3 crucial factors in budget setting

The future can be only determined in hindsight and so it is crucial that strategic investments of people, technology, money and yes, even time, are well thought through.

Picture this: As you walk into the meeting you are excited. Your team have finalised the budget for each of the next 12 months and three years. Its importance cannot be overstated as it will set the firm’s behaviour for the coming year and beyond.

This year there are two elements of note. A strategic plan had been created by the whole team and you have decided to become a leader (Okay, you are the Owner/CEO, and you’ve always held control, but you’ve come to realise that this does not mean you are a leader.).

The strategy is exciting, innovative and you are sure that it will set the firm well apart from its competitors. Major lines will be dropped, new markets built. Productivity and innovation are the new catch phrases. Your team are great. Now their ideas and energy can be fully utilised as you step into the role of helping them be all they can be. Now the firm will be run by many brains, not just one.

Sitting at the table are the accountant and senior managers. Each has had a say in the calculations and today they will be presenting the results. In prior years the budget has been limited to one year, and created by you and but this year things are being done differently.

You wait for the presentation to begin. As it progresses anxiety begins to build in your chest. Your face becomes increasingly perplexed. It is little different to last year. “Why?” you ask. “Why?”

You thank them for their efforts and return to your office.

You  ponder: Your team is experienced and tough and so it doesn’t make sense. You begin to research why such talented individuals would allocate funds so differently than needed. Your research surprised you. The obvious factor – lack of experience – is not the cause.

The three factors:

Stephen Hall and others of McKinsey and Company did a review of 1,600 listed companies over a 15 year period ending in 2005. They found that one in three firms actively changed resource allocations over a period of more than 3 years and one in three (“stable group”),  didn’t change allocations very much at all.

All firms were stock listed so it was expected that strategic planning would be high on the agenda. It was surprising that there appeared no apparent reflection of this in the resource allocations of the stable group of around 500 firms.

This could be important you realise.

It seemed that lethargy and game playing were issues in this stable group of firms.

Lethargy

Inertia may be caused by any number of reasons but a large contributor is unknown bias. There are many biases impacting the human psyche but the ones most influential in this situation are:

  1. Anchoring. Where decision makers refer back to the original value and gain comfort from it unconsciously (and consciously) making arguments to its relevance.
  2. Loss aversion. As humans we feel losses more acutely than gains and so will hold on to an idea even when a rational exploration would show it to be unsuitable. We don’t like to face pain.
  3. Sunk cost fallacy. This is along the same lines as loss aversion where past costs are considered an investment, when they are merely sunk costs and should be ignored from the evaluation.
  4. Status quo bias. It’s always easier to accept the status quo than to challenge it, that is if there is no mechanism in place to do otherwise.

You recall a statement by HL Mencken “There is always an easy solution to every human problem – neat, plausible and wrong”.

Game playing

Game playing is when the budget is created with a slush fund amount.

The problem with game playing is not the slush fund per se – many executives like to know that their managers have discretionary balances that are accessible when needed – the problem arises when the slush fund is hidden and has been created to protect the manager: against loss of prestige (removal of budget shows weakness), loss of remuneration (where managers are paid a bonus on the difference between actual and budgeted results), inability to perform role (the manager believes that funding will be cut below what is needed to run a functioning section) and so on.

This information is very interesting, and you wonder whether you and the accountant employed these factors in past years. Well it’s too late to worry about history, but this knowledge is useful for the future. But it doesn’t seem enough.

You think: Where there is a need for protection demonstrated through these games then the firm suffers an overarching lack of trust. You know that lack of trust is much more significant than a budget misallocation, indeed it can be terminal, and you wonder if that is the real heart of the issue.

Lack of trust

Trust sets the culture of the firm – accountability, team work, respect and so on. It is a perception which is built from past experience and inherent beliefs. It is dynamic and situational so will change as knowledge and situation change.

When trust is high a workplace is fun and productive. When it is low it is stressful and results are slow. The culture of trust is set by the actions of those at the top and reinforced by actions down the line.Trust is a delicate and timid asset which doesn’t come when asked. It must be earned.

In the past you have held decision-making tight to your chest. You’ve done this because your team do not have the skills to do things themselves. You’ve made all the decisions in the past – the strategic direction, who to employ and where to spend the money.

You realise that by acting as you did you have told your team that you don’t trust them and they don’t deserve to be trusted. Well, you realise, they must fear what will happen when they don’t achieve the strategic outcomes.

You call a meeting for the morning and in it open up about what you’ve found. You ask your team for help in making you a leader. You listen attentively as you know this shows respect, key in building trust. And you start by working alongside them to create the budget. It takes longer than it would if you were to do it alone because you acted as teacher but in the end the budget is better.

The team go and create a checklist to help future budgets and the quarterly budget reviews

The checklist

  1. Be open in dialogue.
  2. Create opportunities to debate how resources should be allocated.
  3. Don’t forget the scenarios. Look for the things that could go wrong as well as go right.
  4. Recognise that bias will creep into decision making regardless of the situation. It cannot be removed. All that can be done is instigate actions to uncover it.
  5. Break objectives down to a granular level; If a strategy says increase international sales to 15% specify the countries or cities that are to be targeted.
  6. Conduct an audit of each business area, product line, and project to uncover if it is still meeting investment criteria and then take appropriate action.
  7. Revisit the allocation criteria by considering external factors such as market growth and competitor activities.
  8. Have a transparent slush fund preferably at the highest level and use it in accord with strict guidelines. Easy money is still wasted opportunity.

You reconvene. They show you their checklist and you share your checklist with them.

Your checklist

  1. Remove budget responsibility from performance assessment. If a manager has done all they could possibly do and it didn’t work they should be lauded for the effort not are hung out to dry because the budget was not met.
  2. Be firm on action: If a project is to be cut then the manager must either let it go or prove that it can be turned around. No other option.
  3. Regularly review the motivations of  leaders and do something about it. Are they aligned with the firm’s goals? Prima Donna’s don’t align well with a team culture.
  4. Be open and honest and accountable. Recognise that it is your responsibility to nurture and support.
  5. You will make mistakes, so will they. From mistakes we learn.
  6. How we treat mistakes must be monitored. This as important as the mistakes we make.

You return to your desk and create daily triggers that remind you to earn and build trust.

The future can be only determined in hindsight and so it is crucial that strategic investments of people, technology, money and yes, even time, are well thought through. You now know the full weight of your  responsibility and plan to shoulder it well.

You are pleased that the original budget presentation went as badly as it did.

 


Further reading

Bart, Christopher K.  1988 Budgeting gamesmanship,  The Academy of Management EXECUTIVE, Vol.11, No 4. pp 285 – 294

Hall Stephen et al 2012,  How to put your money where your strategy is. McKinsey Quarterly, Accessed  5th April 2016

Walker, Kenton B.  et al 2013,  Toeing the Line: The ethics of manipulating budgets and earnings,  Management Accounting Quarterly, 14, No. 3. pp 18-24

de Waal, Andre et al 2011, The evolutionary framework: explaining the budgeting paradox,  Journal of Accounting and Organizational Change, Vol. 7, No. 4. pp 316 – 336

Wiseman, Liz and Greg McKeown 2010,  Multipliers: How the best leaders make everyone smarter,  HarperCollins e-Books

Wolfe, Robert F.   2012,  How to minimise your biases when making decisions. Harvard Business Review, Accessed 31st March 2016

 

By Jennifer Bishop

Jennifer Bishop helps leaders turn their strategies into results.

She assists executives and business owners to achieve goals without delay regardless of whether those goals are increases in profit, productivity, leadership skills or something else. Her services are Business and Executive Coaching, Group Facilitation, Strategic Planning, and advising on Board Governance.

She is a Graduate of the Institute of Company Directors, Fellow of Chartered Accountants ANZ, Certified Management Consultant  and an Accredited Mindshop Facilitator. To find out how she can help you, call +61 439 520 182 or email.