Budgeting — an unnecessary evil

How the BBRT envisions a world without traditional budgeting

The budget is the bane of corporate America. It never should have existed.... Making a budget
is an exercise in minimalization. You’re always trying to get the lowest out of people, because
everyone is negotiating to get a lower number. — Jack Welch

By Theresa Libby and R. Murray Lindsay, CMA

As noted in the March 2003 issue of Management, the budget

has gone from playing centre stage in most organizations’
control systems to being the subject of considerable criticism.
Some people have gone so far as to call budgeting “broken,”
and “a thing of the past.”

The case against traditional budgeting has been systematically

investigated and reported upon by a European think-tank
known as the Beyond Budgeting Roundtable (BBRT), a
program of the Consortium for Advanced Manufacturing
International (Europe). The think-tank argues that firms today
must be more flexible and responsive to deal with
unpredictable change, hyper-competition, and increasingly
fickle customers. This isn’t considered possible with the traditional budgeting model, as
explained in the last issue of Management. The BBRT’s movement is gaining momentum and
the clarity and cogency of its argument suggests that it deserves serious consideration.

The BBRT’s new management model

Figure 1 outlines the framework for the BBRT’s vision for a new management model. It
consists of two basic components: principles underlying effective strategic management, and
principles for empowering employees.

The BBRT’s key contribution lies

in documenting how the fixed
performance contract model of
budgeting is antithetical to
empowering employees and
replacing it with a number of
complementary principles based
on using relative performance
targets. While organizations may
implement the BBRT model in
different ways, the following are
some of its basic principles.

Principle #1 — Setting
challenging relative performance
targets

Setting fixed targets in advance is abandoned in favour of short-run and medium-term targets
based on internal or external benchmarks. These targets are both financial and non-financial,
with the latter being clearly linked to the strategy for increasing shareholder and customer
value. These benchmarks might be relative to the industry, specific competitors, best in the
world, internal performance league comparisons, or last period’s performance. The inherent
logic of using relative benchmarks is compelling: “if others can do it, why can’t we?” This
eliminates gaming behaviour and continually raises the performance bar.

Principle #2 — Adopting continuous and inclusive planning

Corporate strategic objectives are devolved to lower levels so that everyone’s behaviour is
aligned with corporate strategy. Lower levels are responsible for translating corporate strategy
into local objectives for the mid-term and selecting key performance indicators (KPI), as well
as determining initiatives to attain objectives. External and internal benchmarks and higher-
level management reviews serve as a catalyst stretching ambition and ensuring action plans
are continuously reviewed, realistic and the risks appropriate. These “strategic plans” provide
the context for managing the business in the short term. This process supports a “sense and
respond” orientation that allows local managers to adjust strategy and tactics as they
anticipate or respond to changing conditions.

Principle #3 — Using rolling forecasts

Managers use rolling forecasts to identify necessary changes in key estimates. These updates
typically occur each quarter and consist of re-forecasting for at least the upcoming year. The
key point is that these forecasts are entirely separate from performance targets, measures
and rewards. They are prepared quickly, often at the corporate level, and provide a broad-
brush picture of key numbers that local managers can use to manage their operations.

Principle #4 — Coordinating market-like structures

This model abandons centralized coordination. Instead, coordination occurs through managing
a nexus of customer-supplier relationships beginning with the external customer (akin to a
demand pull orientation). Inside the firm, central services serve and support operating units
through the use of “service level” agreements, often based on market prices. This promotes
the notion of mutual accountability and helps the company promote a customer service
orientation and act in an integrated manner for a common goal.

Principle #5 — Decentralizing resource management

Operating resources are made available as required to allow lower management levels to deal
with threats and/or opportunities, and changes in demand. It also allows them to undertake
initiatives aimed at implementing strategy. “Fast-track” approval channels exist for larger
discretionary investments. Control is achieved in such ways as “challenging” strategic plans,
using market transfer prices for central services, setting KPI limits within which units must
operate, and holding units accountable for costs through such means as moving averages and
benchmarking. The key point is that front line people are given the freedom to manage their
own resources and are then held accountable for their actions.

Principle #6 — Controlling through self-regulation and transparent information

The basic idea is to use controls to provide local managers with strategic, competitive and
market-based information so they can self-regulate. Leading and lagging KPI measures
provide both benchmarks and learning tools. Graphs and charts show trends and moving
averages relative to established benchmarks. The information is transparent and available to
everyone.

Principle #7 — Using low-powered incentives linked to group or organizational performance

The practice of paying individuals significant (high-powered) incentives for achieving fixed
targets negotiated in advance is replaced by modest rewards based on unit, group or
company-wide performance in meeting relative benchmark targets. Since the comparison
benchmarks face similar market challenges, both help and harm that comes from these
exogenous market factors is excluded. The use of collective measures and the inclusion of
everyone in the reward program also encourages taking a holistic view and promotes
teamwork and peer pressure, as well as information sharing.

Moreover, the modest rewards reduce the motivational obstacles preventing employees from
pursuing a balance between short- and long-run performance. As noted organizational
consultant Alfie Kohn puts it: “Whenever people are encouraged to think about what they get
for engaging in a task, they become less inclined to take risks or explore possibilities, to play
hunches or to consider incidental stimuli. In a word, the number one casualty of rewards is
creativity....”

Empowerment

The performance management practices discussed above are consistent with transitioning to
an empowered organization — which the BBRT sees as the bigger prize. The basic argument
for empowerment is twofold. First, success requires that organizations adapt to changes taking
place in the business environment (e.g., technology, customer or societal needs, and
competitors’ actions). Empowering front line managers is necessary because adapting
effectively and efficiently requires accurate information and intuition. Also, innovation requires
granting more responsibility and control to the doers: those who know the work best and
confront, often on a daily basis, the problems and/or opportunities for making improvements.
In both cases, the basic principle of motivation comes into play: when you appeal to the
highest level of thinking, you get the highest level of performance.

The performance management practices were developed to be consistent with an empowered

workforce. Yet, some fundamental devolution principles are also necessary to maintain
adequate control and avoid unpleasant surprises. At a basic level, people need the freedom to
act. But freedom to act doesn’t mean giving employees a blank check. Employees need to be
given boundaries within which to make decisions. Beyond basic codes of conduct, this includes
considering strategic boundaries. And people need to understand how their work links to the
big picture — strategic goals. People need the appropriate training and support to act
decisively; they need access to resources to deal with problems and opportunities; and
perhaps most importantly, they need timely and complete information to be truly accountable.

While the above considerations are important, they aren’t enough on their own. People also
have to be motivated to lead. They must willingly take ownership of problems and accept the
responsibility to improve and grow the business through exploration and experimentation. In
short, true empowerment only occurs when employees belong to, or identify with, the
company, and such a commitment can never be bought with financial incentives. Such a
culture is instilled by a company’s belief system (vision and values). Additionally, while
operating performance is considered very important, the culture must also emphasize fairness
and encourage risk taking through a “no fear of failure” approach to undertaking new ideas.
Finally, there must be an open discussion of problems and a team approach to problem
solving.

Taking it further

While the case against traditional budgeting made by the BBRT is compelling, we believe it
requires systematic examination against empirical evidence, especially in a North American
context. The underlying culture of North American firms may be considerably different from
European firms and thus it’s by no means assured that the BBRT prescription will work in
North America. Moreover, there are examples of extremely successful firms in North America
whose budgeting system lies at the heart of their management control system.
We are currently involved in a comprehensive study of the state of budgeting and control in
North American companies. Our objective is to gain insight into the validity of claims made by
the BBRT in the North American context. We invite you to visit www.budgeting-
reconsidered.com to find out more about participating in this study. Your participation is
extremely valuable in obtaining a representative sample of organizational practices and views.

Theresa Libby, CA, is an associate professor in the School of Business and Economics, Wilfred Laurier University.
Murray Lindsay, CMA, is an associate professor at the Richard Ivey School of Business, University of Western
Ontario. For a complete list of references to this article and its predecessor, please contact the editor at
rcolman@managementmag.com.

Beyond Budgeting in Practice — Borealis

Borealis was created in 1994 from the merger of the petrochemical divisions of Statoil of
Norway and Neste of Finland. It’s the world’s fourth largest producer of polyfins in the world
with sales of US $4 billion. The merger provided the opportunity to develop a unique culture
that would help the new company respond more quickly to the cyclical and continually
changing plastics business. The company realized early on that the traditional annual budget
didn’t have much value in an environment where volatile oil prices and highly unpredictable
business cycles could invalidate the budget in a matter of weeks. The company examined the
various roles the budget served and decided to replace it with four different systems that were
tailor-made for their specific application (see Figure 2).

One key change was to completely sever planning from performance management to reconcile
the conflict between the need for accurate forecasts for planning and coordination with the
need to set stretch targets for performance management. For the former, the company
wanted honest information to forecast high-level income and balance sheet information that
could provide operating units with an up-to-date context in which to manage their businesses.
The planning role was achieved by using rolling forecasts, which were updated quarterly,
almost on the back of an envelope. As one Borealis executive stated, “The rolling financial
forecasts literally gave us more for less; better reliability because of no gaming and frequent
updating, and significantly less data collection and number crunching.”

For performance management, the company used benchmarks based on the best industry
performers, encouraging people to find innovative ways of meeting them and examining the
trends in closing the gaps. The targeted areas reflected the cascading of corporate objectives
down into local objectives, followed by a selection of a mixture of financial and non-financial
KPIs commensurate with the balanced scorecard approach. In this way, strategy was
communicated and employee’s objectives were aligned with corporate strategy. The use of
relative financial performance measures resulted in fairer evaluations in a cyclical industry
because the vagaries of the market were excluded.

In the petrochemical industry, managing costs and capacity are critical. By tracking costs by
activities rather than department budget lines, the organization achieved a much clearer
understanding of costs; in addition, benchmarking against internal and external units could
now be supported, and learning from improvement efforts could occur. Trends in 12 month
moving averages of activity-based costs became the principle control mechanism.

Finally, the performance management system provided front-line managers with a clear
picture of the company’s strategic priorities and, in conjunction with the fixed cost tracking
system, accountability for making wise investments. These changes made it possible to
significantly decentralize investment management to place resource control in the hands of
those both closest to the marketplace and those responsible for strategy implementation.
Developing Operating &
DCapital Budgeting

Figure 2: Borealis’ New Tool Box to Replace Traditional Budgeting

Rolling Financial Forecast

• used for financial and tax planning at group level

• updated quarterly, covering next 5 quarters
• high level P&L projection, few details
• few people involved
• “honest” forecast about what the future holds

Controlling Fixed (Operating) Costs

• ABC/M methods used to understand and manage resources

• moving averages replace calendar year focus
• costs, small investments tracked by trends
• everyone is expected to manage within first quartile benchmarks
• capacity management is monitored

Balanced Scorecard for Performance Management

• corporate objectives are cascaded down into local objectives, which lead to KPIs
• “balance” between financial and non-financial, leading and lagging
• scorecard is used for personal target-setting and reporting progress
• focus is on trends compared to benchmarks based on best performers

Investment Management

• Small investments (below 1 m EUR)

- trend reporting

- decentralized decision making

• Medium (between 1 and 7 m EUR)

- various hurdle rates depending upon resources available

- prioritized according to strategic fit

• Strategic (above 7 m EUR)

- executive board decides