It’s that time of year again, when organizations go through the annual -- almost mystical -- ritual of compiling numbers (pages and pages of numbers, thanks to the wonder of budgeting software) to create “The Budget”. Executives lead the way, believing that through the budget they can coordinate the various functions of their organization. By sharing accurate information and making decisions from a common set of numbers, functions will work in harmony, processes will be more efficient, products will be of the highest quality, inventories will be managed effectively, customers will be happy … the band will play, the sun will shine, birds will chirp, the prince will slay the dragon to save the princess, and they will ride off into the sunset to live happily ever after. Sound familiar?

Well, rather than living in a fairy tale, how about a big fat dose of reality. Because bonuses are based on achieving specific budget goals, managers argue behind closed doors throughout the entire budgeting process. Sales and marketing set their targets low so that they can easily achieve them, and then play games with their numbers throughout the year to ensure that they get the maximum bonus allowed. Manufacturing suspects the gaming, so it orders the same amount of inventory as it did last year, ignoring this year’s sales budget. Finance needs to cover its own derriére, so it pads the budget here and there, playing its own shell game to compensate for the games played between other departments -- and on and on it goes.

Instead of harmony and efficiency, the budget process creates an environment that is chaotic, decisions that are based on distorted information, and an organization that is rife with cynicism and skepticism. Having observed this budgeting process over the years in many companies, I’ve concluded that it’s like watching sausage being made: Once you see it, you don’t ever want to eat it again.

The budget becomes a joke. It’s based on unrealistic sales forecasts and distorted expense estimates, painting an impractical -- yet always rosy -- picture of next year’s profits. Therefore, the budgeting process has earned my affectionate nickname, the “Annual Rain Dance”.

During the year, the finance folks will produce volumes of monthly reports demonstrating actual performance compared to the budget. And by mid-year or sooner, it becomes obvious that the budget is obsolete. Perhaps revenues haven’t materialized like the sales people dreamed they would. Or cutting expenses out of production looked good on paper, but hasn’t been as easy to do as the production team thought it would be. Or, the cost of materials has gone up dramatically due to some unforeseen or overlooked event. Or the numbers were so distorted that nobody believed in them from the get-go, but just wanted to get the anguishing budget process over with. The budget is ignored for the remainder of the year -- until it’s dusted off to write next year’s budget.

The reality is that the budget ritual often does the opposite of what is intended. Now, I’m not advocating throwing budgets entirely out the window. Budgets are not only necessary, they are the essence of management; they are the primary instrument of planning and control – when they’re done right. From what I’ve observed, budgets fail when executives expect them to do things budgets shouldn’t do.

BUDGETS SHOULDN’T LEAD STRATEGY

I’ve worked with many organizations that have been operating by the seat of their pants, strategically speaking, because they did not have a well-written strategic plan with measurable goals and objectives. The annual budget is the only document managers take the time to produce. Therefore, by default, the budget is in the driver’s seat of strategy.

But budgets should not drive strategic goals and objectives; strategy should drive budgeting decisions. When budgets lead strategy, decisions are based on short-term budget objectives instead of long-term strategic goals. Allocation of resources is based on which manager whines the best or screams the loudest, instead of being allocated strategically.

Hand in hand with the Annual Rain Dance, companies should carry out an examination of customers, competitors, and economic and technological changes, as well as an internal examination of performance and ability to compete. Then, a handful of performance-based corporate objectives should be written -- to make a return on investment of 15 percent after taxes by the end of five years, for instance. Several functional objectives (goals for sales, gross profits, work force, and production capacity, to name a few examples) need to back up each objective, and tactics to achieve each functional objective are needed to finalize the document.

Linking corporate strategy with the budget leads to greater support of corporate objectives, better coordination of tactical plans, and in the end, greater performance organization wide. This link is made even stronger by effective communication of the goals and objectives to employees. Companies that build effective communication channels will find that their budgets are more realistic and helpful in supporting strategic goals.

BUDGETS SHOULDN’T MEASURE PERFORMANCE

Many executives evaluate the performance of their managers primarily on how well they hit their budget targets. This may be necessary and logical, but it doesn’t acknowledge reality. A one-dimensional evaluation like this is like putting a big steak bone in front of my dog: It’s just too darn tempting for managers to play games with their budget goals or to make short-term changes that aren’t necessarily in the organization’s best interest.

I’ve seen executive teams that have set forth pie-in-the-sky budget goals that would either require divine intervention or cooking the books to achieve. Or, if the organization has a history of failed attempts in performing up to budget expectations, rather than dealing with the question of why, they low-ball goals and settle for mediocrity. In several cases, organizations have made goals that they don’t have the necessary capital resources to support. Then at the end of the month, quarter, or year, when actual performance doesn’t match budget goals, frustration, cynicism, and finger-pointing erupt. And a few very ambitious, creative, and carnivorous managers – those without consciences – may even be tempted to rearrange and play games with their numbers. Can we say Enron, Tyco, Adelphia, WorldCom?

One effective way to change this nonsensical behavior may be to establish a linear compensation plan that rewards actual performance independent of budget targets. If managers receive the same bonus for a certain level of performance whether the budget target is beneath or above that level, the motivation to play games with the numbers is reduced. Or, instead of rewarding only budget performance, use a balanced set of performance measures relevant to the function, such as growth in market share, reduction in product defect rates, or increased speed to market for new products.

BUDGETS SHOULDN’T PREDICT THE FUTURE

History is not necessarily the best predictor of the future, yet most organizations build budgets from the prior year’s numbers. Many times, I’ve seen multiyear budgets that are nothing more than linear sequential projections of 10 percent revenue growth and 5 percent profit margin growth each year for the next three to five years – even though the company has never hit any of those numbers before!

Budgets should provide flexibility and adaptability to reflect factors outside the organization’s control. They should accommodate change and allow managers to use resources efficiently to take advantage of new opportunities or respond to competitive threats. Flexibility also frees budget developers from the temptation to pad budgets to cover the wide variety of possible unforeseen developments.

Whether an organization reviews its budget on a quarterly, monthly, or even weekly basis, it should include in those reviews an examination of changes in business conditions. This will alert management that a revision in the budget may be necessary. While it’s inexcusable to revise budgets to cover up poor performance or bad planning, it’s moronic to stick to a budget that no longer reflects the current environment. Some organizations create built-in flexibility by using rolling forecasts instead of traditional annual budgets.

Another method that allows for flexibility is to create multiple scenarios based on possible events. For example, what impact would a 300-basis point move in interest rates have on your business? Or, how would you respond to pricing changes by your competition? These “what if” scenarios help organizations respond more quickly and effectively when one of these events actually happens, instead of reacting blindly or being caught flat-footed.

The budget process doesn’t have to lead to chaos, mistrust, and lying. Rather, the Annual Rain Dance can be an opportunity to think strategically and creatively about the future of the business. When done right, budgets can help organizations make better decisions and plan long-term goals. They can be a powerful motivator for people. Then, the Annual Rain Dance can be replaced with … The Victory Dance!