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 learn from our parents for keeping our finances (and lives) on track. And annual budgeting exercises have been the norm in almost all companies, big and small, across the world for decades.
However, after a challenging few years, there have been a lot of reports of companies doing away with their annual budgets and moving to a monthly rolling forecast-based system to manage fast-changing circumstances better.
This switch has made finance professionals, and business executives question their own company's budgeting processes, 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 your Annual Budget, and how does it work?
An annual budget is, essentially, a plan for an organization's revenues and expenditures for the coming year. The process of formulating this budget is elaborate. It identifies the organization's long-term strategic goals, translates them into targets for the year ahead, and optimizes resource allocation to achieve this goal.
Depending on the organization, typically, these plans are made at a division, segment, category, brand, or geography level. For example, a global consumer products company would probably have budgets for their different product categories, such as personal care, hair care, or home care, further broken down at a brand level and at a geographical level for the countries they operate in.
The entire annual budgeting process in most companies takes around 2-3 months. So, if a company operates on a calendar year basis, budgeting usually happens from September to November of the previous year to be finalized by December.
The shortcomings of Annual budgets for today's business environments
Today's business world is highly dynamic. Considering that you formulate your budgets 2-3 months before the year commences, the business realities at that time vs. the year itself may be significantly different. For example, you could unexpectedly face:
- A new foreign competitor with deep pockets entering the market, or
- An existing competitor unexpectedly slashing prices, or
- Crude oil prices skyrocketing and pushing your input costs through the roof, or
- Regulators passing a new tax law!
With the pace of change in business environments increasing by the day, it is no exaggeration to say that your annual budget is outdated the minute it is made.
Processes that cope with the changing times
To adapt to the world's dynamism, organizations have to develop processes to mitigate the shortcomings of their annual budgets. A popular mechanism for this is to schedule budget revisions (latest estimates) periodically throughout the year. These revised budgets let your organization take new circumstances into account and adjust as necessary to make your budgets more realistic for the remainder of the year.
Most organizations also have monthly rolling forecasts of 12-36 months, depending upon the nature of the business. These are bottom-up monthly forecasts with inputs from across divisions and functions that capture the impact of events that occur during the month to ensure maximum agility.
The value added by rolling forecasts is immense. They let managers respond quickly to changing dynamics. Allowing them to take actions like raising prices of their products in response to increases in commodity costs or allocating discretionary resources such as media budgets to a business segment that sees tremendous growth potential rather than a segment facing hurdles. In the absence of a rolling forecast, business teams would simply stick to the original annual budget.
A scenario where a division's sales have hit hard in the first half of the year can lead to a significant shortfall vs. the annual target. Sticking to the annual target may demotivate business teams. They will know the shortfall is impossible to make up and deliver sub-optimal results in the remainder of the year. Holding teams accountable to realistic monthly goals set just before the month ensures optimal performance of divisions and, hence, the organization.
Is it time to say goodbye to the traditional budget?
However, despite the apparent limitations of conventional annual budgets, they still serve some purpose. Your annual budgeting exercise is quite distinct from rolling forecasts in that it is an elaborate process that starts laying down a long-term strategy. Representing 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.
You then break this plan into years and translate it into an annual plan for the upcoming year. This process ensures that your end goal is always front of mind. While business environments may change and you will need to respond, it is critical to measure the actual position of the organization at the end of a year against the intended position.
For example, suppose a manufacturer has determined its strategic direction by diversifying consumer-packaged products over the next 10 years. In that case, it is critical to ensure that they make investments every year to achieve this. However, 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 areas of the business.
The Middle ground
While it is clear that "once-a-year budgets" alone are no longer capable of handling the complexities and pace of today's business environments, companies across the globe have realized that the annual budget remains critical from a strategic and controlling standpoint. However, it is also true that allowing an annual budget to dictate how you manage your business daily would severely restrict the agility that today's dynamic landscape demands of organizations. So most companies now follow a hybrid system where annual budgets track their strategic direction, and they supplement this with dynamic rolling forecasts.
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