Budgets: Overcoming Their Potential Downsides

Many experts contend that budgets often emphasize departmental spending limits and head counts and overlook quality and customer service – as well as profits. Budgets may also create barriers between the various functional and product market areas of a firm and between a firm and its customers. Robert Gunn, a consultant with AT&T, claims, ‘when you’re controlled by a budget, you’re not controlling your business.’

Some common problems:

budgeting is often an annual ritual, not connected to the firm’s overall strategy. Although budgets are useful for tracking expenditures, when used inappropriately they can become harmful. Budgets may become management’s main tool for assessing performance and may distort long term planning or prevent managers from shifting resources. A budget may become an end unto itself, as managers come to believe that ‘making the numbers’ should be their primary goal. Budgets may be used primarily to control negative behavior, such as spending too much, instead of reinforcing positive behavior, such as growing the business. As a consequence of such problems, successful companies of not base their control system strictly on budgets. They typically blend a reliance on financial measures, such as return on invested capital, with the use of non financial measures, such as market share and indicators of customer satisfaction and product quality. Below are additional examples of how well managed firms have improved the effectiveness of budgets as a form of control.

Avoid becoming too inwardly focused: Budgets typically stress cost targets. Thus mangers focus on controlling how much their operations spend, rather than how much they earn. Becoming inwardly oriented, mangers emphasize rules instead of initiative and question every small variance in a department’s original budget. At Emerson Electric, however, the key measure is profit growth, not spending, and this encourages an external focus on growth – as far down the organization chart as possible. President Al Suter says, ‘if a division president has an opportunity to gain market share, he can go out and buy all the steel he needs. No one has to ask.’

Design against turf wars:

When divisions are oriented primarily toward ‘making their budgets’ they may attempt to transfer work and costs to other divisions and these handoffs can alienate customers. Donald Curtis, a senior partner at Deloitte & Touche, says, ‘an excuse like ‘it’s not my fault; it’s the credit department’s fault’ is a non-answer to the customer’. Because of this organizations need to find ways to link budgets together horizontally, not vertically. At Xerox, field operations have been restructured to combine sales, service, and order entry into geographic units, rather than separate hierarchies that might disagree on funding allocations. Also at Emerson Electric, the reward structure provides a good reason for all operations in a division to collaborate. The separate operations much account for profits – not costs- and the manager’s incentive pay is based on the division’s performance as a whole.

Build budget busting into the system:

Simply revising an annual budget every few months may serve only to tighten budgetary constraints. Such an approach does little to encourage managers to think or act strategically. In contrast, 3M’s chief financial officer asks his operating managers to include a line in their strategic forecasts labeled NIGOs- Non-incremental growth opportunities. These include either new products that may be developed within the coming year or potential entries into new markets. The revenues and costs associated with such items are difficult to predict, but 3M has learned to live with this ambiguity. Allen Jacobsen, CEO of 3M, has told his division general managers, ‘I never want to hear anyone put down a project because it isn’t in the budget.’ Managers should feel safe to act on the knowledge that their business is not based strictly on a fiscal year. Robert Hershock, a group vice president at 3M, reflects the perspective of his chairman, ‘I’ve overrun budgets – overrun them pretty good sometimes. I was never criticized if I could justify it.’ This is an excellent example of using budgeting as a control lever based on organizational learning rather than strategy programming.