The Problems with Budgeting (#130)
/In this podcast episode, we cover the multitude of problems with budgeting. Key points made are noted below.
I talked about creating and improving budgets in earlier episodes, but have you ever considered that you might not want a budget at all? They have a lot of problems. Let’s talk about why budgets can actually harm a business.
Budgets are Wrong
The first issue is that the blasted things are always wrong. You create a budget around the end of the year, and it’s based on fairly good predictions of what will happen in the next couple of months, and then things get pretty dicey after a few more months. This can be really bad in an industry where there’s lots of upheaval, and less of a problem when you have lots of long-term contracts or the competitive environment is stable. Nonetheless, even in the latter case, the budget will eventually depart from reality. I’ve been doing budgets for a long time, and almost all of them could be classified as science fiction by the time we reached the end of the budget year.
You just cannot predict events perfectly. This has two bad results. The first is that variances from the budget keep getting bigger as the months go by, to the point where people start to ignore the budget. And second, people tend to look upon budgeted expenses as money they can spend – but what if actual revenues are lower than expected, but you’re still spending money according to the budget? Then the company loses money.
Budgets Require Revisions
Another problem with the budget is that managers get into the mindset of only doing planning once a year, for the budget. But what if the industry is changing so fast that you have to keep updating strategy every few months? If management has that annual planning mindset, it’ll keep right on using that annual budget, even though you should scrap it.
Budgets Take Time to Construct
And here’s another problem. What about the time required to construct it? You can put a bunch of people on it for months, and managers have to provide their input, too. And then you go through God only knows how many iterations to fine tune it. And, for what? If you evaluate what a company does with its budget, a lot of the time, it’s not worth the effort.
Budgets Allow for Gaming the System
And then we have the problem of gaming the system. This means that managers know they’re going to be evaluated based on how well they perform against the budget. So, doesn’t it make sense to predict really low revenues and really high expenses? That way, you’re bound to look like a hero. Of course, it also means that the budget is wildly conservative, and it also means there’s not much of an incentive to push the organization to perform better.
The Use it or Lose it Problem
But we’re not done yet with budgeting problems. I’m just getting warmed up. The next issue is the “use it or lose it” syndrome. Everybody knows that if you don’t spend every last cent in your expense budget, you’ll be assigned a smaller budget the next year. So that means managers spend money like crazy in the last month of the year, even if they don’t need to. This is why December is such an unprofitable month for so many companies.
Problems with Capital Budgeting
And then we have capital budgeting. The trouble here is that you plan for all of the fixed asset purchases for the next year during a few weeks at the end of the preceding year. So everyone submits their proposals, and the winners have their expenditures built into the budget.
OK, but what if you have an unexpected need for more fixed assets sometime later in the budget year? You’ll probably buy them, and that means you’ll spend more money on fixed assets than you expected. In fact, it means you absolutely always spend more money on fixed assets than you expected. The reason is that a pre-approved fixed asset will be bought, and it’s usually bought earlier in the budget year. Therefore, expect to need more cash than you expected for fixed asset purchases.
Command and Control Problems
And then we have the biggest problem of all, which is the command and control system. This is the very common management system where the senior management team makes all of the large decisions, and everybody else implements them. When you have a command and control system, the “control” part of the equation is the budget.
The senior management group creates a performance contract with every manager in the company, where it hands out bonuses only if managers meet their expected performance – and that performance is detailed in the budget. Now, if you think the command and control system is fine, then you’re thinking, so what’s wrong with that?
There’re several problems with that. First, there’s that gaming the system issue that I just talked about. Budgets will be conservative, so that managers can make their bonuses. Count on it.
Second, people defend their budgets ferociously, so it’s really hard to shift money into new lines of business. This means that a business with a command and control system becomes rigid – it can’t react quickly to new opportunities.
For example, what if you’re a manager, and you see a hot new opportunity. But getting the money to pursue it outside of the normal budget process requires all kinds of approvals. Chances are, you won’t bother to spend the time getting a special dispensation, and you’ll wait until the next budget year to get funding for it. And by that time, the opportunity may have passed.
And on top of all those problems, you have ethical issues. If a manager is not quite going to make his numbers, and therefore won’t be paid a bonus, do you think there’s maybe just a little temptation to bend the rules to create better results? Yeah, just maybe.
Finally, command and control systems are both expensive and self-perpetuating. You need a budgeting staff, as well as people who run around and figure out why there’re variances between actual and budgeted results, and who generally try to keep the company running in accordance with the budget. And, these people obviously have a vested interest in maintaining the budgeting system, if not expanding it. After all, if there were no budget, they’d have no jobs.
So that covers the masses of problems with budgets. In the next episode, we’ll talk about how to operate without a budget. That episode might be delayed a few weeks, since I’m trying to fit in an interview on a different topic – so, stay tuned on that one.