Budgeting, as most corporations practice it, should be abolished.”
—Jeremy Hope and Robin Fraser, Harvard Business Review, 2003
The budget often constitutes one of the last—and largest—stumbling blocks to creating a truly Agile organization.
Budgeting as practiced in most large organizations today is cumbersome, expensive, time-consuming and wasteful. It often cripples innovation. It is riddled with gaming-the-system. It encourages unnecessary spending and fosters sub-optimal targets. It hides accountability. It is demoralizing to the participants, inefficient, ineffective, built on fictions, and fundamentally at odds with the dynamic of business agility.
None of this is new. Way back in 2003, Jeremy Hope and Robin Fraser wrote as much in Harvard Business Review. Yet traditional budgeting remains entrenched in big organizations, even those implementing Agile. Why? A key reason is that budgeting interlocks with other aspects of the internal bureaucracy.
Budgeting In Theory
The term “budget” comes from the old French word, bougette, meaning a small bag. “That was the small purse filled with gold coins that the shipowners gave to the sea captains before sending them off to the Far East to buy spices and other goods to be brought back to Europe,” writes Bjarte Bognes in his book, Implementing Beyond Budgeting (Wiley, 2017). “It was a very physical constraint on available resources. Too bad if great unexpected purchasing opportunities popped up. When the bougette was empty, it was empty… In 1922, James O. McKinsey introduced budgeting as a management technology: ‘Budgetary control is urgently needed as the basis for centralized executive control.’”
In theory, budgeting is a brilliant idea. It embodies the orderliness that emerges when the costs and outputs of every single activity in an organization are mapped together in a single comprehensive system that is consistent from the top to the lowliest team, from the center to the most distant periphery. The senior management can look out and see what every division, unit or team is spending and what they are spending it on, down to the last dollar, in any given year and what the organization is getting for its money.
In theory, the budget also represents a crystal-clear binding contract with every part of the organization to deliver outputs in simple quantitative terms. The top management can see at once how their priorities are being worked on. They can track the implementation of their strategies, plans and programs in the most minute detail and make instant adjustments on the fly. They can, if they wish, explore whether a unit is overspending its travel budget or falling short of its deliveries.
In theory, the budget enables action. By adjusting the budget, top management can cut through the mush of endless internal debate and send unambiguous signals to everyone in the organization about the firm’s true goals and priorities. By funding the future, they can inspire innovation. By making budget cuts where appropriate, they can eliminate waste.
In theory, the budget is also a measure of performance. The budget provides an objective of performance against commitments and a guide to issuing rewards and punishments. For all these reasons, the budget has usually been seen as the centerpiece of sound management.
Budgeting In Practice
Yet in practice, the budget often works very differently, particularly in large, siloed organizations.
- Fundamentally, the budget counts outputs, whereas Agile management counts customer outcomes. Thus the budget reinforces the idea that work is done when it is completed within its organizational silo (such as a software development division) rather than when it generates revenue and delights the ultimate customer or client. In effect, whereas Agile is externally focused on delivering value to external customers, traditional budgeting is focused on internal outputs.
- The process of arriving at an agreed budget can be very heavy, often taking many grueling months. A top-down cascade of directives can quickly destroy staff ownership and motivation. Yet when budgets are prepared bottom-up, the reconciliation of the proposals to form a coherent institutional whole can often be just as dispiriting. Overall, decisions tend to be made too early and too high up.
- Each unit tends to maximize its inputs and regard the level of inputs from last year’s budget as its entitlement or “floor” for the coming year.
- Yet each unit also tries to minimize its commitment in terms of outputs. The level of outputs from the previous year is often presented as a ceiling for the coming year.
- A lot of game-playing goes on. There is often an ethic of “spend it or lose it.” It is doubtful whether all the expenditures towards the end of the fiscal year are really high priority.
- The budget process itself is costly, as there are many disputes as to how to reconcile the conflicting claims on the budget. There are often are many months of in-fighting over not-much-change from last year.
- One reason for the difficulty in reaching agreement is that the budget is often treated as a combined target, forecast, commitment, and resource allocation process. As a result, it often ends up performing none of those functions very well. “A target is what we want to happen,” says Bjarte Bogsnes in Implementing Beyond Budgeting; “a forecast is what we think will happen, whether we like what we see or not. Forcing a target and a forecast into being one number in one process is almost guaranteed to result in either a bad target or a bad forecast or both,” Not surprisingly, the result is often an unhappy compromise, an “in-between number” that nobody is really likes.
- Because the budget numbers are a suboptimal compromise, they constitute a poor basis for performance evaluation.
- The budget quickly gets out of sync with the external marketplace, which doesn’t run on annual cycles. Some activities happen in much shorter cycles. As a result, by the time the budget is complete on day one of the fiscal year, it is often already out of sync with the outside world. Other activities concern long-term investments which involve multi-year decisions. Forcing everything into an annual time frame confuses, rather than clarifies, the issues.
- Adjusting the budget is an enormous task. given the interlocking nature of the overall system. The budget is often updated on a quarterly basis, but major changes are difficult, even when they are obviously needed.
- The ability of top management to monitor the minute details of spending often leads to top-down category-specific diktats, such as “freeze all travel expenditures” which can disrupt important operational plans at the working level and deprive units of the opportunity to find the best way to resolve a spending problem, if there is one. It is thus bizarre but common to find firms distrusting executives on tiny expenditures on travel when the same executives are given responsibility to manage billion-dollar investments. In effect, traditional budgeting is predicated on distrust, while Agile is predicated on trust.
- At the start of the fiscal year, the budget horizon covers 12 months into the future. By the time of the fourth quarter, the budget horizon has been reduced to a couple of months. At this point, only minor ad hoc adjustments are possible, as attention shifts to the huge task of preparing and agreeing on next year’s budget. It’s as if the world will come to an end at the close of the fiscal year.
- In effect, the appearance of control that budgets offer to senior management is often an illusion of control not the reality.
Budgeting’s Links To Other Issues
None of this is new. The issues were described by Jeremy Hope and Robin Fraser, in their 2003 Harvard Business Review article, “Who Needs Budgets?”, which began, “Budgeting, as most corporations practice it, should be abolished.” Yet traditional budgeting lives on in many large organizations, often because it interlocks with other institutional issues. In effect, you can’t fix the budget unless you fix these other issues.
- Organizational structure: The budget often reflects, reinforces and aggravates the siloed organizational structure, which gets in the way of delivering value to customers. Rather than having truly cross-functional teams, with end-to-end responsibilities to deliver value to customers, Agile teams work within their silo (say Tech) and hand off work to another silo (say Product) to be incorporated in their work program. If Product has yet to embrace Agile, then Product is likely to be working at a slower pace than Tech, so Product–and subsequently Sales–become the key organizational constraints to gaining the real value from Agile.
- An internal mindset: The budget often reflects an internal mindset, rather than a customer-oriented external mindset. An interesting account by Simon Caulkin of nine UK organizations that are Managing For The Better concludes among other things:
The opposite of top-down is not bottom-up, but outside-in. GE’s Jack Welch once defined hierarchical organizations as places in which ‘everyone has their face toward the CEO and their ass toward the customer’… The focal point is the customer who defines the organization’s purpose and thus the value work that it exists to carry out.”
- Cost accounting: Budgeting is often tightly aligned with traditional cost accounting which, not surprisingly, focuses on costs and tends to register the number and cost of outputs within each organizational silo. An organizational silo may have met its budget commitment to deliver a certain number of outputs, even though the outcome for any customer is still a long way away in another silo. The notion of throughput accounting, which measures and tracks progress of delivering value to customers, is still unknown in many large organizations.
- The HR system: These tendencies are also reinforced and aggravated by the HR system, which often reflects and reinforces the siloed and hierarchical organizational structure and the budget and can be disconnected from outcomes for customers. Thus individuals within each silo tend to be evaluated and rewarded on producing the budgeted level of outputs within the given budget envelope.
- Executive compensation and share buybacks: The internal focus can be further accentuated in firms where senior managers are compensated with stock options which depend on the level of the stock price: share buybacks become a convenient way to boost the share price, independently of any value delivered to customers. Given the lucrative nature and scale of this compensation in many public organizations, there are strong disincentives to change the system or the internally oriented budget on which it is based.
- The disconnect with strategy: These problems are also often reinforced and aggravated by the frequent disconnect between the soaring rhetoric of the firm’s mission statement in terms of delivering wins and high value outcomes to customers, and the mundane reality of the delivery of internal outputs in each organizational silo. This disconnect tends to be masked by efforts to “tag” activities and relate each activity and output to some top management strategic priority, but the causal connection between the two is often tenuous and reflects aspiration rather than reality.
As a result, “fixing the budget” usually involves a lot more than fixing the budget. You have to fix a tangle of other big issues if you are really going to make sustained progress.
The process changes championed by the Beyond Budgeting movement include abandoning annual budgets, and adopting distributed budgets, variable budgets, use of internal and external rankings, rolling forecasting and budgets, balanced scorecards, KPIs, OKRs and the like. These process innovations have had different degrees of success. They have tended to work well in firms that were already operating as a distributed network like Svenska Handelsbanken AB or in a values-driven firm like Equinor (formerly Statoil) that produces a commodity and so doesn’t have customers. Their success has been less obvious in big top-down siloed, inward-looking hierarchies that are faced with the challenge of delighting external customers.
“At the core of traditional management,” Bjarte Bogsnes told me last year, “you find the budgeting process and the budgeting mindset. The budget is ‘the elephant in the room.’ An organization can never be truly agile unless you also address that budget mindset, and that process. It is necessary but not sufficient.”