At a glance
- Unprecedented events such as the COVID-19 pandemic make budgeting difficult, especially when gauging long- term impact and engaging staff in the budgeting process.
- The first step is to rethink the process and set targets that encourage problem-solving and innovation.
- It is also important to allocate resources to areas of the organisation that are most likely to face challenges.
Former British Prime Minister Sir Winston Churchill said, “It’s a mistake to try to look too far ahead. The chain of destiny can only be grasped one link at a time.” Anyone in business with the job of looking ahead knows how true this is, particularly in uncertain times, but there are methods that can provide a road map to the future and help finance professionals avoid dead ends and potholes.
The place to start, according to Prabhu Sivabalan, professor of accounting and associate dean – external engagement, at Sydney’s UTS Business School, is to rethink the budgeting process.
Sivabalan believes most organisations struggle with budgeting because the future is always hard to predict, and managers generally don’t want to make firm on-the- record forecasts, particularly in times of frequent change.
“There are two intrinsic weaknesses,” he says. “First, there is the inherent difficulty in predicting how the real world will impact the organisation in the future. Second, there is the issue of getting managers and employees to engage with this process in an authentic way. Usually, it is a bit of both.”
The most common form of budgeting in Australia is the annual budget, usually structured in a traditional way and broken down by divisions, business units and even teams.
Monthly and quarterly rolling budgets are often used alongside annual budgets in larger organisations.
By and large, a budget is the expected financial quantification of a company’s goals, ideally based on a considered reflection of its circumstances.
It is then used as a tool to hold managers accountable for a level of performance. In being used to evaluate performance, however, it sets off a chain of incentives that lowers its utility for planning and resource allocation.
“The main weakness is the unyielding focus managers and staff have on over-specifying the use of a budget as a performance evaluation device, while missing its value as a planning and management device,” Sivabalan says. “These are related, but by over-emphasising the evaluation, we ruin planning. Emphasise planning, and you reduce the negativity associated with evaluation.”
Telling employees their performance assessment will be judged on adherence to a set of numbers can induce pressure. If targets are too difficult to achieve, they naturally discourage creativity and innovation. However, the same budget that is perceived as a constraint can also enable people. If a looser, more generous research and development (R&D) budget is given, for example, it encourages staff creativity.
Getting ahead of the curve
“It is human nature to stay with the safe and the known if you are rewarded for doing so,” Sivabalan says. “What we need is to take the pressure off budgets as the sole determinant of performance evaluation.
My research shows that a lot of companies have a range of financial and non-financial KPIs [key performance indicators], but they do not actually walk the walk when bonus determination time arrives. Inevitably, staff are rewarded if they hit a financial number, with cursory acknowledgement of their non-financial outcomes.”
The executive team also needs to be able to look at the larger picture from a forecasting perspective. When mapping out the way forward from the COVID-19 crisis, for example, this means staying up-to-date with information on how the economy is reacting to the changes that unfold.
It is also important to be aware of emerging technologies and social issues, so that longer-term objectives are met, rather than just the annual profit target. Resources can then be allocated through the budget process to areas of the organisation that are most likely to face challenges, or where there are opportunities to mitigate the impact of extreme events.
This can be disruptive compared to the steady-as-she-goes mentality often associated with traditional budgeting.
“It requires bold leadership – a special kind of executive,” Sivabalan says. “You can’t blame most C-suite executives for not taking this on. You initially rock the boat when you incentivise staff based on factors other than budget adherence.”
Forecasting methods are likely to vary across industry sectors, and the team responsible for looking ahead needs to choose the right metrics and most appropriate time-frame.
Financial institutions, for example, need to look at likely future interest rates and the economic framework with a long horizon. In the retail sector, forecasts are better made on a weekly or monthly basis.
Yet the fundamental principles of taking a broad view, considering a range of data and acknowledging uncertainty are universal. Sivabalan notes there are software tools that can help with forecasting, but emphasises they are no substitute for a strategic mindset.
“No software explains uncertainty,” he says. “We have all the technology we need. What is in short supply is a willingness to embrace uncertainty. When you determine budgets at the start of a period, you know they’re likely to be wrong. If you can accept this and work with it, you’re ready to start thinking about smarter ways of benefitting from a budget.”
Sivabalan argues for a pragmatic, planning-based perspective. “We need to turn budgeting into a forward-looking process, where managers adapt to uncertainty when it arises, and not game around it before a period starts by arguing for easy numbers so they get a larger bonus later.”
What forecasting software can do for you
Forecasting apps are straightforward and easy to use, drawing out budget numbers or recent actual figures from accounting software. These tools enable you to prepare for the year ahead by plugging in different growth scenarios and running the numbers.
This drives opportunities to take on an advisory role by presenting clients with forecasts based on different assumptions. Another useful function – particularly for small businesses – is the ability to feed the software information on how quickly invoices are paid in order to create a picture of cash flow.