Anyone who’s been part of budgeting has some scars. You may feel completely qualified to write this article on the challenges in budgeting.
I will talk through some major challenges I’ve encountered in the budgeting process that are common with many businesses. I’ll then give you tips on how to mitigate them.
A Cast of Characters
First, let me introduce you to a cast of characters you may have run into during budgeting.
- Sam the Sandbagger in sales, who’s negotiating for low sales targets so he can get a big bonus when he blows past them.
- Whiney Whitney, who plays the victim. She is disavowing all responsibility for her budget, which she says is forced upon her by Finance and senior management.
- Non-Committal Norm, who claims he has no idea what his project’s revenues and costs will be, so he wants Finance to make up the numbers.
- Twenty-Percent Tim, who just takes last year’s spending and increases it by twenty percent in the first draft of the budget. In the inevitable second draft, he lowers it to 10%. He’s used this strategy for years, and it’s never failed him.
- Big Goal Bill, the CEO, who says we can double sales next year without hiring any staff.
You’ve probably met these characters and others like them.
What’s wrong with these people? Any time you create a game, people play to win the game. Finance and others who create the budgeting process make the rules of the game. We must accept some responsibility for how others play our game.
Let’s look at some struggles in the common game of budgeting. I will suggest ways to improve the game and make it more fun for everyone.
Major Time and Energy Commitment
When I was an auditor in public accounting, the busy season was January through April. When I was part of the staff of non-CPA companies, my busiest season was the budget season.
The budget consumes a massive amount of Accounting and Finance staff time. We began planning in the summer. We prepared the budget system in the early fall and trained new managers on the budget process. A large amount of analysis from the strategic planning process needed to be done to make budget decisions.
And then, the budget process was unleashed on the rest of the company. It began with lots of communication about this year’s process, priorities, and budget assumptions. There were many difficult meetings and discussions.
Finally, a budget was agreed upon. It’s not unlike all the nations of the world forming peace treaties. The budget and related planning were compiled into a massive budget packet. It was then sent to the Board of Directors, some of whom read it. They then second-guessed parts of it until they felt they had satisfied their fiduciary duty.
It was finally approved. Accounting staff then spent hours entering it into the accounting and performance systems.
This is an overwrought description, but that’s how it sometimes feels. I’ll cover some process and system options to mitigate some of this pain. Some of this pain is just called management, and it doesn’t go away. It’s why managers are paid the big bucks.
There’s no silver bullet for this challenge. There are ways to improve the process. It begins with good communication. First drafts of the budget are much more aligned when everyone understands the business environment, the company’s strategies, and goals.
One option is a very top-down budgeting process. These tightly aligned budgets can be produced with a small group of people. However, the budget may have massive blind spots if it doesn’t reflect the ideas and observations from other parts of the company. Managers may protest accountability to a budget in which they had little input.
An option at the other end of the spectrum is operating without a budget. However, you need other processes to gain the benefits that were provided by budgeting. These processes may take as much or more time than budgeting. Those processes may be more effective at achieving the benefits of budgeting.
Quickly Obsolete
I like to joke that budgets are a collection of guesses. Sometimes we can make fairly accurate guesses. Sometimes we can’t. Many of these guesses are made weeks or months before the start of the fiscal year being budgeted.
Within a few months into the budgeted year, actual results are beginning to diverge from our guesses. This divergence becomes bigger and bigger as the year progresses.
Some companies don’t update their budgets during the year. They tend to pay less and less attention to budget-to-actual variances as the year progresses. That’s at least true for variances that don’t impact compensation. Other companies update budgeted amounts to varying degrees. This keeps budgeted numbers more accurate, but did I mention that budgeting takes lots of time?
Rolling forecasts and flexible budgeting are ways to address this throughout the year. Conditional budgeting pre-approves actions when triggers are reached. The maximum flexibility of planning is provided by processes that need to be put in place when a company operates without a budget.
Accountability Without Authority
A common complaint by managers is that they are responsible for budgeted amounts that they can’t control.
This occurs with overhead allocations. Overhead is a massive pool of costs that are perceived to be arbitrarily allocated to each department. These departments may see themselves as “the people who make money for the company.” Overhead departments are blood-sucking leeches. Budget staff, who are a subspecies of these blood-sucking leeches, then face hostility in the budget process. It complicates working relationships.
Managers may be responsible for targets that others control the drivers for. For example:
- Sales may be greatly driven by pricing
- Sales may be greatly driven by ad spend or the types of ads that are run
Managers may be allocated costs related to their department but for which they can’t control the amounts:
- Employee benefits costs
- Cost of materials
A more bottom-up process allows more input and buy-in from managers. Finance should never develop the budget so unilaterally that everyone else disowns it as “Finance’s budget.”
Top leaders may decide to only hold managers accountable for some items in their department budgets for which they have more control. Another option is to assess the performance of managers on metrics rather than budgeted dollar amounts. For example, did production managers scale their costs to the actual number of units produced? This is one of the benefits of flexible budgets.
The Finance Power Trip
Many people see the budget as the Finance department’s chance to wield power. In budget negotiations, the CEO is pushing for more sales while the CFO is miserly allocating the resources needed to achieve the sales. Is it any wonder the process is stressful for everyone?
Finance should have a voice in the budget process. It may be better if that voice is equal to other voices during the budget process rather than a dominant voice. It may be better for those negotiations to be led by the CEO or senior leader.
The budget becomes “Finance’s budget” when Finance unilaterally sets budgets or frequently wields veto power. Others will try to avoid accountability to the budget and the plans it flows from. It’s disowned and lacks motivation. It has then lost its usefulness as a management tool.
Finance should always be seen as providing honest profitability assessments. Finance can be a vital honest broker or advisor in budget negotiations. As noted earlier, the budget should never be dismissed as “Finance’s budget.”
Bottom-up budgeting processes can mitigate this since Finance dominates budgets from the top. If managers believe in the results of ABC costing, activity-based budgeting provides rational bases for budget targets.
Budgetary Slack and Gamesmanship
Budgetary slack occurs when people underestimate revenues and overestimate expenses in the budget.
Sandbagging is a term for setting low expectations so you can greatly exceed them. This may be a good strategy in sales, but it causes many problems in budgeting. These include:
- If sales are budgeted too low, then expenses have to be set very low. This causes investments to be delayed.
- When expenses are budgeted too high in one area, other areas have to make unnecessary sacrifices.
- When expenses are budgeted too high across the company, top managers may set unrealistic sales goals to hit profit targets.
- Incentive compensation isn’t paid for exceptional actual performance but for aggressive budget negotiation. Those who are honest or accurate get lower bonuses. They may even be seen as not performing as well as others if performance is based solely on budget-to-actual performance.
Budgetary slack can be intentional and unintentional. Intentional slack is a form of gamesmanship. It often occurs when managers send a first draft of a budget with large amounts of cushion in them. They know everyone will be asked to cut expenses in the first draft. It’s easy for them to cut out the excess expenses in their first draft to arrive at the expense level they really wanted.
Unintentional slack arises from cautious planning done in good faith. An area I’ve seen this commonly in is conferences and education. Let’s assume we have a manager with ten employees. She expects each to attend a conference, webinar, or training at an average cost of $200 per person, for a total cost of $2,000. Looking back over the past year, she can see that scheduling conflicts or busy workloads caused only half of her staff to attend training last year. Should she cut her budget to $1,000 to reflect past experience or budget the full amount that could occur?
These are small amounts for ten people, but I’ve seen it grow to large amounts across hundreds of employees and multiple expense lines.
As John Tennent notes in The Economist Guide to Financial Management:
“Layered on top of the budgeting process are varying degrees of internal politics, implied performance assessment of the budget-holders (including bonuses) and compromise in sharing limited resources. It is this behavioural aspect that lies at the heart of any adverse view on budgeting, not the financial mechanics.”
A top-down budget can reduce gamesmanship by middle managers but comes with drawbacks I’ve mentioned earlier. Good analysis of the business environment can help leaders reach a consensus on revenue forecasts.
Once a revenue forecast is set, budget alternatives offer ways to assess the reasonableness of costs relative to revenue. Activity-based budgeting and driver-based budgeting can show the relationships between activities and costs. Zero-based budgeting can help challenge costs that have accreted over the years. ZBB also forces managers to justify costs.
Gamesmanship is greatly exacerbated by incentive compensation plans. Simplistic revenue-based plans are especially problematic. Compensation plans based on a set of metrics or profit-sharing can reduce gamesmanship. Completely unlinking pay from the budget further reduces incentives for budgetary slack.
Spending the Full Budgeted Amount
When next year’s budgeted expenses are based on this year’s expenses, there’s an incentive to keep this year’s expenses high. It creates a “use it or lose it” mentality. Employees think they lost money they could have spent this year, and they lose it for all future years.
I had an accounts payable person in a department that reported to me who would scrutinize every expense she processed for others. However, she was adamant that we spend all of our department’s office supply budget each year.
It was like Christmas for the department. It actually did occur near the end of the year, like Christmas. Everyone in the department could order their favorite pens, colorful staplers, or favorite color of sticky notes.
Did I stop it as the department manager? ABSOLUTELY NOT. I would be seen as the Grinch. Once the budget came out, they felt like it was theirs. To take it away would feel like a loss, which is more painful than the gain of the allocation. This is a form of the endowment effect and prospect theory that I explain in my behavioral finance course.
Some see the expense budget as an authorization to spend despite changes in revenue or profit. These people may not even know what’s happening with the company’s revenue or profit. This leads to the next weakness.
A “use it or lose it” mentality perpetuates overspending. Zero-based budgeting is an excellent tool for challenging this. Flexible budgeting, activity-based budgeting, and driver-based budgeting can also help determine proper spending levels for the amount of actual activity or revenue. Process management tools like Lean Six Sigma focus on cutting waste. Conditional budgeting is a way to not commit to spending until revenue triggers are hit.
Lack of Coordination and Scaling
Are expenses usually authorized as a dollar amount or as a percent of revenues? Final budgets are often distributed as dollar amounts. However, some costs should naturally scale up and down with sales. Other expenses should be cut when profit targets aren’t likely to be hit. In other words, costs should scale to revenues or profits.
Many times, they don’t. Revenues can be very volatile, while costs are stubbornly inflexible.
This may be exacerbated by some departments being responsible only for expenses (e.g., IT) and others being responsible for revenues (e.g., sales and marketing). If sales are lower than budgeted, should we spend less on technology? This has to be decided by a forward-looking strategy, not just backward-looking results.
A static budget does a poor job of allowing costs and projects to scale with actual revenue or cash flow. Top-down budgeting allows tight alignment. Bottom-up budgeting may promote better organic coordination between teams. Goal methodologies with short cycles, like objectives and key results (OKRs), promote coordination and scaling.
Flexible budgeting scales budgeted costs to sales for variance reporting. Rolling forecasts allow periodic reallocation of resources. Operating without a budget uses other processes for dynamic coordination and scaling.
Budget Myopia
Myopia is defined as a “lack of imagination, foresight, or intellectual insight.” Budget myopia is my term for tunnel vision or overemphasis on the budget. The problem can be summarized by Abraham Malsow’s quote, “If the only tool you have is a hammer, you tend to see every problem as a nail.”
In some companies, the budget is developed and soon forgotten. In other companies, there is an overemphasis on the budget at the expense of the larger strategy and purpose of the company. This may cause short-term thinking and underinvestment. At worst, it provides an incentive for fraud.
There is a lot of pressure from investors or owners for companies to “make the numbers.” Employee bonuses and incentive compensation may be based on hitting budget targets. These companies are more prone to budget myopia.
Some businesses create budgets but lack other planning or management tools. They then try to manage their company with only their budget. The financial numbers in budgets are lagging indicators. They are the outcomes of customer service, product competitiveness, and other leading indicators.
This is where other tools like a KPI scorecard or OKRs provide better balance. Budgets are just part of the definition of success.
Simplistic compensation systems tightly tied to the budget can cause this. Goal systems like key performance indicators (KPIs) and OKRs allow performance to be assessed across a wider range of metrics. More flexible budget alternatives also prevent numbers from being set in stone regardless of what the business environment does.
Stifles Innovation
The budget creation process may stifle ideas and investments that lead to innovation. Budgets often allocate money in almost the same way as the previous year’s expenses. Budgets that are developed by top management may lack the input and insights of many employees. These employees often have more detailed operation knowledge and customer insight than top management.
Bottom-up budgeting promotes idea formation and communication throughout a company. Value proposition budgeting and zero-based budgeting help challenge past allocations. They align spending with desired outcomes.
Lack of Relevance
The challenges listed above can cause the budget to lack credibility and relevance. Some employees will work to reduce expectations of budgets they deem difficult or impossible to achieve. Managers and employees may not understand the budget and its assumptions. Costs allocated to them may seem unfair.
This may cause a pattern of ignoring budget reporting throughout the year. The accounting department may spend hours creating budget variance reports, but few people look at them. Variances aren’t investigated because the budget is assumed to be wrong. When there is no accountability to the budget, little progress is made toward the goals and improvements envisioned in it.
Company strategy is constantly evolving. In the section on obsolescence, I talked about budgeting options that allow the budget to evolve with strategy. Goal systems like KPIs show how targets flow from the budget. OKRs allow goals and tactics to be updated more frequently.
Whatever budgeting and goal processes a company chooses, top leaders must commit to managing with them. Variances must be investigated throughout the year. Strategies and plans reflected in the budget must be communicated appropriately for each company level. Some would promote tying compensation to the budget to increase its relevance; others contend this creates more problems than benefits.
Check out my Better Budgeting course if you want more information about the budgeting alternatives I’ve listed above to mitigate budgeting challenges.
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