Analyzing Your Corporate Budgeting System

In a broad sense, a corporate budget is just a synonym for a short-term financial plan. Of any kind. Usually annual, but semiannual, quarterly and even monthly budgets can be easily found in corporate financial management systems.  

In a more narrow meaning (which I will use in this section), a corporate budget is a corporate financial plan in a ‘classic’ (‘traditional’) form broken down by either functional unit (functional budget) or by geography – regional branches, retail locations, etc.

If a company has more than one business unit, the company in question breaks its consolidated budget into business unit budgets with each business unit developing its own functional budget. Each internal value center can (and usually does) have its own budget.

The process of developing and updating the corporate budget is called, obviously, corporate budgeting. How well does it work? Well, let’s see what The Wall Street Journal – a highly respectable source – said about it about a year ago (on July 21, 2013).

Let’s start with a title.  “Companies Get Budgets All Wrong”. Pretty impressive, isn’t it? Wait until you see the subtitle. “The annual budgeting process leads to bad decision-making. It needs a total overhaul”. It is so bad, it needs a total overhaul.

Let’s see why by continuing with the main body of the article by Kenneth A. Merchant:

“Almost all companies prepare a budget, or annual operating plan. And almost all companies do it wrong”. [Quite a statement, I must admit].

“That shouldn't come as a surprise to managers, many of whom are highly critical about both the way budgets are prepared and the way they are subsequently used. The typical budget process, they say, mainly serves to distract managers from doing their jobs and to discourage them from taking risks. It undermines integrity, distorts information and leads to bad decision-making from mailroom to boardroom.

They complain, for instance, about the endless meetings where managers crunch and discuss numbers that have long since gone out of date. They complain that budget targets are almost universally defined in backward-looking financial terms and as a result don't reflect what successes—or failures—an organization may currently be having.

At the same time, they say the budget processes too often serve as opportunities for self-aggrandizement—and enrichment—by undeserving and unscrupulous managers. Those who earn the best performance ratings are often the most skilled in negotiating easily achievable budget targets for themselves. Even more damaging, many will manipulate numbers in their budget reports to inflate results and artificially achieve short-term targets. And others will spend money wastefully so as not to see a reduction in next year's budget allocation.

The annual budget process is too inflexible, too infrequent, and too easy to manipulate, to accomplish all of the functions it is expected to—including strategic planning, resource allocation, evaluating performance and determining compensation”.

This article basically states that the current corporate budgeting process has fundamental – some would say even existential problems. The crucial one is that the current corporate management methodology is a relic of times long gone, where business was nowhere as complex as it is nowadays.

This relic not only does not reflect the ways financial value is generated in business systems in a modern economy (by brands, products, clients and other stakeholders via activities combined into projects and processes). It exists in a totally separate universe.

And when these universes overlap (e.g. in budgeting for business units), the ‘traditional’ uses the totally inadequate – both in structure and content – form of a cash budget, instead of the natural form of financial valuation model.

Does it mean then that we should do away with corporate budgeting altogether? Not at all. But we do need to completely overhaul it – just as The Wall Street Journal calls us to do. Albeit in a significantly different way from what Kenneth A. Merchant suggests:

1.      Replace cash budgets with financial valuation models

2.      Develop financial plans for all corporate objects where it is applicable – then consolidate into a comprehensive corporate budget

3.      Transform corporate functional units into internal value centers – then prepare the corresponding financial plans for each one and integrate into a consolidated corporate budget