THE STORY
Joe the carpenter wanted to
be as efficient as possible, so he decided to only carry around only one tool—a
hammer.
Joe had three tasks that day:
hammer some nails, screw some screws and cut some boards. Joe decided to do all
three tasks with his hammer. Hammering the nails went quite well with the use
of the hammer.
Getting the screws into the
wood with the hammer, however, was far more difficult. By the time Joe could bang
the screw into the wood with the hammer, the screw was all bent, the wood was a
bit shattered, and the screw was doing a lousy job of holding the wood
together.
Finally, Joe discovered that
if you whack at a board long enough with a hammer, you can break it into two
pieces. But when compared to cutting a board with a saw, whacking it with a
hammer was less accurate in getting the cut in the right place, and the edges
where it was “cut” with the hammer were all distorted and ragged. This made the
board less useful than if a saw had been used.
But in spite of all the
problems with the results, Joe the carpenter was still proud of his work. After
all, as Joe put it, “I simplified my work by having to carry only one tool.”
Joe’s approach to his work was rather misguided. What good
does it do to simplify the number of tools you carry if the end results are
awful? Replacing the screwdriver and saw with a hammer lead to a rather useless
outcome. Not only would the results have been better if Joe had used a
different tool for each task, it would have taken less time and been easier.
Business leaders wouldn’t be as misguided at Joe, would
they? In one way, I think many are. There is this tool that businesses use,
called a “budget.” The budget is a good business tool, just as a hammer is a
good carpentry tool. But just as a hammer cannot effectively do all the work of
carpentry, a budget cannot effectively do all the work of business.
Three of the key tasks of business management are to:
- Effectively manage the
treasury function;
- Make sure the business
operating divisions are doing the right things; and
- Provide incentives for employees
to act in the best interests of the company.
Many companies rely primarily on the budget process to do
all three tasks. But as we will see in this blog, that is like using a hammer
to tighten screws and cut boards. The budget is an effective tool to help the
treasury function, just as the hammer is effective in hammering nails. But for
the other two tasks, there are better tools than budgets. By trying to use a
single budgeting process to do all three, one ends up with a mess. There are
better tools for monitoring the operating functions and providing employee incentives,
and they should be used instead of the “hammer” of budgets.
The principle here is that companies are not doing
themselves any favors by using budgets as a tool where it doesn’t belong. It is
great for the treasury function, but inappropriate for many of the additional
places where it is used.
1. The Budget “Hammer”
Works Well on the Treasury “Nail”
The key function of treasury is to ensure that the cash of
the business is properly managed. It looks for efficient (and cost effective)
sources of cash when internal cash flows fall short of need and looks for
efficient uses of excess cash produced internally. Timing of these actions is
very important, so that the proper level of funding is available to match the
fluctuating cash flow needs.
The budgeting process is a rather good tool to help in this
treasury function. It provides a broad overview of cash flows over time. This
helps the treasury function plan in advance so that the right amount of money
is in the right place at the right time at the best price. The budget is also a
good tool to share with the debt and equity community, so that they will
cooperate more favorably with your cash needs. It helps build trust, so that
they will provide cash at a favorable rate. Treasury should be the primary goal
of the budget.
2. The Budget “Hammer”
is a Poor Choice for the Employee Incentive “Screw”
However, when budgets are also used as the primary tool to incentivize
employees, it destroys the integrity of the budget. Employees will try to “game
the budget system” in order to insure easier and higher bonuses. This creates a
budget which no longer reflects best estimate of cash flows, because the
numbers are padded to improve the likelihood of a bonus. As a result, it
damages not only the ability of the budget to get employees to work harder but
it damages the ability of the budget to accurately help the treasury plan
accurate cash flow estimates.
In addition, employees understand that there is usually more
than one way to hit a budget number—and not all of these ways are equally good
for the long term health of the business. For example, this quarter’s budgeted
profit number can be hit by doing lots of actions harmful to long term
prosperity, like improperly cutting investment in the future, cutting research,
cutting maintenance, cutting quality, cutting service, overcharging customers,
and so on. Since both good and bad behaviors can be used to hit a budget
number, the budget is not very effective as an incentive for ensuring right
behavior. It is like trying to secure a screw by banging at it with a hammer.
3. The Budget “Hammer”
is a Poor Choice for the Operational “Board”
Similarly, the budget is a poor choice as the primary means of
determining the specific actions of the operating divisions. The main problem
is that budgets are frozen well in advance, before the year begins. As we all
know, the marketplace is a dynamic, rapidly changing environment. It is
impossible to fully anticipate all of these potential changes. It makes no
sense to tie up your operations into budgeting straightjackets, unable to
adjust to the changing business environment just because the best guess
estimate put into the budget nearly a year earlier has proven to be off.
Does it make sense to not exploit a great opportunity
merely because that opportunity was not in the budget? That would be like a
miner refusing to take advantage of a huge find of gold in the mountain because
they only budgeted to take a meager amount of silver out of the mountain. And
the opposite is also true…why continue a particular action merely because it is
in the budget if the changing situation makes that action no longer viable?
Budgets are typically broad-based numeric documents. They
are not good at understanding strategic nuances, competitive dynamics or the actions
behind the numbers. To expect that out
of budgets is like expecting a hammer to effectively cut a board.
Recommendations
To get around these problems, I suggest the following:
a) Get A Screwdriver. Get a tool specifically designed for
incenting employees. To insure people are incented to do the right things,
specifically outline what right things those are and reward achieving behaviors
instead of numbers. For example, if you want an employee to master a skill,
make skill mastery the criterion for bonus. Or if you want an employee to
successfully roll out a new product or enter the Brazilian market or reduce the
time to convert a plant to a new production run, then spell it out IN WORDS (specific
enough to be difficult to game). In the
old days, we called that Management by Objectives which then morphed into
Balanced Scorecards and now Key Performance Indicators (KPI). I think the
migration may be going in the wrong direction towards fewer behavior-based words
and more game-able numbers, but at least it is better than bonuses based almost
exclusively on budgets. In fact, I might suggest doing the “screwdriver” in the
spring and the “hammer” in the fall in order to keep budgets from creeping too
deeply into the incentive process.
b) Get A Saw. Get a tool specifically designed for directing
operations on what is an acceptable approach to their sphere of influence. This
tool would tend to set up measures using a more strategic language. It would
explain the strategic role that operational unit has within the organization.
It would explain what “winning” would look like for that group. It would
explain what the proper trade-offs are on attributes and outcomes. It would
point the direction in which the operations are to migrate to in order to reach
future strategic goals. Then the company delegates the specifics, to free up
the operating unit to bob and weave with the changing environment in order to
exploit the moment, provided the actions remain within the strategic boundaries.
c) Improve the Hammer. Budgets can be more dynamic. Draw up
some contingency budgets in advance (based on different scenarios) so that you
are ready if situations drastically change. Consider rolling budgets that
adjust quarterly or semi-annually (depending on your business). Note: this
becomes easier to do when the budget is freed by no longer having to also work
as a screwdriver and saw. Also, consider doing the screwdriver and saw work
PRIOR to finalizing the budget. That way, the budget more accurately reflects
what will actually be done, instead of being just a wish list. Remember, the
budget shows financial outcomes which are determined by action inputs. So get
the inputs figured out before declaring the outcomes.
This is not to say that budgets are totally ignored outside
of treasury. The budget provides discipline for the more routine aspects of
business. The budget can help to determine if the desired strategy is
achievable under current cash constraints. And if the budget has no connection
to actions, it ceases to accurately reflect what the future cash situation will
really be. So a little bit of the strategy needs to permeate the other areas.
But it shouldn’t be the primary driver.
Budgets are very useful, but they should not be the master
tool to drive all of your management concerns. Budgets are most effective when
centered primarily on the needs of the treasury function. A second, more
action-related tool would be used to incent employees and a third, more
strategic tool would be used to manage operational units.
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