Even without any research to back me up, I think it is safe to say that most companies reverse engineer their budgets. That is, they decide on a final profit number or percentage and then go about building all the P&Ls to support that final number. From Wall Street to Main Street (sorry for the cliche), business managers tend to build budgets that reflect the expectations of owners and shareholders. Owners like this approach because it allows them to set a hurdle and have their minions scurry around to meet it. Even in companies where budgets are rolled up, the lower level budgets tend to be reversed engineered from a corporate directive to see X% growth. I can bet that you have worked for a business unit that has submitted a less-than-overly-ambitious budget only to have corporate request a revision with bigger expectations. Unfortunately, this approach has some serious unintended consequences that can actually destroy a company’s efficiency and effectiveness. Here are just five of the effects that I have witnessed at companies that budget by putting the cart before the horse.
Managers don’t focus on improving the process. Profit is always the result of pricing or process. The latter is harder to control and takes much more sophistication to improve. When operational managers know that the top line has been met they tend to do little to research how to improve the bottom line. That is because they know that their profit margin only has to match the budget and that tends to be modeled from previous year’s P&Ls. Even when revenue targets are not met, the manager is safe if they can explain how the P&L is in-line with previous year’s ratios.
There is no learning. The brilliant Stanford mathematician Samuel Karlin once noted, “The purpose of models is not to fit the data but to sharpen the questions.” When managers are forced to create a budget with no pre-formulated expectation of performance it forces them to think through the cause and effect relationships that affect profit. That never happens when managers are simply “fitting” numbers to a target. The budgeting process can be a great managerial development tool if managers were actually asked to think.
It promotes rationalization instead of investigation. When your budgeting process promotes a culture of “tell them what they want to hear”, then that is exactly what you will get. In that environment, the month-end Variance to Budget explanation exercise tends to be more art than science. One of my first jobs was to document variance to budget explanations for each of the business units of a large corporation. I remember distinctly one conversation where a manager gave me a long, eloquent exposition on why his unit had beat the the budget. After I explained that they actually missed budget, he gave an equally articulate summary as to why his unit had under-performed.
Manager’s act in their own best interest instead of the company’s. When goals are tasked instead of sourced, managers tend to manage to the goal. That means that they will use tactics like “sandbagging” the gross margin by “padding” the costs so that they can “reserve” their good performance in one period to mask lower than normal results in another. That behavior is counterproductive to any organization because, again, it prevents a serious investigation of why both, the high and low, periods were different than expected. Managers will also “spend to budget” so as to not lose their allocation for the following year. Again, a result of reverse engineering the rest of the P&L to meet previous year’s performance benchmarks.
Managers lose respect for the process. The delusional intention of most reverse engineered budgets is that mangers will use it a s a tool to manage throughout the year. However, when managers know that the budget is a top-down exercise that will be rendered obsolete as soon as the year starts, they tend to ignore it as soon as they are done with it. In other words,it’s basically only finance that cares about the budget after it’s submitted. The result is the promotion of “managing without numbers”, which is an all too common problem even in today’s data-filled business environment.
For most companies, the budgeting process is an expensive and time-consuming activity that yields far too few changes in productivity and performance. It is basically a bureaucratic exercise in organized imagineering. Yet it does not have to be this way. By using a data-driven instead of a dream-driven approach to budgeting, it can once again become the useful managerial tool that it was intended to be.
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Robert Hernandez, Revenue Discovery Expert Author Info: Robert Hernandez is an expert in the field of mathematical Optimization and Analytics. He has spent his entire career building data-driven forecasting and optimization models for companies in over 20 different industries, from tech to tourism. Robert possesses a very unique skill set including cross-disciplinary experience, advanced mathematical and analytics skills, data transformation, industry-specific knowledge and business-process improvement expertise. Read More+