How to Shift Budgeting From Gamesmanship to Real Planning

April 16, 2018
The afflictions that rigid annual budgets impose on manufacturing can be cured by applying a more adaptive model to planning and forecasting.

Budgeting and planning should be complementary and reinforcing activities. However, most manufacturing personnel probably haven’t experienced such delightful circumstances. Why? Because like many powerful tools, budgeting for operations is often held hostage to the demands of external financial reporting and the performance incentives associated with it. The result is a contentious environment where budgets are completed once a year with static spending targets (unless there is a dire need for a quarterly revision), all stakeholders play liar’s poker to maintain a reserve of flexibility (since the real world changes continuously), and often performance is manipulated with marginally ethical maneuvers to achieve unrealistic budgeted outcomes.

The impact on manufacturing is most severe since its budget and planning is highly dependent on sales forecasts. Also, most of its costs—beyond material and energy costs—are fixed or relatively inflexible.

Inflexible budgets can impose negative impacts in both good markets and bad. In bad markets, manufacturing has a tendency to align production to original budget targets, resulting in over production. Alternatively, if manufacturing slows production it risks being penalized in the upcoming budget cycle for not spending its budgeted targets. In good markets, production may not be ramped up to meet rising demands due to fear of overspending the budgeted targets.

The afflictions of rigid operating budgets have been widely diagnosed, but rigidity is an extremely resilient disease. Rigidity offers a façade of certainty and simplicity because it ties to financial statements and senior executive bonuses.

The antidote for the fixed budget disease is a dose of reality based on frequently updated sales forecasts—or, ideally, production based on orders—and clear, causal linkages between costs and operations. This is a surprisingly tough pill for CFO’s and CEO’s to swallow because it requires them to change performance management practices, accept that external financial statements are not the only financial version of the truth, and supplement financial accounting costing practices to incorporate more managerial (i.e. resource- and operations-based) costing. There is a great deal of literature available on implementing “rolling forecasts” for demand planning. One good source is the Beyond Budgeting Roundtable, which addresses both leadership principles and management processes for making planning and forecasting (they prefer to avoid the term “budgeting”) an adaptive model rather than an annual contest of negotiating skills.

Connecting costs to operations is the most challenging part of the change since finance and accounting must completely realign their typical thought processes. They are trained to build a financial model that resembles operations. Establishing meaningful connections to operations means finance must understand and use the operational model, and then design and collect monetary metrics that reflect in detail the operational and support processes and resources through to the final product. This must be done in a manner that makes strong causal relationships clear, eliminates weak or non-causal relationships that distort decision-making, and makes information available when needed—often within time frames that don’t match typical accounting activities, periods and cut-offs.

The only reference that focuses on building an operational model first and then molding monetary metrics to it is the Institute of Management Accountants’ “Conceptual Framework for Managerial Costing.” It ignores accounting standards and focuses solely on internal decision support. It identifies causality as the primary principle for building an operational and cost model, and it presents ten concepts that define causality to provide the means to assess an organization’s costing needs and evaluate advanced costing solutions and systems. A new IMA-associated website has also been developed to focus on costing for internal decision support.

>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.