The budgeting process enables a company to determine next year’s:
Financial targets, including revenue, margin, profit, cash flow, and debt levels.
Operating targets and key performance indicators, including inventory turns, product and service quality, supplier effectiveness, sales closing rate, and customer satisfaction.
Developing financial targets is critical to a well-designed annual operating strategy and performance incentive framework. A strong budgeting process also provides a direct link to the organization’s overall strategy, management buy-in on strategic goals, and the identification of the assumptions that drive the budget.
Static budgeting limits your options
In an ideal world, companies that use successful budget processes can reap the benefits of good budgeting. In reality, few companies do. Many companies do not realize all the benefits of good budgeting because they consider their budgeting season a one-time event. These companies do not reopen their budgets until the following budget season.
By following a static budgeting process, you lose two major opportunities. You are unable to reassess budgeting assumptions and to adjust operating and compensation strategies in response to changing business conditions.
You can’t revise your assumptions
When creating a static budget, management essentially makes its best educated guess about next year’s performance. The prediction is based on certain assumptions. As economic, market, competitive, and operating events unfold, the assumptions prove to be either right, wrong, or somewhere in between.
Sometimes management’s assumptions totally miss the mark, leaving the organization vulnerable to risk. As a result, the original operating budget might look like a very poor educated guess by Month 4.
You can’t adjust your strategies
If you base your budget on incorrect assumptions, your operating strategies might be addressing targets that should now be of lower priority. Your company might also need to adjust its compensation strategy. If the company will not meet its key performance targets, low employee morale might occur when employees anticipate that they might receive reduced variable pay at the end of the period.
Static budgeting in action
To see how static budgeting holds a company back, consider the example of a small regional retailer of high-end apparel.
Company’s objectives The company developed a plan that focused on three objectives: annual revenue growth of 20%, customer satisfaction of 99.99%, and maintaining its premium brand image. The company considered earnings an important afterthought, based on the company’s previously high margins relative to its peers and the strong economy.
Management set the annual operating budget and strategy with these three high-level objectives in mind. An annual bonus plan drove compensation and tied employees to the objectives (33.3% for each target).
Changing economic conditions As the year progressed, economic conditions unexpectedly began to sour. As a result, the customer base began shifting to discounters, reducing revenue. By midyear, employees lost faith in the annual budget and feared that they wouldn’t receive their bonuses.
Company’s response to decreasing revenue To combat decreasing revenue (and to help meet bonus targets), management promoted certain products. However, the company did not substantially lower prices in order to protect the store’s premium image, which a brand consultant measured quarterly. To ensure strong customer satisfaction (also measured quarterly by a consultant), the company continued its lenient return policy.
End-of-year results Not surprisingly, operating results quickly deteriorated. By the end of the fiscal year, the company had an enormous loss. Even so, many employees received partial bonuses for meeting customer satisfaction and brand perception targets. Because of aggressive discounting, the company achieved a portion of its revenue target, causing incentive payouts despite the company’s large operating loss. After the year was over, management laid off 10% of the workforce in an attempt to cut costs.
Analyzing the company’s situation Why did this company pay bonuses despite a poor operating year that resulted in huge losses? Was the original plan and operating strategy flawed? Though it’s highly simplified, this case illustrates how a static budgeting process can weigh down a company. The section “Integrated budgeting in action” addresses how this company could have adjusted its strategy midstream if it had a more flexible budgeting process.
What is integrated budgeting?
Integrated budgeting is a flexible budgeting framework that integrates forecasting within the budgeting process. By using integrated budgeting, you can respond to changing business conditions throughout the year and avoid the pitfalls of a static budgeting process. Integrated budgeting consists of five elements.
Classification of performance targets Management needs to prioritize financial and operating targets. The company should treat primary targets as relatively immovable during the fiscal year, regardless of changing business conditions. Secondary targets can be modified, exchanged, or even eliminated in order to support primary targets.
Operating reviews Operating reviews are the heart of integrated budgeting. Conducted on a quarterly basis, operating reviews provide the key stakeholders in the budget process with a forum to assess results and realign targets, strategies, and compensation.
Budget reforecasting Integrated budgeting relies on reforecasting that uses the rolling budget and forecast to assess operating results. Stakeholders can use the rolling budget and forecast to see the variances from the budget targets to actual results and to analyze the causes of any variances. This tool also provides the workspace where you can conduct a “look-ahead forecast” to analyze the effects of changing certain assumptions or targets for the remainder of the fiscal year.
Realigned operating strategy After you develop a look-ahead forecast, management should reevaluate operating strategy to focus on meeting new objectives.
Realigned compensation The critical missing link in aligning strategy to performance is often compensation. If the organization bases management and employee compensation at least partly on enterprise or business unit performance, performance goals should be reset after the operating review.
To avoid renegotiating compensation targets, management should change compensation targets selectively. In general, if the organization is not meeting key performance targets, management must stick to these targets and allow flexibility only for top performers.
Integrated budgeting in action
To see how a company can benefit from using integrated budgeting, consider again the example of the small regional retailer of high-end apparel discussed in the “Static budgeting in action” section. What would management have done if they used a robust and flexible budgeting process rather than a static budgeting process?
The five integrated budgeting elements provide a structure for comparing what the company did using a static budgeting process with what they could have done if they used an integrated budgeting process.
Classification of performance targets
Static budgeting The company’s original priorities were aggressive revenue, customer satisfaction, and a strong brand image. Though they are worthy, these goals required tradeoffs that resulted in poor operating performance. Management needed to decide which of these goals were primary and secondary so that the company could make midstream adjustments.
Integrated budgeting At the beginning of the year, the retailer could have classified brand image and customer satisfaction as primary goals and revenue growth as a secondary goal.
Operating reviews
Static budgeting Management continually adjusted operating strategies by implementing new promotions at the local level without considering all of the causes of the revenue shortfall. Management also did not focus on remedial actions that it could have taken in response to the revenue shortfall.
Integrated budgeting The retailer could have conducted operating reviews on a quarterly basis. During the Quarter 1 review, after assessing the economic situation, management could have upgraded operating income to a secondary goal that had a higher priority than that of revenue growth.
Budget reforecasting
Static budgeting Despite the dramatic change in business conditions, the retailer did not formally adjust targets in response. The static budget became a relic, as opposed to being a key management tool.
Integrated budgeting The retailer could have used a rolling budget and forecast to determine the causes of key variances. Obvious causes were the economy and competitors that were stealing business with copycat apparel lines. Management could have revised the look-forward forecast to reflect a weaker economy. To spur revenue growth, management could have developed several new marketing strategies that did not compromise brand image or customer satisfaction.
Realigning operating strategy
Static budgeting Management did not comprehensively adapt its operating strategy to respond to changing business conditions. The retailer implemented program strategies locally, focusing on achieving secondary targets at a high cost.
Integrated budgeting The retailer could have implemented new competitive and marketing strategies based on the operating review reforecast. After evaluating the reforecasted budget, management could have cut costs by reducing the workforce by 2%, cutting the bottom 2% of performers.
Realigning compensation
Static budgeting Because the company used a static compensation plan, employees focused on meeting targets that were not in the company’s best interest.
Integrated budgeting For the last three quarters, the company could have modified compensation by using a “60/40 plan” with compensation based on the following: 30% on customer satisfaction, 30% on brand image, 20% on operating income, and 20% on revenue growth. Quarter 1 bonuses could have been paid under the old plan to eliminate renegotiating. Management could give a select group of high achievers (the top 10%) concessions to ensure continued motivation.
Benefits of integrated budgeting
By using the integrated budgeting approach, the apparel retailer could gain many benefits.
Focus Instead of chasing multiple and often conflicting performance targets, the retailer would have had the flexibility to refocus on the core targets (brand image and customer satisfaction) that were achievable during the economic downturn. Management would have been able to more effectively consider the tradeoffs between targets, which might have helped stem a large operating loss that led to layoffs.
Workforce alignment The average employee’s variable compensation would have been better aligned with the company’s overall performance.
Fairness Employees would not have been completely demotivated by the poor economic conditions (particularly top employees, who would have enjoyed more compensation flexibility). Likewise, the company would have likely paid out deservedly smaller bonuses, which makes sense when operating results are poor.
Innovation By conducting quarterly operating reviews, management could have reviewed reforecasted budgets in order to determine the causes of variances. A more intelligent forecast of future activity could have been built. The operating review would have become a forum for innovation, where key players discuss the challenges of the business climate and create strategies to overcome the challenges.
Build better budgets
The integrated budgeting approach provides a method that you can use to lead your company’s response to ever-changing business conditions. By adding forecasting to the budgeting process, your company can successfully adapt to the situations that defy the initial budgeting assumptions.