Newer approaches to budgeting, based primarily on forecasting and accurately measuring performance, are becoming as important as the budget – if not more so.
“There is a great deal of inertia in the corporate world surrounding the budget process,” says Greg Pazmandy, senior lecturer in accounting and business analysis at University of Technology, Sydney. “The budget has become not a means to an end, but the end itself. Managers spend six months putting together the budget, and it can be out-of-date as soon as it is finished.
“Worse, the budget can be used for the wrong reasons. For instance, people should never be judged or remunerated against a budget, but it happens all the time. The idea is to beat the competition – not the budget.”
Encouraging the wrong view
Pazmandy says the inertia surrounding the budget can lead to an inverted view of its importance, which can work contrary to the organisation’s best interests. “There is a cultural view in many organisations that you have to spend every last cent of the budget, otherwise you won’t get that level of funding again, or the department might lose a couple of positions. You can find departments in May and December finding themselves with surplus money, and they need to get rid of it. They’re completely forgetting the fact that the corporate profits go up if they don’t spent it. In particular, you often find this mentality in cost centres.”
Duncan Stevenson, director at Deloitte Private, says the problem with the traditional approach to once-a-year budgeting is not only the time and importance vested in it, but the fact that it is collated from a backward-looking perspective. “The basis of the budgeting approach has usually been taking last year’s actuals and adding a percentage for CPI, but the problem for businesses these days is that life moves too quickly now to be a slave to that approach,” he says.
A flexible approach needed
“It’s still good practice to set a budget, but the dynamics of business are such that forecasting is taking on a much greater importance – and rolling forecasting, with performance-reporting against that forecasting, and analysis of any variance. Rolling forecasting is really just continuous updating of the budget: you’re continuously forced to review your revenue and your operations.
We have clients that re-forecast on a monthly basis, because they understand that things are moving so quickly now that the view of the business – performance, cash flow, P&L and balance sheet – has to be much more dynamic,” says Stevenson.
Even very small companies can be highly flexible, he says.
“With things like MYOB, Xero, Accounting Online, you have now got the ability to
collate information on your business and report even if you’re not an accountant. You don’t even need an accountant. Even a kitchen-bench business can now get this constant reporting on the business that it probably didn’t have available before,” says Stevenson.
Future focus
The need to look forward is what has made traditional budgeting “obsolete,” says Pazmandy. “Budgeting was always based on looking backwards, and businesses have to look forward. Forecasting is simply a matter of predicting business activity for the future. That is much more important now.”
The problem, says Pazmandy, is that business measurement “got caught up in money” – which actually doesn’t tell the business much about what it does physically. “Budgeting is nothing more than cost allocation based on a certain level of activity that you expect. The business is converting physical operations into financial operations: money is just the financial representation of the physical operations.
“I think businesses are now going beyond the numbers, to also use the physical aspects to do the predictions, to allocate cost to that level of capacity that the business expects to be working on. Where the forecasting comes in relates more to revenue prediction, and you’ve got to use the physical operations,” says Pazmandy.
Mining the data
Duncan Stevenson says the information flow available allows businesses to become far more comfortable with, and professional about, forecasting. “People are armed with much more information than ever before.
The old-fashioned budgeting process would be built around saying, ‘OK, we did this much in sales last year, therefore we’re going to do 10 per cent better this year.’ But it’s now saying, ‘we did this much in sales last year because we sold this many units, and we sold them to this part of the market and that part of the market.’
“It’s breaking it right down into the key elements of the business that drive performance. You’re getting non-financial information, unit-based, where you’re getting actual results against that. So when you set your budget for next year, you’re actually not thinking, ‘last year plus’, you’re actually thinking, ‘OK, I think I can sell this many units in this market and that market’. The granularity of detail can enable the business to conduct rolling forecasting – continuous re-forecasting – that is much more flexible and adaptive to changing circumstances.”
[breakoutbox][breakoutbox_title]Forecasting of needs works for aged-care provider[/breakoutbox_title][breakoutbox_excerpt]Klaus Zimmermann, chief executive of South Australian aged care and retirement living provider Eldercare, is a strong advocate of using forecasting as an addition to the budgeting process…[/breakoutbox_excerpt][breakoutbox_content]From his perspective in the “not-for-loss” sector – he prefers that to “not-for-profit” – Klaus Zimmermann, chief executive of South Australian aged care and retirement living provider Eldercare, is a strong advocate of using forecasting as an addition to the budgeting process – for the very reason that Eldercare is “not for loss.”
Eldercare’s revenue is largely fixed: the only thing it can adjust is expenses. It still works from a budget, but its prime focus is on five-year rolling cash flow forecasts: then it works backwards and constructs its operational budget from that basis.
“We do five-year rolling cash flow forecasts, on a quarterly to six-monthly basis, and P&L forecasts naturally arise from that,” says Zimmermann. “We have a lot of infrastructure costs, and we can’t just turn the tap on and off for that. We’ll project our goals out five years: if we want to spend $200 million on new buildings over the next five years, this is what the budget needs to look like this year and next year and the year after, to achieve those goals,” he says. All the business decisions are made on the five-year forecast, not on the annual budget.
“The annual budget is the day-to-day operational stuff that we measure and do the KPIs on, but all the key business decisions, whether we build infrastructure or buy equipment, is done on five-year rolling cash flow forecasts,” Zimmermann says.
Eldercare’s ‘mission-critical’ information – KPIs and benchmarks – is contained in its ‘dashboard’, which prints out to the size of an A4 page.
“That’s where we list all of our income and expenses, per resident. We get industry data and compare ourselves to that, across the organisation, so we’re benchmarking ourselves against the industry and across Eldercare.
“We call it a dashboard because it’s all on one piece of paper, it’s sitting in front of you, and we use the traffic light system to say ‘danger, danger’ or ‘go, go, go’.
“I might have two sites where wages have blown out, or two sites where income per resident is down – the dashboard will tell me. All the key organisational KPIs are on that one bit of paper, and we find that is a really easy tool to understand and read,” says Zimmermann.[/breakoutbox_content][/breakoutbox]
Adapt or die
This adaptability is “absolutely critical,” he says. “No-one can afford to be complacent. Look at what online retail has done in the last couple of years, aided by the high dollar. Look at that media spat between the likes of Harvey Norman and JB Hi-Fi versus Kogan, which is importing TVs directly from China, selling them online and avoiding the GST threshold. In all sorts of businesses, web-based models have started to become very effective competitors.
“We’ve seen businesses turn around and have a complete change in business model – for example, shutting down their physical stores and going completely online. That completely changes your cost base, everything: the budget that you set last year becomes completely meaningless,” says Stevenson. The uncertain business environment can also “make a mockery” of corporate budgets, he says. “The ongoing effects of the GFC – the debt turmoil in Europe, the possibility of double-dip recession in Europe and the US, the over-reliance on China – are virtually a permanent overlay for business at the moment. We speak to businesses that have halved in size, but there are other businesses growing faster than they were forecast to grow. In either case, the budgets they set last year aren’t much help to them now,” says Stevenson.
Impact of global pressures
Randy Wong, director of business performance services at KPMG, says the continuous disclosure requirements of the Australian Securities Exchange (ASX) and the influence of US quarterly reporting requirements on Australia’s globally-oriented companies was already “trickling down” into Australian companies and making them more forward-looking, but the GFC has accentuated this pressure.
“There is much more pressure on companies to understand where they’re going, and equally importantly, disclose and convey this to the external market. It’s not just shareholders and stakeholders, but the regulators,” says Wong.
“The banks, too, have become a much more important player, and they’re demanding much more up-to-date information than they did pre-GFC. A company has to be able to understand where it is heading, so forecasting has become a core business skill.”
Wong says there will “always be a role” for a budget, because it is a “target-setting” exercise. “But there’s a clear distinction between a target-setting exercise and your forecasting process. Rolling forecasting is not about putting in a continuously updated budget; it’s about gathering information that tells management and the board exactly where things look like they’re going to land, based on the latest insights that the company has, to allow the business to make decisions on different aspects of what it may need to change.” To this end, says Wong, the company must have its benchmarking, its KPIs and the ‘dashboard’ reporting those KPIs all working together.
“The KPIs are absolutely critical. An organisation needs a ‘cascading’ element of KPIs, and only the KPIs that are important, so everyone is aligned to the overall business strategy. A lot of departments inside organisations set their own KPIs which in the end have no alignment to the overall KPIs for management to the board. So you’ve got to understand how your KPIs link, and your dashboard is a tool for telling you that.”
A “really key” change that comes about when you have this in place, says Wong, is that where the budget tends to sit with finance as the owner, the forecasting process is owned by the whole business. “It’s got to be that way, because the managers and executives need to be held accountable for the accuracy of those forecasts,” he says.
