Some say budgets are a hindrance, in fact the renowned businessman Jack Welsh of General Electric thought “they hid opportunity and stunted growth”. Hope and Frazer, authors of the renowned book “Beyond Budgeting” said budgets should be “abolished”.
But how many listened? They are still used by the vast majority of organisations today.
In my view it is not the process of budgeting that should be abolished, done well it can focus the minds of managers and encourage them to think strategically. It is the process of variance analysis that should be abolished.
Everyone knows that budgets are out of date soon after their production; many unforeseen happenings and new management decisions make actual cost comparisons with budget invalid, even inequitable. Perhaps the only worthwhile figure on a budget is the Net Result because frankly, if this figure is met at the year end then no one cares a hoot about the other variances from budget.
To get the best of this blog, the third in my series, it may be helpful, to read the other two first: 'There's no such thing as a Fixed Cost' & 'Categorising and reporting costs for better cost management'
So how do we keep budgetary control without cost variance analysis?
When a cost budget is constructed it is set after considering the value of budgeted sales on the top line and according to the plans and strategies set at that time. When cost variances are struck in each following month they compare these same budgeted costs with those originally budgeted despite the fact that the actual, latest sales value can be different from that within the original budget. This is not to mention any management changes to plans or strategies since the original budget.
Budgets are also too detailed. Is the board really interested in whether a manager spends too much on stationery and less on postage? If they are, then replace the board!
Budgets should be broad and flexible. Think in terms of the main costs. How much does it cost to make this product, how much to sell it, how much to administer it and so on. Within these categories, bespoke to your needs, individual managers may be interested in the detail but for senior management it is unimportant.
What is of interest to boards however is how cost groups change in relation to one another when top line actual sales value is different from the original budget.
EG. 6 months into the financial year, let's say actual sales and marketing cost is running at 15% of the actual sales value which has itself dropped significantly against budget. Budgeted sales and marketing cost, in the original budget was just 12%. This change in percentage should prompt valid questions from senior management
Simply striking a value variance between the actual sales and marketing cost against the originally budgeted sales and marketing cost is not a valid question; this variance could even be positive and it is unlikely in these circumstances that any question would arise from senior management.
This is a major deficiency in variance analysis yet many tens of thousands of managers live with this flaw many times a year.
Dwell a little longer on this situation, what impact has this 3% change in sales and marketing prompted. If all other actual cost percentages are consistent with the original budget it will have come from the 'Net Result' percentage. If that was originally 10% of sales then it means your profit would be 30% less.
When the percentages that each cost group bears to sales are expressed as 12 month rolling totals it becomes simple to see how the trends in overall cost proportions are changing and this facilitates the management of these changes. It is still budgetary control but without the deficiencies of variance analysis. In future just budget cost group percentages instead of individual cost values and monitor the trends that result.