Use budgets for planning and learning

ACCOUNTANCY

I have been in teaching sessions on budgetary control in executive education programmes for a long time now. Of late, I see a new excitement in the managers who participate in these sessions. They are animated in classroom discussions, eager to share their experiences and opinions with fellow participants.

This excitement is a sign of a fundamental change happening in budgetary control. Earlier, line managers viewed budgets as an annual ritual in which they were merely passive participants.

Preparing the budget seemed to be the sole responsibility of the financial controller's office and the invitations to managers to provide estimates and to participate in budget-making looked like mere formalities. They were neither encouraged nor motivated to actively participate in the budget process. The situation has changed radically. More and more companies are now seriously involving managers at various levels in their budgetary control systems.

At the same time, in my recent interactions with senior managers I also get an impression that managers are beginning to doubt the relevance of the budgetary control system.

Some of them feel that rigid and inflexible targets lead to manipulation and unethical behaviour by managers since they are rewarded or penalised based on their performance against pre-determined targets which may no longer be relevant. In extreme situations, it might even lead to fraud. This happens not just with middle-level managers. Even the CEO might be tempted to resort to earnings management to avoid shortfalls against budget targets and to report better than actual result to the board of directors and to stakeholders.

When the going is good, they roll over some production and sales to the next year as a back up against shortfalls in the coming year. Those opposed to traditional budgetary control think that targets should be flexible rather than being rigid. They argue that since the focus of the budget is control, it does not allow managers and their teams to innovate and thus fail to create a self-motivated work force. It stifles the entrepreneurial spirit in managers.

The apprehensions of these managers have a basis. The traditional planning system is a hierarchical system with the annual budget at the bottom, corporate planning in the middle and strategic planning at the top.

Strategic planning is 'timeless planning' in the sense that it does not have a well defined terminal horizon. A corporate plan is usually for five to seven years. For every year there is a budget with the annual budget being further broken down into monthly budgets. The corporate plan flows from strategy and the budget flows from the corporate plan.

This strict planning hierarchy seems to be crumbling in the face of increasing uncertainties. Strategies and corporate plans are no longer as stable as they used to be. Five to seven years is now too long a period to make reasonable forecast about the future business environment. Even a year is too long to establish rigid financial targets.

Change in the business environment is now more rapid than ever. Not only are changes more frequent, but their consequences are usually so large that the budget assumptions do not remain valid even within the short span of a year. Uncertainties in terms of sources of inputs, location of assets and customers and location of competitors have increased with globalisation.

In this uncertain environment, the success of companies depends more on the problem solving ability and entrepreneurial spirit of managers and the effectiveness of the networking and information sharing system in the organisation than on the ability of managers to forecast the future accurately. Managers operating in such business environments are more comfortable working with three-month rolling forecasts.

Therefore, many feel that the corporate plans should be abandoned altogether and annual budgets should be replaced by a short-term, say quarterly, rolling forecast. Performance of managers should be measured against the performance of peer groups within the organisation or outside the organisation, rather than against rigid budget targets.

There certainly is some merit in these arguments, I do not agree to the proposition that the planning system has lost its relevance. A company cannot live on a day-to-day basis. Both stability and change are important. It is planning that provides the stability. I believe that the three-tier planning system is still important.

However, there should be adequate flexibility to incorporate changes and feedback from the implementation process. The planning process provides managers with an opportunity to think, to understand business and financial risks, and to recognise the challenges and opportunities in different functional areas. Removing this opportunity may prove fatal to the organisation. A company without a planning system is like a ship without radar "" blind and deaf to the threats looming ahead.

Companies must continue with the planning system. However, the budgetary control system should not be used as a tool for 'command and control'. The system has a huge potential as a learning tool. As in the traditional system, variance should be reported by comparing actual results with budget targets. Rolling forecasts should be used in conjunction with budget.

So let us keep using budgets as a tool for planning and learning. Managers learn as they plan. They learn when they compare actual results with planned results and investigate the reasons for variances. Let us not stop this learning process. Let us not abandon a system that provides stability in change.