Budgets on a Roll

Recalculating a business’s outlook several times a year.
BY RANDY MYERS

EXECUTIVE SUMMARY
MANY COMPANIES ARE recognizing that the conventional static budget—produced near yearend and then used as a guide for the following year even though it’s out of date—is just not good enough.

INSTEAD, THEY ARE turning to rolling budgets—forecasts that are updated every few months—in effect, reassessing the company’s outlook several times a year.

THE RESULT: an always-current financial forecast that not only reflects a business’s most recent monthly results but also any material changes to its business outlook or the economy.

IMPLEMENTING ROLLING budgets doesn’t necessarily require any fundamental change in the way a company has been doing its budgets—except, of course, it no longer does the job just once a year. However, companies that decide to step up to rolling budgets may want to take advantage of the decision to make changes in the way they approach the task. They may search for new ways to speed up the budgeting process and make it more useful.

IN THE VIEW OF many accountants, traditional budgets too often are useless because they are hopelessly out of date soon after they are assembled.

WHEN A COMPANY uses a traditional static budget process and finds that it misses its sales targets in the first month, it typically pushes those projected sales into subsequent quarters, acting as if the outlook for the full year remains unchanged.

FOR ROLLING BUDGETS to work, management must access and process information more quickly, and that often means acquiring special software that does the job.

RANDY MYERS is a freelance financial writer who lives in Dover, Pennsylvania. His e-mail address is randy@randymyers.net .
 
or years, senior managers at REL Consultancy Group handled budgeting and revenue forecasting much the way most other companies do. As year-end approached, they would evaluate performance, set sales targets for the upcoming year and then work to see that everyone met or exceeded the goals. Unfortunately, the process didn’t always produce the intended results.

“Invariably,” recalls Stephen Payne, president of the London-based global management consulting firm, “one of the account directors would land a couple of good clients early in the year and make his annual budget well before the year closed. More often than not, he’d then take his foot off the gas and coast.”

To make the budgeting process more timely and relevant, the firm embraced a more complex, albeit intuitive, approach to financial forecasting—the rolling budget. Rather than creating an annual financial forecast that remains static for the year, he and his colleagues now produce an 18-month budget and then update projections every month—in effect, recalculating the whole budget. As the firm’s actual sales figures come in each month, directors plug them into their forecasting model in place of what they had projected, then roll the budget forward one more month.

Software for Budget Planning and Analysis

Everest budget planning and analysis software from OutlookSoft Corp., Stamford, Connecticut ( www.outlooksoft.com ).

Comshare MPC from Comshare Inc. of Ann Arbor, Michigan ( www.comshare.com ).

Hyperion Planning from Hyperion Solutions Corp. of Sunnyvale, California ( www.hyperion.com ).

Cartesis Magnitude from Cartesis, a unit of PricewaterhouseCoopers ( www.cartesis.com ).

In addition, all the major players in enterprise resource planning (ERP) software—Oracle Corp. ( www.oracle.com ), PeopleSoft Inc. ( www.peoplesoft.com ) and SAP AG ( www.sap.com )—also are beefing up the budget planning and forecasting features of their software to handle deployment of dynamic rolling budgets.

NO MORE FREE RIDES

The result: an always-current financial forecast that reflects not only the company’s most recent monthly results but also any material changes to its business outlook or the economy. In addition, it provides fewer opportunities for account directors to ride the coattails of past performance.

“Now, even the guy who booked a million dollars’ worth of business in one month can’t sit still because 30 days later, we’re going to have an entirely new forecast,” Payne says, adding, “It’s a dynamic process that makes a lot more sense.”

Although traditional one-year budgets are still the norm at most companies large and small, many accountants argue that rolling budgets can be a far more useful tool. Unlike static budgets, they encourage managers to react more quickly to changing economic developments or business conditions. They discourage what is too often a fruitless focus on the past (“Why didn’t we meet our numbers?”) in favor of a realistic focus on the future. And they produce forecasts that, over the near term, are never more than a few months old, even when companies are rolling them forward on a quarterly basis—the more common approach—rather than REL’s monthly basis.

“A static budget simply doesn’t reflect the pace of business today,” says Jill Langerman, CPA, president and CFO of the accounting firm Fair, Anderson & Langerman in Las Vegas. “If at midyear you add a new product to your lineup, you want to calculate the costs and profit margins associated with that and reflect those calculations in your budget. If you’re evaluating your product lines and decide to eliminate one, you want your budget to reflect the impact that it will have on your remaining product lines. That way, you can set an accurate performance target and make informed decisions about whether you’re now free to invest more in the remaining product lines or perhaps add a new line. If you’re not incorporating these new analyses into your budget, it becomes a rather useless document.”

Implementing rolling budgets doesn’t necessarily require any fundamental change in the way a company has been doing its budgets—except, of course, it no longer does the job just once a year. However, companies that decide to step up to rolling budgets may want to take advantage of the decision to make a change and consider what else they can do to improve the process. After all, if a company can get everyone on board to make such a fundamental change, a further nudge to make the process more effective and efficient in other ways may be possible, too.

THE PROBLEM OF RELEVANCE

In the view of many accountants, traditional budgets too often are useless because they are out of date soon after they are assembled. Assuming that much of the decision making that goes into them gets done in the fourth quarter of the prior year, by the end of the following year, traditional budgets reflect thinking and data more than 12 months old. Not surprisingly, such documents tend to get short shrift from front-line managers. In worst-case scenarios, they can even promote behaviors and business decisions that are counterproductive.

Consider the real-world example of a Fortune 500 company that has been talking with REL about how it might improve its forecasting to produce better financial results. The company uses a traditional static annual budgeting process in which it sets monthly sales goals for each of its products. If the company misses its sales targets in the first month, product managers will typically push those projected sales into the final quarter of the year. By doing that, corporate management is acting as if the outlook for the full year remains unchanged even though sales were off to a slow start.

But if the slow pace continues and product managers begin to realize that their lost sales can’t be made up in the last quarter, they start to budget them out over all of the remaining quarters of the year. Frequently, they wind up running massive discounting programs at the end of each quarter to hit their annual targets. Fortunately, the company can afford such budget maneuvering because it enjoys relatively high margins on its products, but such manipulation isn’t maximizing its return on investment.

ACTING RATIONALLY

“The static budget encourages managers to create artificial demand for their products, not end-user demand,” observes Payne. In other words, the company stuffs its distribution channel and simply delays future shipments. If the company had a more realistic budget, product managers would be able to act more rationally, eliminating the last-minute forced discounts.

In addition, says Payne, with a better picture of what they were going to sell, they could make better investment decisions. “Maybe a product manager would decide not to spend another $6 million on a new packaging line, for example, if he knows he’s not going to sell the 20 million units he thought he was going to sell. You take the gamesmanship out of the organization.”

Not only are static annual budgets restrictive, it turns out that many managers don’t really like them. “Most of our clients complain that their current planning process is extremely painful and time-consuming,” says Anne Swaller, general manager of the Stanford, Connecticut, office of Parson Group, a national consulting firm focused on finance, accounting and business systems. Assuming the client is operating on a calendar year, Swaller adds, everyone runs around feverishly in October and November to do budgeting, and then at the end of the process, they’re happy to get it over with—knowing they don’t have to do it again until the next November.

Unfortunately, those same managers often have their compensation tied to the budget, which lends it import even when it’s no longer accurate. “If I’m a manager responsible for meeting my monthly numbers,” Swaller says, “I’m going to spend a lot of nonvalue-added time to ensure those numbers are met, even if it means shipping [extra] product at month’s end.”

“It becomes a merry old dance,” agrees Payne, who recalls doing work for a British manufacturer that routinely shipped extra product at the end of each year to meet sales targets and then sold only spare parts in January and February. The trouble is, once you start that process, you have to keep the charade going year after year, Payne explains. “What this company really needs is a new CEO to come in and say, ‘I’m not going to do this anymore.’ But anybody who does will realize that they will have to take a big hit to sales and earnings in that first year, and that is quite a lot for anybody to take on.”

MANAGE THE INFORMATION

Implementing a rolling budget involves more than going through the annual budgeting process four times a year instead of one. Because the time between budgets has been compressed, management must access and process information more quickly than it was able to do in the past. To do that, line managers must become more involved in the process and the company must embrace technology that will allow it to quickly capture and disseminate the raw data needed for decision making and forecasting.

Most organizations today rely on Microsoft Excel spreadsheets to do their budgeting. They work, but they can be laborious, requiring finance managers to piece together input from all the operations managers throughout the organization. “We were called in recently by an insurance company that was using huge, linked spreadsheets to do all of its budgeting and planning,” recalls Swaller. The process was slow and exhausting, producing a static and reactive product that was built on data that was typically at least six months old.

Today, that company uses a specially designed budget planning, forecasting and analysis software product to do the job. (For a list of such software, see the sidebar “Software for Budget Planning and Analysis.” ) This kind of software makes it easier for managers throughout a company to access, enter and share data on a real-time basis, using the Internet as a communications medium.

“This company now has the ability to react quickly to changes,” Swaller says. “Also, its budgeting process is no longer a push from the top down. It’s become a process that involves everybody from the senior level of management to the line managers, who now have a commitment to the process that they never had before.”

Managers used to spend a lot of time allocating expenses among different segments of the business. Since the new software automates the process, managers can spend more time analyzing the data.

THE BIG PICTURE

“This is how technology makes a difference—by gathering real-time information from all over and putting it into a central resource,” Payne explains. It gives top management an overview of what’s happening on a local level—even if an enterprise operates worldwide.

For public companies, the benefits of more timely and accurate budgets may ultimately extend beyond operations. Under Wall Street’s close scrutiny, meeting earnings forecasts has become more important than ever. A misstep, even one that’s just a penny per share below expectations, can translate into a sharp stock sell-off and, in the long run, drive up a company’s cost of capital.

“Theoretically, between rolling budgets and predictive accounting, companies can minimize the controllable factors that cause inaccurate earnings projections,” says Swaller. “Therefore, they would have fewer actual-to-forecast variations, which in turn would help cut down on stock price volatility.”

Although no budgeting technique can predict the future, these techniques allow companies to get much closer to the ideal. The only holdback is the willingness of a company’s managers to use these new technology tools that are now available.

 
The Limitations of Predictive Accounting

W ith the advent of information systems that can collect and distribute up-to-the-minute sales and production data with just a few clicks of the mouse, accountants and financial executives are being pushed harder than ever to predict the future. But while technology has enhanced the art of predictive accounting, it’s still not a science.

“A lot of companies can budget very accurately for their business expenses,” explains Richard Kopelman, CPA, a partner in charge of the manufacturing, distribution and technology practice at Habif, Arogeti & Wynne, one of Atlanta’s largest accounting firms. “They have a much harder time predicting revenues.”

Just ask Cisco Systems Inc. of San Jose, California. Producer of three-quarters of the world’s routers, switches and other computer networking equipment, Cisco became one of the most admired corporations in the world over the past decade as its annual revenue grew from $183 million to an astonishing $22 billion. But the company stumbled badly in the first four months of this year when an abrupt slowdown in technology spending sent sales spiraling downward. The stunning decline, perhaps the fastest deceleration any company of Cisco’s size has ever experienced, prompted a $2.2 billion writeoff of excess inventory.

For Jonathan Chadwick, Cisco’s vice-president of corporate finance and planning, the experience illustrated both the benefits and the limitations of revenue forecasting.

“It all comes down to demand,” Chadwick explains. “The limitations of any system are always going to be tied to the fact that you’re waiting on inputs from somebody or something. If you’re really going to forecast demand correctly, you have to know—with absolute certainty—that a customer is going to give you in three weeks the order you are forecasting today. Unfortunately, nobody has yet invented the virtual crystal ball or crystalball.com. If they have, I would love to see it.”

Still, Chadwick says Cisco’s renowned operating model, which includes an Internet-based ordering system that keeps the company in constant touch with its vendors and customers and pours copious volumes of real-time sales and production data into its managers’ hands, probably helped the company deal with the recent downturn faster than it could have otherwise—and thereby minimized the financial fallout. When it announced its inventory writeoff in April, for example, Cisco also disclosed it would be laying off 8,500 full-time and temporary employees, even though it had just hired 4,000 between November and March. It also recently implemented steep spending cuts.

“We are able to react extremely quickly to current business dynamics and the marketplace,” Chadwick says. “We are able to shift on a dime, and I don’t think there are many companies our size that can do that.”

Cisco employs a hybrid of traditional and rolling budgets and financial forecasts. Each year, it establishes an annual plan, or budget, based on top-down management guidance and bottom-up input from operational managers. This “plan of record” generally remains fixed for the year. Each quarter, however, management goes through what Chadwick calls a “commit” process during which it reviews the annual plan against actual performance and adjusts the outlook for the remainder of the year. These forecasts become the “tools” that shape future business decisions.

Meanwhile, Chadwick’s finance group produces rolling 12-month financial forecasts on a monthly basis, incorporating numerous “what-if” scenarios into its calculations. The company uses these forecasts to help determine how it advises the Wall Street community about its sales and earnings outlook. The forecasts also help management make decisions about manufacturing-capacity planning, real estate planning, inventory purchasing and staffing.

SPONSORED REPORT

How to make the most of a negotiation

Negotiators are made, not born. In this sponsored report, we cover strategies and tactics to help you head into 2017 ready to take on business deals, salary discussions and more.

VIDEO

Will the Affordable Care Act be repealed?

The results of the 2016 presidential election are likely to have a big impact on federal tax policy in the coming years. Eddie Adkins, CPA, a partner in the Washington National Tax Office at Grant Thornton, discusses what parts of the ACA might survive the repeal of most of the law.

COLUMN

Deflecting clients’ requests for defense and indemnity

Client requests for defense and indemnity by the CPA firm are on the rise. Requests for such clauses are unnecessary and unfair, and, in some cases, are unenforceable.