What Budgets Are For

The several purposes

• Planning — translating strategy into resources and activity.
• Coordination — ensuring sales, production, procurement and staffing plans are consistent with each other.
• Communication — telling managers what is expected and what they may spend.
• Authorisation — granting spending authority within limits.
• Control — a benchmark against which actual results are compared.
• Motivation — setting targets.
• Evaluation — assessing performance.

The built-in conflict

These purposes pull against each other. A budget used for evaluation invites managers to build in slack so the target is comfortably met — which makes it useless as a plan. A budget set as a stretch target is a poor basis for cash planning, because it will not be achieved. A single set of numbers cannot simultaneously be the most likely outcome, an ambitious target and a spending limit. Many organisations resolve this by separating the forecast (most likely) from the target (what we are aiming for) and from the budget (what may be spent).

Behavioural effects

Budgets change behaviour, frequently in unintended ways:

• Budgetary slack — overstating costs and understating revenue so the target is easy.
• Use it or lose it — spending the remaining budget near the year end to protect next year’s allocation. Rational for the manager, wasteful for the organisation, and produced entirely by how the budget is administered.
• Short-termism — deferring maintenance, training and development to hit an annual number, which moves cost into the future at a premium.
• Gaming the timing — pulling revenue forward or pushing cost back across the year end.
• Silo behaviour — protecting a departmental budget at the expense of the whole.

These are not character failings; they are responses to how the system is designed. Reducing them means separating targets from forecasts, allowing carry-forward where appropriate, evaluating on more than budget adherence, and involving people genuinely in setting their own numbers.

Top-down, bottom-up and negotiated

• Top-down — set by senior management. Fast and aligned with strategy; often unrealistic in detail and poorly owned.
• Bottom-up — built by budget holders. Realistic and owned; slow, prone to slack, and it will not add up to what the business needs.
• Negotiated — targets set centrally, detail built locally, reconciled in between. The usual approach, and the reconciliation is where the real work is.

Approaches

• Incremental — last year plus an adjustment. Quick, and it perpetuates whatever inefficiency is already there.
• Zero-based — every cost justified from nothing each cycle. Thorough and expensive; best applied selectively to areas under review rather than everywhere every year.
• Activity-based — built from planned activity volumes and the cost of the activities that support them.
• Rolling — always covering a constant horizon, extended each period.