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.
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.