Should we abandon the annual budget process?
May 7, 2016
Annual budgets have seen a lot of criticism and competition from other budget (management) tools. Is the annual budget process so bad? Should it be completely eliminated and replaced with a new management tool? In this article, we will cover the perceived drawbacks of annual budgets and whether annual budgets should be eliminated.
There has been a lot of discussion about the annual budget process and how this process is a thing of the past. A lot of people (finance and non-finance alike) suggest getting rid of the annual budget process because it is inefficient and ineffective.
A lot of new exciting tools (e.g., beyond budgeting) are proposed to replace the annual budget. However, is it time to abandon the annual budget process?
Like in many situations, there are different opinions. Some argue that it is time to use something different and let the annual budget go. Others indicate that it is not the time to do so.
One of such studies indicating the annual budget process is very much alive was performed in 2010. It is called “Beyond budgeting or budgeting reconsidered? A survey of North-American budgeting practice” Management Accounting Research 2010. A survey about the current annual budget practices was sent to employees of Canadian and U.S. companies (e.g., CFO, Controller) responsible for this activity in their organizations. More than 500 responses were received and analyzed.
The study aimed to analyze more prominent drawbacks of the annual budget process. Let’s take a look at them in more detail.
The first drawback is that the annual budget process takes a lot of time and resources and may be a rather expensive process. According to the study, it takes six weeks on average to complete the budget process. It may appear somewhat lengthy, but in reality six weeks in a business organization environment is not that long.
By the time the annual budget has been finalized and approved, the assumptions utilized to create it are proven wrong. In the study, respondents agreed that is may be possible to predict certain trends for the budgeting process, but it was not possible to predict enough to say that the annual budget is a very good predictor of the future environment of the company. To somewhat remediate the issue with obsolete annual budget numbers at the time budgets come into effect, about half of the study participants indicated their budgets are revised during the budget year to incorporate new information. Based on this, it appears that the annual budget may not be a good benchmark to guide management in changing environments, but when it’s paired with a periodic budget update process, it may be sufficient.
The annual budget process may result in undesirable behavior by managers. In order to protect their incentive payments (e.g., bonuses tied to meeting budget targets), business unit managers may:
- Defer necessary expenditures into the next year (to reduce expenses in the current year). The study shows that this happens in at least 80% of companies included in the survey.
- Artificially overstate expense budgets or understating revenue budgets with the hopes that when actuals are compared to budget targets consequently, the business unit performance will look favorable. This is sometimes called sandbagging. According to the study, sandbagging happens in about 80% of companies included in the survey.
- Make arrangements to move anticipated next year's sales to the current year's sales (to increase revenues). Study participants indicated this happens in about 40-60% of companies depending on whether it’s a U.S. or Canadian company.
- Incur next year's expenditures in the current year if current year budget targets are already known to be unattainable. This practice decreases expenditures of the following year and thus, creates better chances of meeting next year's targets. According to the study, this happens in about 50-70% of companies in the survey.
- Try to spend the remaining budget by the end of the year even if such spending is not needed to ensure the budget is not cut next year (use-it-or-lose-it mentality). This behavior happens in about 40-80% of companies in the survey.
A disconnect may exist between the annual budget and company strategy which may harm the company strategy execution. According to the study results, on the contrary, survey participants indicated they (strongly) agree that strategy is linked to the annual budget which indicates this issue may not be as prevalent as once thought.
In addition, the study found that:
- 79% of respondents continue to use budgets for control (motivation and performance evaluation);
- 94% of respondents indicated they were not planning to abandon annual budgets;
- Majority of respondents see value added by using budgets even in light of any negative aspects associated with the annual budget process.
So, is the annual budget process perfect? The answer is No. There are some aspects that may make this process look bad. However, overall, the survey participants indicated they do see more benefits in keeping annual budgets, and it is unlikely that annual budgets will go away any time soon.
Another interesting question to explore is whether annual budgets can be supplemented with other tools to remediate any drawbacks of the annual budget process. Some companies are starting to use rolling budgets or activity-based budgeting and these may be a subject of a different article.
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