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Do Annual Budgets Make Sense Anymore?
The idea of a budget is so core to financial wisdom that it’s one of the first lessons we learnt from our parents for keeping our finances (and lives) on track. Annual Budgeting exercises have been the norm in almost all companies, big and small, across the world for decades. However, in recent years, there has been a lot of news about companies, some very prominent headline-grabbing ones, doing away with their annual budgets and moving to a monthly rolling forecast-based system. This has made finance professionals and business executives question their own company’s budgeting processes and their worth, especially since they eat up a significant amount of organizational time. While each company must decide what works best for it depending on the nuances of its operations, below is a discussion on some key issues impacting this decision.
What is the Annual Budget and how does it work?
An annual budget is, essentially, a plan of an organization’s revenues and expenditures for the coming year. The process of formulating an annual budget is an elaborate one wherein the long term strategic goals of the organization are identified and translated into targets for the year and optimal allocation of resources is determined to achieve the same. Depending on the organization, the plans will be made at a division, segment, category, brand, or geography level. For example, a global consumer products company would have budgets for their different categories such as personal care, hair care or home care further broken down at a brand level as well as at a geography level for various countries where they operate.
The entire annual budgeting process in most companies takes around 2-3 months. Thus, if a company is operating on a calendar year basis, the budget would be worked upon during September to November of the previous year and finalized by December.
Modern-day business environments and shortcomings of Annual budgets
Today’s business world is extremely dynamic. Considering that the budget is formulated around 2-3 months prior to the year even commencing, the business realities at the time of making the budget vs as the year actually progresses may be significantly different – a new foreign competitor with deep pockets may have entered the market, an existing competitor may have slashed prices, crude oil prices may have skyrocketed taking input costs through the roof, a natural calamity may have occurred, a new revolutionary technology breakthrough may have been achieved or a new tax law may have been passed by the regulators! With the pace of change in business environments increasing by the day, it won’t be an exaggeration to say that the budget is outdated the minute it is made.
Processes that cope with the changing times
In order to adapt to the dynamism of the world, organizations have devised processes to mitigate the shortcomings of annual budgets. A popular mechanism is to have scheduled Budget revisions (latest estimates) made once or twice during the year, for example in April and August. The revised budgets allow the organization to take cognizance of the new circumstances and make a more realistic plan for the remainder of the year.
Most organizations today, also have monthly rolling forecasts of 12-36 months, depending upon the nature of the business. A bottom-up monthly forecast with inputs from across divisions and functions captures the impact of events that have occurred during the month and ensures maximum agility. The value added by such forecasts is immense as it allows management to respond quickly to changing dynamics such as raising prices of their products in response to increases in commodity costs or allocating discretionary resources such as media budgets to a business segment which is seeing tremendous growth potential rather than a segment facing hurdles. In the absence of a rolling forecast, business teams would just stick to the original annual budget. In a scenario where the sales of a division have been sorely hit in the first half of the year leading to a significant shortfall vs the annual target, sticking to the annual target may lead to demotivated business teams who know the shortfall is impossible to make up anyway and, hence, deliver sub-optimal results in the remainder of the year too. Holding teams accountable for realistic monthly goals set just before the month ensures optimal performance of divisions and, hence, the organization.
Time to say goodbye to the traditional budget then?
Despite the obvious limitations of the traditional annual budgets, however, they arguably, still serve some purpose. An annual budgeting exercise is quite distinct from rolling forecasts in that it is an elaborate process that starts with laying down a long term strategy. This represents where the organization intends to reach in the next 5 or 10 years – which business segments or categories, how much sales revenues and net worth, which geographies, etc. This is then broken down into years and translated into an annual plan for the upcoming year. This process ensures the end goal is kept in mind. While business environments may change and need to be responded to, it is critical to measure the actual position of the organization at the end of a year against the intended position.
For example, if a cigarette manufacturer has determined its strategic direction as diversification into consumer packaged products over the next 10 years, it is critical to ensure that investments are made in that direction every year although this may mean lower margins or higher capital and media expenditure initially. In the absence of an annual budget that captures this strategic intent and allocates resources accordingly, mere reliance on monthly rolling forecasts may lead to the organization cutting its investments in the new business and directing it to the familiar higher-margin cigarette business.
The Middle ground
While it is clear that “once a year budgets” are no longer capable of enabling companies to handle the complexities and pace of today’s business environments, companies across the globe seem to have realized that the annual budget remains critical from a strategic as well as controlling standpoint. However, it is also true that allowing an annual budget to dictate how business is managed on a daily basis would severely restrict the agility that today’s dynamic landscape demands of organizations. Thus, most companies seem to have decided to follow a hybrid system of annual budgets which allow tracking of their strategic direction supplemented by rolling forecasts which allow the business to be managed dynamically.
The article was first published in Unit 4 Prevero Blog