Buffetts and Bill Gateses, the Mark Zuckerbergs of today — needed a way to manage all this money that was coming their way and to ensure that it was spent effectively.
From the coalface of that problem, to solve that issue they had, they created a system where they demarcated organisations into business units [and] departments as we know it now. They gave each department a dollar figure to spend and asked them to stick to it.
The document that compared, that identified how much they had to spend, and the comparison made at the end of the year, these weren’t things they read from a textbook, but they figured out. And I think that's one of the reasons why budgets continue to exist till today.
We continue to grapple with this idea of “how much money do I have”, “how much can I spend”, “what if something goes wrong [and] what do I do”, [type of] scenario analysis. If the world changes, how do I change my numbers to stay relevant?
I've got to say, that doesn't mean these instruments are perfect. A budget is by no means perfect, and you'd be hard pressed finding someone who is excited about going to work on Monday because budget season is starting. Budgets don't elicit enthusiasm for many.
But budgets, a very important financial instrument to help you manage that financial uncertainty you have, to help you coordinate resources so different parts of your business know how much they have to spend. For that reason. I think budgets continue to be relevant.
Studies coming out of Europe in the early 2000s, out of North America around 2009 or 2010, and a more recent study we're doing around budgeting in Australia and in the UK, a collaboration between UTS and the Saïd business school in Oxford, the data from all these studies show that the traditional annual budget continues to be used by well over 90% of surveyed organisations.
So I would say the origins of budgets explain why budgeting continues to be relevant today. The problems haven't changed. They'll never change. And the financial instruments we need to tackle them, similarly, won’t change substantively.
See Tho: So companies use budgets to do quite a number of things — to set targets, to forecast what will happen next year, to allocate resources. And on top of all those, a budget is also used to decide whether a staff did a good job and deserves a bonus or salary increment. You've said that there's an inherent weakness in using budgets that way. Could you share a bit on that?
Sivabalan: When a budget is used for performance evaluation, effectively, we are asking a manager, “What do you think the number should be? I’m trusting you to tell me the truth. And by the way, if you beat it, you'll get a bonus.”
If I were to ask my students in university, “What should your pass mark be? I trust you. Should it be 50?” Do you think they’ll say 75? You know, really push them, so they’ll really do well? Or might they say 40? Not because they want to be lazy, but they worry that they might not get 50 but still understand the content. And they might have a bad day and get 40, when really, they know it and it's ridiculous that they have to come back and do the subject again.
Staff may have very authentic reasons for arguing for a lower budget number. And we too simplistically critique this whole “when I budget to evaluate, I encourage a staff to lowball numbers”. Your staff might lowball numbers, but they might lowball numbers for very authentic reasons. The world's uncertain, they're not sure, they can't make promises they can't keep. It's not because they want to fleece the company for more money, though that may be a related outcome.
The bottom line, whatever the intentions of staff — good or otherwise — the bottom line is that when you use a budget to evaluate someone personally, then you link that person's salary or bonus to the budget’s performance, you are asking for that budget number to be gamed by that same individual. So, you might say, well, that's nice. But how do you solve that problem? How do you give someone a budget, get them motivated to achieve the budget, but not link it to their salary?
There's been a lot of thinking of this, and there are many ways you can do this. One is, don't just make it just about the budget. So don't just link someone's budget to their salary. Make the bonus and amalgamation of a number of things. Budget adherence, beating the budget being one of them. That's one. So you minimise the extent to which they worry and stress and therefore are more likely to game a budget.
The second thing is when you pick the other things to KPI someone with, to give them targets that link to their bonuses, pick other things that basically negatively drive their inclination to game.
So, for example, if you think someone might game a budget by trying to make quick sales that might upset customers in the long run but allow someone to beat a target today, this year, you might have a corresponding nonfinancial metric that relates to customer satisfaction. You have another metric that guards against the risk of the physical behaviours that are undesirable, that are driven by the budget number being used as a target.
The second, which is a bit more radical, is to not evaluate people on budgets, but just those other metrics. I think that's it's not a bad idea. I think it takes a bold organisation to do that. It has worked in the past. You do find though that that does not work as well for many companies because they just don't want to get out of a comfort zone and not use a budget as a target.
The third device, and this I think is an extremely sensible alternative, is to think about how the budget might be used more innovatively in its use as a bonus device. So, you might, for example, link bonuses to longer-term horizons. So, you might say, “You'll get 40% of your bonus this year, and the other 30% next year. The final 30% the year after if your performance persists”.
So there are lots of ways you can use a budget to evaluate someone and still have people being more authentic with the budget process.
See Tho: If we zoom into our current COVID-19 environment and the difficulty in predicting what will happen next year, how should companies in budgeting and planning season now be rethinking their approach?
Sivabalan: The first thing I'd say is that when in times of crisis or high uncertainty, the more you're uncertain as to what your future numbers will be — cash inflows or cash outflows — the more you need to think about not hanging your hat on one set of budget numbers.
If I'm in an organisation that traditionally has a budget process at the start of the year, [where] I come up with a set of numbers and we all agree [that] these are the numbers, and I hold my departments accountable for the rest of the year, the rest of the remaining 12 months on those numbers, I'm going to have problems. Because those numbers in a highly uncertain environment, for better or worse, are going to become irrelevant very quickly.
Now this is not surprising. You don't need a professor with a Ph.D. in budgeting to tell you this. It's quite self-evident. But then the question becomes: so then, what do you? Well, what you do is, you have two options. You either continually update the budget as you realise the numbers become irrelevant because something's happened out there in practice. The moment that happens, you update your numbers. So the budget remains relevant.
Of course, we know rolling budgets, rolling forecasts, they have this very ethos. So if you have monthly rolling budgets over a 12-month horizon or 18-month horizon, you will every month, update your budgets for the next 12 months or 18 months depending on your horizon. But you're updating that every month.
So in a highly uncertain environment like we have now with the pandemic, your budgets will be updated frequently. As a treasurer of a board of a medium-size organisation, I often get updates to our budgets; updated monthly numbers on a monthly basis this year, that is purely driven by the pandemic.
The other thing you might think about is to do reforecasts. So, reforecasts aren’t like rolling budgets. With rolling budgets, you do it periodically — monthly, quarterly, etc. Reforecasts are when you either discretionarily or on demand change your budget numbers based on a shock. Perhaps, companies might have reforecasted when the pandemic first hit us. And then when the government announced in Australia that JobKeeper would be scaled back post-September but continued beyond September, companies reforecasted again, because the fundamental rules driving cash inflows for them would have changed. So, you change when something happens and you update your numbers on demand, not periodically.
See Tho: What are alternatives to traditional incremental budgeting? So I’m thinking about zero-based budgeting and Beyond Budgeting that some of our listeners might be familiar with.
Sivabalan: You know, it's an excellent question. When a lot of companies budget today — and I do apologise if the listeners on this podcast don't have this experience, but from my experience talking to companies, for a lot of companies out there — most of their numbers budgeted are effectively a prior year number plus some sort of estimated inflation rate, some sort of growth factor that leads to this year's numbers. And that's fine. It's often relevant and accurate enough and it does the job.
That type of budgeting is what we'd call incremental budgeting. You're predicting a future budget number by thinking about a prior budget number that there, already created, and adjusting it to get your future budget number.
It's especially fine and more than fine if you're in a low-uncertainty environment. In a high-uncertainty environment incremental budgeting can work sometimes, but generally won't work if your objective is to try and get a set of numbers that you think will reflect what's going to happen in the future.
So, enter zero-based budgeting. What's zero-based budgeting? I kind of always chuckle to myself. You know, there are folks out there I'm sure who live budgets every day and know about budgets and might agree with me; zero-based budgeting garnered some real energy and traction more recently, when consulting firm started to pick up on this term and make it a thing. “Don't do budgeting, do zero-based budgeting.” What’s zero-based budgeting? Zero-based budgeting is what budgeting was always meant to be and what budgeting was when we first did budgeting in the 1920s and 1930s and I dare say up to probably the 1960s and 1970s.
We didn't just take last year's numbers and add in any inflation. We thought about what was going to happen before putting a number over what we thought would happen. We didn't just take a series of financial numbers and add in inflation. So, zero-based budgeting is how budgeting was always meant to be done. And if you talk to most budgeting academics, they'll tell you the same.
But zero-based budgeting takes a lot of work, because you're thinking about everything from scratch. And because it's a lot of work we started to try to think smart about how we budget the future period. And that’s how we’ve moved away from zero-based budgeting, to the point where most firms now do incremental budgeting.
But if you really think about what — in a perfect world — would you do. Yeah, you would forget all your prior numbers, especially if you're in an uncertain environment where the past does not proxy the future. You would think your best chance at getting the future right would be to just think from scratch, not being burdened by the past, [to] think from scratch now and into the future; what's going to happen, why do I think it's going to happen. OK, that's going to happen; what will it cost?
If you do that at every layer of your operations from granular to macro, and you then come up with numbers, that's zero-based budgeting. In more uncertain environments, it gets you more accuracy. So then you might ask what's Beyond Budgeting?
We've talked about incremental. We talked about zero. What's Beyond Budgeting? There are different schools of thought. There was a nice piece in 2003 in the Journal of Management Accounting Research, which comes out of the US, that talked about how there were two different Beyond Budgeting worlds:
The European Beyond Budgeting world, where Beyond Budgeting was getting rid of the traditional annual budget and coming up with a whole new system focusing on fluid benchmarks with relative performance evaluation, not target-based aggregate performance evaluation.
And North America, where Beyond Budgeting was a more activity-based form of budgeting; you think about activities [and] you don't think about departments. You think about activities and whatever an activity costs you budget that and you cost that into your budget. In that way, you minimise gaming, you get better budgets, etc.
Beyond Budgeting in principle is moving away from the traditional annual budget and focusing instead on more up-to-date technologies around forecasting for your future. We don't want every year to spend three months in ten days, as I said before, preparing this annual budget and throwing it out the door when it becomes less relevant. We just focus on key numbers and we evaluate stuff relatively.
We don't give you a bonus because you beat your target. We give you a bonus if you're in the top 10% of sales people. You are judged relatively. In a good year, you need an amazing number to be in the top 10%. In a bad year, you can do OK and still be in the top 10%. It's relative. The fact that you beat your peers means you're good. You don't need a budget number anymore.
Now, part of the problem with Beyond Budgeting was, sorry, not the problem with the Beyond Budgeting, it's a fine idea. But the reason why Beyond Budgeting, arguably, didn't get as much traction, [and] this is my personal view, is because Beyond Budgeting in its traditional form — I do have colleagues in academia, who would agree with me on this and some in practice — required you to get rid of the annual budget.
If you look at the work of Hope and Fraser, who invented Beyond Budgeting [and] Jan Wallander, the CEO of Svenska Handelsbanken in the late ’90s, who claim to have got rid of budgets and made Svenska the most profitable bank in Europe by costs-to-income ratio, these guys all swore by the hardcore, traditional Beyond Budgeting; getting rid of the annual budget and coming up with this new system.
That was a bridge too far for a lot of organisations. If you're a successful organisation and you're doing CEO interviews or CFO interviews for the next CFO, [if] that CFO comes in and says, “I'm going to get rid of your budget. But don't worry, I'll put something else in that will be fine”.
If you're on the board or the selection panel, I dare say, you're getting a little nervous. We're doing OK, we're hitting our return on equities (ROEs), we’re hitting our targets, we don't need to get rid of our budget. By all means, get a bit clever and try some new things. But, no, you can't get rid of a budget. To the credit of the Beyond Budgeting movement, if you were to speak to members of the Beyond Budgeting Roundtable today, you'll see that Beyond Budgeting today is not what Beyond Budgeting was thought of as being many years ago when it started.
Beyond Budgeting today is a very, very wonderful idea. It's a more flexible type of budgeting. It allows for the traditional annual budget. They say exactly what we've talked about today, which is move away from using a budget to evaluate people; use more nonfinancial KPIs and targets and clever benchmarking; use relative evaluation; and think about the budget more flexibly. Adjust if you have to.
That is the modern day Beyond Budgeting, and that thinking today is very different to the way Beyond Budgeting was expressed very early on, which is what a lot of people hang on to when they talk about it. But even Beyond Budgeting people have gone past that.
See Tho: I reckon to overhaul the way budgets are done, would require an organisation's senior leadership to put down a foot and say, “We need to do this differently”. For management accountants in companies that are still adhering to traditional approaches, what are small steps they can take to improve the way budgets are done?
Sivabalan: Sure. So, there are some very simple process improvements, some quick wins that folks out there doing it at the moment can try in order to improve the budgeting process. The first is, if you can, introduce transparency into the budget process. Often what happens in the budget process is you have these business unit managers being asked to submit a budget. They submit it not knowing what the others are asking for and all these business unit budgets go up to some sort of budget committee or some decision-making group that then have to make a call on how much each division should get.
It's very hard for a committee to make that call. And inevitably, the total sum of budget numbers asked for will probably exceed what the committee has to give. Because folks at the business unit level, at the departmental level, are worried that they will not get what they asked for. So typically, they’ll ask for a bit more.
Now if that happens, what we end up doing is, we have a committee that does not have the tools or the knowledge, to figure out who's asking for how much more and how much should I really cut from each one. They don't know that. So when they don't know how much should be cut, what do they do? They cut equally for everyone.
But when you cut equally for everyone, what you're doing is incentivising dishonesty. They’ll ask for a lot more and they'll remember that next year, so it will just get worse, and you disincentivise and penalise honesty.
So the first thing I would do is, I will, as a simple measure, if I sit on a budget committee, I would create a disincentive for overperforming and underperforming. So, by all means, reward somebody if they beat the budget. But there will be a mitigation or a ceiling. So, if you go beyond this, you don't get any more. So there's no benefit personally for anyone to gain beyond a certain point, if assuming they're even going to do that. That's the first point.
And the second is, I'd create a structure where bonuses are not just based on budgets, but a whole bunch of other things as well as we've touched on before.
The third thing is, I would as a business unit manager, sit down with my manager, the person on the budget committee, or the person who is going to determine my budget, and say very straight, very clearly, in very, very open and straight way, I would say that this is the budget number I think will happen, but I'm not sure.
If these things happen, the budget number will go big. If these things happen, it'll go down, or go small. I'm not sure what's going to happen. So, I've made this particular assumption, and these are the numbers I agree on. I just want you to be aware that these are my assumptions. So, if we don't beat the budget because we have underperformed based on these assumptions, I will accept whatever comes my way. If we do better, I’ll equally accept — very favourably — what comes my way. But if all these other things happen, then I want it known from the planning stage that these are uncontrollables that would have adjusted the budget. And that is what I would say.
Now, a lot of us, listening to this podcast would say, “Look, that's a nice idea, but that's not going to change the bonus”. It may not, and that's a longer journey. But you want to have that conversation with your boss at the start of the year where you say, remember, I told you — you'd obviously say more polite than that — but you'd say, you remember I told you this would happen.
At the end of the year, even if you're not going to get your bonus, you're not going to get your bonus anyway. But by virtue of having that conversation at the start, at the end of the year, you have a stronger leg to stand on where you can tell your manager “remember, I said this was a possibility. And I want you to know that I have delivered”.
Doing that will only increase your likelihood of getting a favourable outcome. [In a] best-case scenario, you get that bonus, if it’s worst-case scenario, you don't get the bonus you weren't going to get any way. So right now in budget planning stage, I would encourage all my management accounting friends out there listening to this podcast, to arrange meetings with your supervisor and have those frank conversations.
The other huge benefit, multi-period benefit, is that when you this year, tell them “remember, I told you the budget would be this and this happened and it wasn't, and that was uncontrollable”. Next year when you go forward and you say, “I think the budget number will be this”, they will be more likely to believe you because you’ve built reputation capital. You built a sense of respect with them. And when you say something, they know they can trust you. And even if the budget is wrong, it's not wrong because you gamed. It's wrong because of the reasons you had flagged that might cause it to be wrong. And that gets you a huge amount of kudos and respect institutionally in your organisation, which can only help you as a management accountant, whether it's the budgeting process, whether it's promotion [and] leadership opportunities.
By going through the budgeting process authentically, you can create your own brand as a leader in your organisation. And I want to, I really want to stress this point. This is extremely important.
Management accountants out there forget the power of management accounting in an organisation. And budgeting is at the pointy end of this. When you have a good management accountant, a good budgeting person, that person naturally has to understand the business, has to be able to translate financial to operational and to be able to construct narratives to make sense of what's going on in their organisation.
When you do it properly and people respect you for it, it doesn't just mean your job is easy. It means that you get recognised and you get seen as a leader. And that only happens when you take budgeting seriously enough to want to be honest and upfront and open to people about what you worry about and come up with systems to tackle it.
So I really want to stress, don't think about management accounting is just being a technique that gets you your paycheque today. That it's your accounting and you get your salary. Think of management accounting as a tool to help you exhibit your leadership, your integrity, your skillset that will only advance you in your career. That is an extremely important idea that I impart to all folks that I come across, from my executive MBA students to first-year undergraduates, to executives I speak with.
It's amazing how many people, even within accounting, undersell what it is they're doing and the value of it. They talk about it and they say it's important, and we go to conferences and bang on about how great it is. But day-to-day in their organisation, they don't walk the walk. They go back to the mode of “Oh I’m just number crunching”. Don't do that. Don't sell yourself short.
See Tho: Well, Prabhu, thank you for being on this podcast.
Sivabalan: Thank you, Alexis. It was a pleasure to be a part of the discussion.