Budget & Politics

What came first?

George Alexander Parson Consulting February 13, 2007

Budget Definition
The budget of a company is compiled annually. A finished budget usually requires considerable effort and can be seen as a financial plan for the new financial year. While traditionally the Finance department compiles the company's budget, modern software allows hundreds or even thousands of people in the various departments (operations, human resources, IT etc) to contribute their expected revenues and expenses to the final budget. If the actual numbers delivered through the financial year turn out to be close to the budget, this will demonstrate that the company understands their business and has been successfully driving it in the direction they had planned. On the other hand, if the actuals diverge wildly from the budget, this sends out an 'out of control' signal and the share price could suffer as a result. - Wikipedia.com
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Budget Etymology
Middle English bouget, wallet, from Old French bougette, diminutive of bouge, leather bag, from Latin bulga, of Celtic origin; see bhelgh- in Indo-European roots. So a budget is a bag of money.

What did we learn in school?

Fundamentals of Financial Management Brigham
2 pages in Planning Tools and Techniques chapter

Management Longenecker/Pringle
4 pages of 684 = of 1% Of 2000 hour work year = 12 hours

We learned 99% of what we know about the budget process on the job. This does not contribute to an influx of new ideas. This is not a hot academic area, but there is some current attention to it. The current thinking is to align budgeting to strategy, disconnect it from a yearly cycle, and to harmonize personal goals with it. Some suggest it should be abandoned.

Budget Goals
Its simple isnt it?
To choose among investment options. To decide who gets how much in their purse. This is based on what the return will be for that allocation/investment. We learned all this in school, right?

Or is it simple? We have an impressive array of quantitative and process-oriented resource allocations systems at our disposal. THIS is what they taught you in school. How often do you use these analytics in the budget process?

Budget Quotes

Budgeting is governing
- Pete V. Domenici, chairman of the Senate Budget Committee Corporate Budgeting is a Joke
Michael Jensen, HBR

The budget must be balanced. debt must be reduced; arrogance must be moderated and controlled. Payments to [suppliers] must be reduced, if [we] dont want to go bankrupt. People must again learn to work.
- Cicero 55 BC

The budget is the Bane of corporate America. It never should have existed Making a budget is an exercise in minimalization. Youre always getting the lowest out of people, because everyone is negotiating to get the lowest number.
Jack Welch

Budgets are tools of repression, rather than innovation

Bob Lutz, former chairman of Chrysler Corporation

Politics Definitions
Politics - American Heritage Dictionary
(used with a sing. or pl. verb) The often internally conflicting interrelationships among people in a society.

Play politics. (Random House Unabridged Dictionary)

a. to engage in political intrigue, take advantage of a political situation or issue, resort to partisan politics, etc.; exploit a political system or political relationships. b. to deal with people in an opportunistic, manipulative, or devious way, as for job advancement. Random House Unabridged Dictionary

Politics, Ambrose Bierce

n. Strife of interests masquerading as a contest of principles.

Politics Quotes
Politics is supposed to be the second oldest profession. I have come to realize that it bears a very close resemblance to the first. - Ronald Reagan Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy. - Ernest Benn Yes, we have to divide up our time like that, between our politics and our equations. But to me our equations are far more important, for politics are only a matter of present concern. A mathematical equation stands forever. - Albert Einstein

Budget Politics
The budgeting process is so deeply embedded in corporate life that the attendant lies and games are simply accepted as business as usual The best designed systems can be trumped by the power of personality.
It is now commonplace for talented and charismatic managers to spin, manipulate and otherwise cajole senior management into funding their business ideas.

When people get economic with the truth during capital budgeting, the underlying economics get lost.

Budget As Is
Research data suggest that:
5% of the workforce understand their company's strategy 25% of managers have incentives linked to strategy, that 60% of organizations don't link budgets to strategy 85% of executive teams spend less than one hour per month discussing strategy

90% of respondents thought their budget process was cumbersome CFO Magazine If youre involved in the process, no one needs to tell you about the game-playing

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Cheaters Prosper
Typical Comp Scheme
80% of Target Bonus kicks in 120% of Target Bonus Cap This rewards people for what the SAY they will do

Games/Cheats
Sacrifice next year for this year to make 80% Take a big bath this year if you cant hit 80%. This will make next year easier. Push profit into the future to avoid 121% All of these cheat are easy to do

Solution = Straight Line bonus plans

Pay = Performance Challenge is to decide on measures

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Archetypes The Players

Sandbaggers
They plan to achieve less than they can. No one can grow this business by 10% a year!

Magicians
They cover up faults by leaving out facts, or diverting attention. We didn't actually overspend our budget. The health Commission allocation simply fell short of our expenditure. - Frank A. Clark

Lone Agents
Were different. They stonewall and expect special treatment and standards.

Visionaries
If they dont have numbers on their side they appeal to emotions. Breakthroughs, revolutions, cutting edge. Its usually faith-based investing.

Hostage Takers
Require huge investments for huge paybacks. Often risky, but even if not, can starve off other profitable investment options.

Beware the artful ones!

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What Causes Game-Playing?

It may be intentional sometimes, but other times Game-playing sometimes reflects a lack of skills and know-how rather than Machiavellian intentions. Some managers may simply not be team players Some may have a very short-term focus Lack of clarity about performance goals Misunderstanding about the pace at which goals are to be met
Executives teams are often shorter-term focused than line managers

Response to culture or values

If hard-charging sales types are promoted, you may get a surplus of Lone Agents and Hostage Takers If leaders come up through Finance, Sandbaggers and Magicians may prosper.

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Budget Issues Can Hurt the Business

Creates climate of mistrust, cynicism This can extend to other behaviors Managing the numbers can break the law
When you change allocations to meet budget then the financials meet expectations, then the Street is happy, right? What happens next period, next year?

Optimistic budgets alone can be damaging

Can cause entire industries to enter a boom and bust cycle

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Beware of Lack of Clarity

Our measurement systems and goals are often unclear and encourage obfuscation. The great enemy of clear language is insincerity. When there is a gap between one's real and one's declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink - George Orwell
He could have added:
One turns to underestimating (Sandbaggers) One turns to twisting facts (Magicians) One turns to claiming uniqueness (Lone Agents) One turns to fantasy (Visionaries) One turns to snake-oil salesmen (Hostage Takers)

If it doesnt make sense to you, it probably doesnt make sense.

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Games Have Rules

The RULES are either clear, or not When the rules are clear, progress is made. When the rules are unclear, chaos reigns
Have you tried raising kids? The ultimate lack of rules = warfare

Science has strong agreed-upon rules:

In science it often happens that scientists say, 'You know that's a really good argument; my position is mistaken,' and then they would actually change their minds and you never hear that old view from them again. They really do it. It doesn't happen as often as it should, because scientists are human and change is sometimes painful. But it happens every day. I cannot recall the last time something like that happened in politics... - Carl Sagan

That doesnt mean inflexibility

Even when laws have been written down, they ought not always to remain unaltered. - Aristotle Everyone has a budget, I don't care who you are. But they said if we are in a pennant race in the middle of the summer they are going to get some help with added payroll. Dusty Baker
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Establish Clear Measures, Clear Rules

Use a single, clearly defined measure of overall business success
EVA Balanced Scorecard Customer measures

Tie budgeting to strategy, and often. Accept that things will change more often than yearly Do not use ratios (Sales margin, ROA, etc)
This will cause managers to work the numerator or denominator, like selling only the high margin products and backing off on the lower margin to the detriment of total revenue.

Kaplan discusses a diving competition type of measurement. More difficult goals have greater rewards. Team vs. Individual Implement carefully

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New Budget Directions

Sever the link between budgets and bonuses Linear bonus schedules
Reward people for what they DO, not what the SAY they will do.

Eliminate budgets Set bonuses for multiple years, to eliminate year-to-year gaming Set bonuses for monthly periods Institute Rolling Budgets
Common practice among Japanese firms like Toyota Two to three year duration NPV of future cash flows Basic Financial Statement format infected by focus on earnings, cash is a derivative. Zero in on investment (W/C, assets) and financing rather than Assets liabilities and equity. Emphasize level of free cash flows R&D, process improvements, new markets, intellectual property, etc. are what drive longterm cash flows, not earnings.

Restructure Your Planning Formats

Refocus Budgets on growth drivers

Change the vocabulary Value-Creation Planning?

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Can You Change Root Causes of Budget Issues?

Can you tie budgets to strategy? Can you make budgets evergreen? Can you roll the horizon? Can you determine simple, clear measurements? Can you implement them? Can you implement a straight line bonus plan? How is your CEO measured? Can you change that? Can you Address them? The budget isnt the root cause of counterproductive actions; rather its the use of budget targets to determine compensation.

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You Can Change Symptoms

Get it out on the table
Acknowledge the human tendency to twist the facts in ones favor Make it clear that not only the numbers, but the integrity of the individual presenting them will factor into consideration Demand and expect externally supported data for trends, changes, etc

Create a profile of expected behavior

Ability to meet long and short term expectations Ability to be candid about the state of the business

Deal positively with bad behavior

Productive vs. inflammatory responses

Use Peer Pressure/Presence

Require that all managers be present for key budget review sessions. Peers can identify and challenge assumptions and gaming

We might come closer to balancing the Budget if all of us lived closer to the Commandments and the Golden Rule Ronald Reagan
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Change is Hard
Expect massive resistance CFOs may resist the most There may be greater uncertainty in quarter to quarter results, but long-run profits will be superior Remember, it has taken many years to weave lying and deceit into the fabric of our businesses; cleansing the fabric will take time as well. Go do good

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Bibliography
Breaking the Budget Impasse
Loren Gary Harvard Management Update, 2003

Corporate Budgeting is Broken Lets Fix It

Michael C. Jensen Harvard Business Review, November 2001

Turn Your Budgeting Process Upside Down

Robert A. Howell Harvard Business Review, July-August 2004

Games Managers Play at Budget Time

MIT Sloan Management Review, Spring 2004

Financial Management Theory and Practice

Brigham

Fundamentals of Financial Management

Brigham

The Strategy-Focused Organization

Chapter Eleven, Planning and Budgeting Kaplan and Norton, 2001
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