It's 2022: Should we still bother with Budgets?

It's that time of the year again. The new year often ushers in an aura of renewed optimism, hopes of doing better and learning from the year gone by. And if you have spent the last quarter of the last year poring over every detail of a company-department-functional budget, the end of the first quarter can also bring in the sinking sensation that your budgets are inevitably and laughably unrealistic.

This year the Omicron Variant might be to blame, but in an era of drastically fast paced change the idea of setting quantitative targets for a year 15 months in advance seems positively archaic. A lot of people confuse having a set of priorities with having budgets. While priorities set out where a company would want to be in a year's time, they leave room for the company to decide what path they would take to their goals. On the other hand, a budget (or more accurately how most budgets are done) is like setting a route on Google Maps and not changing it even if mid-journey you encounter gridlock, adverse weather, or closed roads.

With the speed of how consumer and business demands change this year, even fixing the destination 15 months in advance can be overly ambitious, never mind the route to it. Continuing the Google Maps analogy, this is like continuing the same route even when the destination changes. Several companies get around this obvious contradiction by having a Rolling Budget process on a periodic basis. A rolling estimate is less time-consuming and follows the same general directions set out in the budget. This flexibility allows decision makers to adjust their operating plans but is less useful for responding to radical changes in the face of consumer trends, competition, and supply chain challenges.

Paradoxically even companies who operate a rolling forecast system tend to keep annual budgets as a reference to measure performance. Employee compensation is still linked with annual targets which by the existence of the rolling forecast are inherently unrealistic. The possible rationale behind this is that people don't consider Rolling Forecasts as goals. Because they are adjusted to real-time events, Rolling Forecasts are more a picture of 'What is going to happen' rather than 'What is the best result that can be achieved'.

19 years ago, The Harvard Business review argued for the abolition of corporate budgets Who Needs Budgets? (hbr.org). Instead arguing for a move to performance standard and ratios. To say that industry-wide adoption of this approach has been slow would be an understatement. Even companies that have changed their approach continue to rely on fixed departmental budgets with an emphasis on Headcount, Capital Expenditure and Travel budgets.

Why are budgets so bad?

At best departmental budgets can cause goal incongruence, department heads being rational humans will always take a course of action that maximizes individual benefit. Almost Every corporate executive has been in a room where radical and promising ideas have been shot down because pursuing them would either exceed the years' IT budget or some other arbitrary measure.

At worst Budgets can lead to behavior that is downright unethical and harmful to the interests of the organization overall. Cost caps could result in a loss of material quality. Headcount budgets may force managers to compromise on safety, quality, or governance staff. The latest example of this is Boeing's failures with the 737 Max where fixed budgets meant that Safety and Quality inspectors were reduced to meet budgets despite evidence that the 737 Max program had significant flaws.

Capital expenditure budgets can sometimes incentivize ludicrous decisions. Managers are under pressure to spend budgets before the end of the year, even when it becomes apparent that such spending might not be productive or beneficial.

Is there a better way of doing this?

19 years ago, when Harvard proposed the abolition of budgets, the amount of data organizations had to inform decision making was limited. Data collection was time-consuming and labor intensive. Hence budgets happened once a year. and while Annual Budgets were too external data dependent, Rolling Forecasts are too internally focused, even vulnerable to political intrigue and good old-fashioned expectations management.

In the intervening 2 decades, the quantity of real-time data organizations collect has grown astronomically. Today Rolling Forecasts can be as data-driven as annual budgets. Such forecasts are developed not just using internal metrics like production capacity and sales pipelines, but also external data. As such they can provide a reference point for 'What is possible' rather than 'What is probable'. This approach establishes a Measurable baseline against which performance can be measured.

An example is the mushrooming growth of Zoom, Slack and other remote work tools during the pandemic. Following a fixed budget approach, the sales teams at these teams probably made a fortune from the ensuing overachievement of sales targets. But a Measured Baseline approach (sensitive to their Key Demand Indicator; people working remotely) would have immediately identified the opportunity allowing these companies to capitalize even more.

This approach requires companies to have a unified and goal-oriented data architecture and data-driven culture. As far as possible the gathering, validation, and deployment of models to establish the baseline must be transparent and agreed in advance. Fortunately, good companies already have such architecture in place to inform other aspects of decision making. The expansion of this mindset to overall organizational goal setting is the next step in creating a company capable of responding to change at light speed.