Flexi time

Peter Williams argues that a realistic budget is crucial to understand where a business is going. But is it worth the effort in times of economic volatility?

Companies vary greatly in terms of size and function. But one thing that most have in common - from small, independent shops to large multinationals - is that they faithfully prepare a budget. However sophisticated the process, the managers of the business set aside considerable amounts of time planning for future expenditure.

But the evidence of failed firms and profit warnings suggest that actuals are nowhere near the budgets. So, does a budget serve any useful purpose, especially given that we are facing such volatile, unpredictable times?

Some business heads give a resounding yes to that question. One chairman who has run various startups, but who declined to be named, swears by the budget process. He says: 'I need a budget to function. Without one, I can't do my job. I ensure the company has a cautious budget. I will then challenge the management regularly on the budget to make sure we meet it or beat it. It is the only way to gain credibility with investors.'

But others are not so sure. Nick Mountcastle, senior manager of KPMG's Financial Management Advisory practice, says, 'Many organisations will be frantically re-running their budget models this month to reflect the unprecedented market turbulence in commodity prices, exchange rates and credit constraints. There will be little or no time for intelligent review of the underlying value drivers as data is crunched and recrunched.'

Peter Charles is managing director of turnaround company PCL Ltd, and an interim finance director. He has seen how budgets are used, and sounds a cautious note. 'A budget is a behavioral tool run by the finance department. Why have a budget? I guess it depends on whether the business is in a volatile or steady state. If you have a reasonable cushion and are reasonably profitable, and you are expecting next year to be a bit worse or a bit better, then I'm not sure what a budget does for you.'

Charles explains that a budget is likely to be most useful to management when a business is experiencing volatility, as it can help them steer the business. 'But that is also precisely the moment when a decent budget is difficult to write. That is when the finance team should really be communicating with the rest of the business to keep a close eye on what is happening.'

On track

But there is another crucial reason to prepare a budget, especially for corporates with outside investors or venture capital financing - to reassure outsiders that the business is still on track. Richard Fox, a partner at venture capital firm Acorn Ventures, says, 'Investors need to know where the business is going. A budget is like setting a course when you start a journey. Without it the business is unable to measure and recognise success. Investors understand that revenues in particular are hard to predict with any degree of accuracy. But that is why budgets should be a tool used by the management on almost a daily basis.'

But the budgeting process seems to have lost its way. Budgeting is either an activity divorced from the real business, or it turns into a corporate political football. Doubts over the budgeting process have been growing for a number of years. In 2003, Harvard University academic Gary Loren wrote an article; Why budgeting is killing your company, published in Harvard Management Update. He said there was no return on investment from the traditional labour-intensive budgeting process. And he suggested there was evidence budgeting had turned into a game between different parts of the organisation.'Business units have used their budgets as a bargaining chip, bidding high to get a larger slice of the pie, while keeping their cards close to their chest.'

Charles believes the budgeting process should be kept simple using a zero-based budgeting approach; in other words, going back to the actuals. He recommends a straightforward approach of budget = last year +/- known changes.

Such a simple approach would certainly find favour with Fox, who says budgets should be realistic. 'The best FDs don't bury investors in too much detail. We don't really mind how much the business is spending on office supplies. We want to see key performance indicators as a monitoring tool that let us assess whether the business is performing as expected and if not provide an early guide as to what action needs to be taken. Budgets should be re-performed on a rolling basis as events unfold. Budgeting remains a vital control tool, and the best businesses use budgets and management information effectively.'

Budgeting is part of overall management, not a separate activity, and is a key tool in financial planning. It ensures the organisation has the resources to carry out its objectives and is also a way of being accountable. Charles says that, crucially, 'While the budget may be driven by the finance department, a good budget process spreads responsibility so there is some wider ownership of the figures.'

So, is there a better way than the traditional approach to budgeting? According to Mountcastle, yes. 'Our research in this area shows that a small pocket of companies get this right through flexible planning models that can better sense the environment and lock in the right course of action. No one can predict where current uncertainty will end. However, the companies that react quickest, and with confidence, will be the first to win back investors and put considerable distance between themselves and the competition.'

It still sounds like hard work, but in the current volatile business environment it may be an approach companies should be adopting.

Peter Williams is a freelance journalist