Interview by: James Nelson
Brian Plowman is a founding partner and Managing Director of the UK-based management consultancy Develin & Partners.
With a focus on cost management and implementation techniques to add corporate value, he has worked with clients including the Royal Bank of Scotland in the financial sector, Land Rover and Avon Rubber in manufacturing and City University in education.
A fellow of the UK’s Institute of Business Consulting and a prominent seminar presenter for UK professional bodies, he is the author of the books High Value, Low Cost and Activity-Based Management.
Here, he talks about the shortcomings of conventional annual budgets, and how companies can improve their budget process beyond recognition, turning it into an indispensable management tool.
What should company budgets be looking to achieve?
Brian Plowman:
There are three fundamental reasons for budgeting:
- To anticipate what is outside our control: such as demand from customers; competitor activity; the impact of changes in the economic, social and political environment; and the constraints that might be imposed by government regulation.
- Then, to plan changes to what is within our control: products and services; methods; processes; organization; people; equipment; relationships with suppliers; and so forth.
- Finally, to translate our plans for reacting to what is outside our control and for changing what is in our control into predictions of financial outcomes. These predictions will inform the board’s dialogue with shareholders and other stakeholders in the business, both internal and external.
It is not surprising that the budget assumes huge importance, nor that boards of directors insist on undertaking it, even when they and operational management acknowledge its weaknesses.
What do you see as the main weaknesses?
Brian Plowman:
We can identify five major problems:
- Budgets are annual.
- Most often, they don’t reflect strategy.
- It’s difficult to predict resource needs from forecasted business volumes.
- They are normally departmental and not cross-functional.
- They can undermine managers’ accountability.
Taking what you see as the first weakness, why is the budget’s annual nature a problem?
Brian Plowman:
All companies report annually to their shareholders and stakeholders. It’s natural that the budget should address the same annual period for which the board will be held to account. But for most companies living in rapidly changing markets, a year is an absurdly long period over which to anticipate the outside world or to plan internal change.
Many organizations produce a quarterly or monthly “now expected” forecast that sits alongside the budget for the financial year. This is not a rolling forecast, because it has a diminishing horizon as the end of the year comes closer. The main weakness of this kind of forecast is that it becomes an exercise in self-defence (when missing forecasts), rather than of anticipation or planning.
What about the second problem you mentioned, that too often the budget does not reflect strategy?
Brian Plowman:
The budget and the organization’s strategy are often separate. This is partly because strategic planning is a conscious attempt by the board to take a longer-term, high-level view of the business and its markets; partly because strategic planning usually takes place at a different time from the annual budgeting exercise.
If the budget is unable to reflect the strategy, it is denied a rational framework. Instead of a careful exercise to align and prioritize resources behind specific outcomes in line with strategic intent, the budget degenerates into “stretch targets” and inter-departmental turf battles.
Even if you do align budget to strategy, an annual budgeting event will seldom, if ever, be adequate. Strategic planning should be a continuous process of anticipation and response to external change, and of initiation of internal change. If resource allocation decisions and change are to be effective, the timing of their planning and implementation will be crucial and will vary enormously, depending on circumstances, from days to years. Waiting for the annual budget to arrive would be to miss most opportunities. This leaves managers with the poor choice of either ignoring strategic requirements that arise or of busting their budget.
What resource needs are most difficult to forecast, and why?
Brian Plowman:
Because there is often no explicit link between projected business volumes and the resulting resources required it is difficult to estimate budgeted needs. This isn’t usually a problem in the areas of the business that deal directly with products, services or customers, where the relationship between business volumes and resources required tends to be linear.
However, this is a real problem in non-direct areas such as HR, finance and IT support. For example, the costs for training may be driven by the number of employees that require it; however, the number of employees in training probably does not vary in line with throughput business volumes. These internal service levels are often a bone of contention, because there is normally no direct link here between such internal service levels and business volumes.
“If overtime increases, or if the backlog of work rises, managers will bid for more resources to tackle these problems, which are usually symptoms of a volume increase. But when volumes fall, managers will seldom argue that they are over-resourced.”
Actual costs for non-direct volume-related overheads like HR and IT are typically close to budget. But, this does not mean the budget is correct. Few organizations attempt to use sales volumes when budgeting for overheads. Instead, they tend to base the budget on last year’s costs, plus inflation. If overtime increases, or if the backlog of work rises, managers will bid for more resources to tackle these problems, which are usually symptoms of a volume increase. But when volumes fall, managers will seldom argue that they are over-resourced. This results in “invisible” spare capacity in the overhead.
The budget for many overhead areas becomes both a floor and a ceiling. Managers will spend up to their budget (for fear of losing it), and will avoid overspending, thereby possibly compromising levels of service.
You’ve said that budgets being broken down departmentally does not reflect reality. Why is this so, and how do you suggest this be addressed?
Brian Plowman:
Conventional management accounts are structured so that costs and revenues are categorized by cost centre and by ledger code. Invoices are coded so that the accounting system assigns them to the correct centre and code. The budget is designed to refer to these same centres and codes, otherwise comparisons with actual expenditure and revenue would be impossible.
But cost centres are usually allocated departmentally or functionally, so the budget ignores cross-functional process links that could be key to operations. In addition, budget holders usually think in terms of projects, activities and goals, not ledger codes. Expressing managers’ resource allocation and their performance by ledger codes makes little connection with the reality of managers’ working lives.
Why do you believe most conventional budgets undermine manager accountability?
Brian Plowman:
One perceived benefit of budgeting is that it makes managers accountable. They are given resources and responsibility for deploying them as best they can in order to achieve the budget’s targets. Then at the end of the year they have to account for their performance.
This is a neat idea, but in practice it doesn’t usually work. First, if managers’ targets are solely cost targets, they can hit them simply by spending within budget, irrespective of the outputs they achieve. Second, to aim managers at a figure which is probably wrong and outside their control, and hold them to it, is to invite disillusionment with the management process. Third, it invokes Goodhart’s Law, which holds that:
“When a measure becomes a target, it ceases to be a good measure.”
Ironically, adhering to a fixed annual budget often avoids management accountability. Managers simply point out that so much has changed during the budget period that expecting them to account for their performance against a prediction made a year ago is absurd, and this is usually a fireproof argument.
Is there a way to overcome all the problems you’ve outlined?
Brian Plowman:
The conventional response is no. The solutions generally sound too complicated, and companies feel they have already got enough on their plate without examining something as permanent as the budget process. And the problem for many managers is that if doing the budget once a year is seen as a time-consuming, irrelevant distraction, then the prospect of doing it quarterly, or monthly, is too horrible to contemplate. But, I argue it is possible to refashion the annual budget as a powerful management tool, while making it much simpler to use.
What, for example, is your solution to the first problem, that the budget is annual?
Brian Plowman:
The most popular reason cited for making the budget annual is to be able to communicate with investors. But organizations don’t need to produce a full-blown annual budget detailed to cost centre level in order to communicate with shareholders. After all, the detail is rarely divulged externally.
The same is true of internal communication. It’s important and desirable, but it doesn’t need a budget, and it certainly should not be once a year. And if the budgeting process has lost credibility, then it becomes a very poor method of communication. So actually, for all the reasons that organizations cite for budgeting, none of them requires it to be annual.
Quite the opposite. A budget must be seen as relevant and useful to operational management. So it must be realistic and credible. Management is a continuous process, not an annual event. So any system that helps management to anticipate the future has to respond continuously, not once a year. It must help managers respond when things change. In almost all organizations, this means replacing the once-a-year budget with rolling forecasts. The annual budget then becomes a one-year snapshot of the rolling forecast.
Not everything in a rolling forecast must roll every month. In some businesses there will be elements of a forecast that must roll daily. At the other extreme, some elements might not merit a glance for several years.
And the second problem you mentioned; that budgets usually don’t reflect strategy?
Brian Plowman:
Many activities in companies are quite perfunctory. But other activities are exciting, and these are the lynchpins of strategy. If you can identify these activities, then you can make sure the budget allocates adequate resources to them to achieve your strategic objective. You can ensure that performance measures are assigned to them so you can track their progress. You can also list all the activities supporting each strategic goal to make sure nothing is missed.
So the solution is to identify in the budget the activities that support each strategic strand. These are then given special attention, initially in the allocation of resources, and then at each rolling budget review in order to check that performance is on track.
How can the continuous rolling budget you recommend more accurately predict resource needs?
Brian Plowman:
These are costs and income that are driven directly by customer and product-related throughput volumes, such as the number of products produced or sold, the number of customers, the number of new products introduced, the number of invoices raised, and so on. These volumes determine the income that can be expected and many of the costs that must be incurred, typically, direct staff or labour costs, and, in manufacturing businesses, raw materials and component costs.
The importance of being able to forecast volumes and their volatility is linked to the timescale over which management is able to vary the related costs. The inability to vary costs when volumes fluctuate creates either spare capacity (which must be funded) or capacity shortfalls (which affect revenue and customer service).
For most commercial organizations, it is these volumes that are the most difficult to forecast accurately over a long period, and which account for most of the inaccuracy in a conventional annual budget. It is these volumes that are likely to need re-forecasting in order to help management respond in a timely fashion. Increasingly, powerful analysis tools are available to help companies re-forecast easily as business volumes change, thus reducing the reliance on long-term, inherently inaccurate forecasts.
How do you suggest addressing the weakness of budgets usually being departmental?
Brian Plowman:
When we talked about this problem earlier, I argued that the conventional annual budget is compromised in its usefulness to management because it has to fit in with existing accounts systems which record everything by departmental cost centre and ledger code. Assessing cost performance against budget considers only whether managers are spending the money, not whether they are spending it wisely, or to good effect.
“Assessing cost performance against budget considers only whether managers are spending the money, not whether they are spending it wisely, or to good effect.”
Where the link between the ledger code and the work to which it relates is obscure, the problem can usually be overcome by modelling the relationship between ledger codes and the activities in which the ledger code resource is used. Salaries are the most frequent example of this problem. Modelling in this way allows managers to budget in a currency with which they are familiar, this currency being activities. In addition, dealing in activities instead of departments is the key to overcoming many other problems that stifle useful budgeting, In particular, dealing in activities can:
- Help find the factor that drives usage of the resource.
- Link the budgeted cost to the performance achieved.
- Be used to budget for an entire process, where a cross-functional process perspective is important.
How would a change to rolling forecasts increase management accountability?
Brian Plowman:
When I described the problem earlier, I pointed out the misconception that annual budgeting makes managers accountable, because at the end of the year they have to account for their performance. Ironically, adhering to a fixed annual budget avoids management accountability because the predictions on which the targets are based usually prove so wild that hitting the targets becomes implausible.
Just as ironic, the most common argument against rolling forecasts – or continuous budgeting – is that if you allow managers to change the numbers, you let them off the hook. The opposite is most often true. By reviewing performance at the end of each rolling period, the issues are recent and fresh in memory. The rolling model allows you to differentiate between what is outside a manager’s control, and what is within their control. So the dialogue on accountability is continuous and valid.
Other advantages?
Brian Plowman:
Three additional advantages accrue from these steps. One is that improvement plans can be incorporated into the budget. So, if costs need to be reduced or service levels improved, budget managers are obliged to demonstrate the means by which they intend to do so. Blind faith that the numbers will somehow be achieved will not do. Either they have to think harder, or the aspirations have to be revised. This imposes the real world.
The second advantage is that activities described in the budget can be combined into processes. So where an entire process is planned to improve, the plans for doing so can be viewed together to aid coordination.
Finally, by coding costs, revenues, activities and improvement plans in the rolling budget model, senior management can get answers to a range of questions such as:
- What is our top ten cost reduction plans?
- Which activities support our strategy and what performance measures are we using to track its implementation?
- How big is our risk if raw material costs go up by 10 per cent rather than the 5 per cent we have forecast?
- What are our plans to improve the service we give on that customer process, and what service level do we intend to achieve?
Can you cite examples of companies which have switched to the rolling budget model, and with what success?
Brian Plowman:
A successful implementation in a complex business has been with the Avon Rubber Group, a world leader in the design and manufacture of rubber compound products. The project started when they had three divisions: US and European automotive component divisions, and a Technical Products Division that supplied industries ranging from defence to dairy equipment.
The budget and the company’s three-year strategic plan had always been the central management mechanisms. However, there was little faith in the budget’s accuracy. Indeed, once into the New Year, the sales and PBIT forecasts would quickly show a variance against the budget – usually negative. As time passed, managers would have to struggle hard to recover the situation, leading them to miss or ignore opportunities beyond the finishing line at the end of the year. Communication with the shareholders was also affected. More than once, statements following a new budget had to be amended in light of forecasts telling a different story – a major source of concern for the board.
The managing director for the US Automotive Division volunteered his division to be a test bed for a rolling forecast – a forecast that has a constant length of horizon and that is updated regularly. He wanted relief from the burden of budgeting and from its deadening influence upon the performance of his division.
Within many organizations, this sort of initiative would be a finance matter – it is, after all, about budgeting and forecasting. However, within Avon, the automotive finance team recognized they had to support this cause by keeping out of the way while the sales team decided how it was going to work. Avon’s sales managers had to know which vehicles each of several thousand parts was fitted to. They also needed to know about the demand for those vehicles, and about any decisions to change or replace them. From this requirement the rolling forecast process was born, becoming the most important tool in their armoury.
When the managing director of the US Automotive Division led a management buyout of the division from the Avon Rubber Group, the strength of the rolling forecast process was a major factor in his decision to proceed – as was the decision by private equity firm Red Diamond Capital to fund the buyout. And back in the UK, the chief executive suspected that the £65 million price tag was enhanced by £3 to £5 million, thanks to the quality of the information available within the rolling forecast.
That’s an extremely good return for making the rolling forecast a key decision support tool.
May 2008.