With national debt crises in both Europe and the United States, a shaky recovery from the deepest recession since World War II and volatile currency markets, it’s not surprising that recent research conducted by the Beyond Budgeting Round Table found that more than two-thirds of corporate budgets are irrelevant before the end of the first quarter. The problem is exacerbated by the inherent weaknesses of the traditional budgeting process, according to Steve Player, principal with Beyond EPS Advisors and program director of the Beyond Budgeting Round Table.
Budget targets are based on assumptions, and the facts on which those assumptions are based can change even in a relatively stable environment. In today’s environment it is almost impossible to predict what will happen.
“Managers spend far too much time explaining again and again why the assumptions in the budget plan are no longer relevant,” Player said.
But faulty assumptions are not the only problem with traditional budgets, according to Player. The greatest problem is that budgets are typically used as performance appraisal tools. “This provides an incentive for managers to negotiate for the lowest acceptable target,” said Player. “The result is that growth potential is left on the table.”
So if you don’t measure performance against budget targets, how do you measure it? The answer, according to Player, is to look at performance relative to peers who are experiencing the same market conditions.
Another problem, on the spending side, is that employees often see budgeted expenditures as an entitlement, which can lead to poor cost controls.
The Beyond Budgeting Round Table, an international organization dedicated to improving the financial planning process and whose membership includes American Express, tw telecom and Unilever, says companies that follow 12 principles can eliminate budgets entirely and enhance performance in the process (see sidebar “12 Beyond Budgeting Principles,” below).
Some of the first principles CPAs in financial leadership positions should consider, according to Player, are those dealing with planning and controls via rolling forecasts rather than traditional budgets.
ROLLING FORECASTS
The purpose of forecasting is to get the most realistic picture possible of the future for as far out as a company’s management can look.
“If you have a short-term operational plan and a long-term strategic plan for what you want to become, the business forecast focuses on the in-between part, how to move from where I am to where I want to be,” said Player.
The Beyond Budgeting Round Table recommends the rolling forecast go out at least five quarters, but many span six quarters. “Really you want to go out as far as people can see,” said Player. “For some, it might be six months. If you go beyond what people can see, then it just becomes a math exercise.”
UPDATE INTERVALS
The intervals when a given item’s forecast is updated should reflect the item’s variability and importance to your business (see Exhibit 1).
“If it’s highly critical and highly volatile, you look at it very frequently,” said Player. “If you have things that are high on one measure and low on the other, you look at them with a medium frequency. If they’re low on both, you can drop back to an infrequent update only as necessary.”
For example, Southwest Airlines, a member of the Beyond Budgeting Round Table, updates its revenue forecast daily and its fuel forecast weekly. But other items may be forecast bimonthly, monthly or quarterly (see Exhibit 2). The updates only cover critical items that are changing. Player noted “some organizations such as American Express take an ad hoc approach with forecasts triggered by when significant changes have occurred in their business.”
Player compared managing a business to navigating a ship. “The ship represents your organization’s cost structure. It is configured based on thousands of decisions you’ve made in the past. You’re sailing in this competitive sea, and over time you can change everything, but you can’t do it overnight. The planning process is about how to forecast ‘what do I need to do differently.’ ”
COMMON MISTAKES
But many forecasting systems fail to achieve their objective, according to Player, for a variety of reasons. Player identifies the following common mistakes to avoid in forecasting:
Forecasting to the wall. Many forecasts focus on the plan year. So each month or quarter into the plan year, the forecast period diminishes by the elapsed time in the plan year (see Exhibit 3). The rolling forecast maintains a continually updated horizon, usually five quarters out (see Exhibit 4).
Confusing forecasts with targets. The purpose of forecasting is to show the most realistic picture of how your organization is tracking toward its objectives, not the picture you want to see. “When a management team allows a forecast and a target to be equal, it becomes a ‘trust me’ forecast—‘Trust me I can hit the plan target,’” said Player. “The problem with this approach is that it eliminates any robust discussion of what actions are needed to reach the target, what risks have to be managed and what resources are required. It also obscures visibility into how to grow faster.”
Demanding forecast accuracy. Forecasting requires assumptions, and conditions will change. Pressure to make forecasts more accurate can provide an incentive for gamesmanship where managers provide lowball forecasts and then stop when they are reached.
Relying on Excel spreadsheets. Unless you are a small company with a single user, Player advises that Excel should be avoided as a forecasting tool due to the high likelihood for error and the inherent constraints of a desktop spreadsheet environment. He recommends companies that are concerned with systems expense look to cloud-based systems (for a list of cloud-based forecasting system vendors, click here).
Excessive detail. The rule of thumb, according to Player, is to limit the detail forecasted to what can realistically be used by management. “You want your managers spending more time using the data than collecting it,” he said.
Relying on “probability-based forecasting.” Some organizations manage uncertainty by estimating the probability that an event will occur. They then plan using that percentage estimate so an item with a 60% chance of occurring would result in a plan that includes 60% of related revenue and expense. Player warns “to be careful with this approach since many events are ‘yes or no.’” For instance an acquisition or government approval to sell a new drug is either yes or no. In those cases, that plan should reflect two separate scenarios rather than a blended approach.
Immediately assuming a growth forecast . Forecasts frequently suffer from what Player calls the “hockey-stick effect” where the forecast gets significantly better as it approaches the end of the plan year. Make sure growth is based on underlying physical factors rather than management’s hopes that things will get better.
Treating forecasting as a “special event.” Forecasting should be an integral, ongoing part of monitoring the business.
Using only one time horizon for all forecasts with the same interval. Use different time horizons for different decisions such as sales and operations planning, financial planning and capital planning. But integrate the system into a unified whole.
Failing to learn from your forecast record. Forecasting should teach you things about your business that you didn’t know before, and that information should be acted on. If you’re not getting actionable data, there’s something wrong with what you’re collecting. If you’re collecting actionable data but not using it to manage your business, there’s a communication problem.
IMPLEMENTATION
The annual budgeting process has long been described as one that takes too long, costs too much and is out of date often before it is printed. Companies such as American Express, tw telecom, Group Health Cooperative, Park Nicollet Health Services and Unilever have implemented rolling forecasts to overcome these problems. “The frustrations of the current budgeting process provide a reason to change. Many organizations have moved to rolling forecast as the first step to more effective ways to plan and control their organizations,” Player said.
12 Beyond Budgeting Principles
Governance and Transparency
1. Values. Bind people to a common cause, not a central plan.
2. Governance. Govern through shared values and sound judgment, not detailed rules and regulations.
3. Transparency. Make information open and transparent; don’t restrict and control it.
Accountable Teams
4. Teams. Organize around a seamless network of accountable teams, not centralized functions.
5. Trust. Trust teams to regulate their performance; don’t micromanage them.
6. Accountability. Base accountability on holistic criteria and peer reviews, not on hierarchical relationships.
Goals and Rewards
7. Goals. Encourage teams to set ambitious goals; don’t turn goals into fixed contracts.
8. Rewards. Base rewards on relative performance, not on fixed targets.
Planning and Controls
9. Planning. Make planning a continual and inclusive process, not a top-down annual event.
10. Coordination. Coordinate interactions dynamically, not through annual budgets.
11. Resources. Make resources available just-in-time, not just-in-case.
12. Controls. Base controls on fast, frequent feedback, not budget variances.
Source: Beyond Budgeting Round Table, bbrt.org .
Share your budgeting experience and hear from other CPAs about their lessons learned. Visit facebook.com/JournalofAccountancy and click “Discussions” to participate.
Vendors that provide rolling forecast tools:
| Planning Software Companies | Phone |
| Adaptive Planning | 650-528-7500 |
| Alight | 800-960-7717 |
| Host Analytics | 659-249-7100 |
| IBM Cognos Planning/TMI/Clarity | 866-601-1934 |
| Infor | 800-260-2640 |
| Longview Solutions (an Exact company) | 905-940-1510 |
| Oracle/Hyperion Planning | 800-633-0738 |
| Prophix | 905-279-8711 |
| SAP/BPC | 877-727-1127 ext. 11080 |
| SAS | 800-727-0025 |
| Acorn (ABC) | 800-982-2676 |
| Senturus | 888-601-6010 |
| River Logic | 214-393-4651 |
Source: Player Group/Beyond Budgeting Roundtable North
America
EXECUTIVE SUMMARY
The
facts on which budget assumptions are based change
even in
relatively stable environments. This makes most budget targets
obsolete shortly after they are prepared.
Traditional budgets, through ties to performance evaluation,
incentivize negotiating the lowest acceptable target.
This
leaves growth potential on the table. Budgets also can encourage
inappropriate spending and discourage appropriate
investment.
The
purpose of forecasting is to get the most realistic picture
possible of the future for as far out as a company’s management
can see.
The
business forecast should link short-term operational plans to
moving toward medium-term strategic goals.
Rolling forecasts typically go out five quarters.
But
you only want to go out as far as people can see. Otherwise, it
becomes a math exercise.
Common mistakes include:
Forecasting
for a plan year rather than in rolling forecasts; confusing
forecasts with targets; demanding forecast accuracy; relying on
Excel spreadsheets; providing excessive detail; relying on
probability-based forecasting; immediately assuming a growth
forecast; treating forecasting as a “special event”; making one
time horizon fit all forecasts with the same interval; and failing
to learn from your forecast record.
Successful implementation requires unified support from
management.
The
support typically comes from a high level of frustration with the
current process.
Matthew G. Lamoreaux (matt@mattlamoreaux.com) is a freelance writer.
To comment on this article or to suggest an idea for another article, contact Kim Nilsen, executive editor, at knilsen@aicpa.org or 919-402-4048.
AICPA RESOURCES
JofA article
“Scenario Planning: Navigating Through Today’s Uncertain World,” March 2011, page 22
Use journalofaccountancy.com to find past JofA articles. In the search box, click “Open Advanced Search” and then search by title.
Publications
- Accountant’s Business Manual (#029418, with CD-ROM toolkit; #ABMXX, online subscription)
- Practical Financial Decision Making: Essential Tools (#091091, paperback; 091092PDF, on-demand)
CPE self-study
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
On-Site Training
- Critical Skills for Creating Great Budgets: Maximizing Profits, People and Power (#CSCB)
- Financial Forecasting and Management Decisions (#FFMD)
- Mastering the Applications of Budgeting While Side Stepping the Pitfalls (#MAPB)
- Strategic Planning: A Simplified and Workable Approach for Private Companies (#SPPC)
- The Nuts and Bolts of Budgeting (#BFAZ)
To access courses, go to aicpalearning.org and click on “On-Site Training” then search by “Acronym Index.” If you need assistance, please contact a training representative at 800-634-6780 (option 1).
OTHER RESOURCES
Websites
- Beyond Budgeting Round Table, bbrt.org
- Forecasting Improvement Road Map, bbrtna.org/letitroll
More from the JofA:
Find us on
Facebook | 
Follow us on
Twitter | 
View JofA videos
