The Annual Budget

The Annual Budget

          
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The Annual Budget

1968
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    • BruceHenderson
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    • Budgets set without a strategy base become mere exhortations to try harder.

    • Budgets based on strategy demand far more than cost control. They also specify what the money buys, and when.

     

    No process in business is more fateful than the decisions which establish the annual budget. And there are few decisions which are more subjective and less subject to logic and analysis. Any improvement in precision would be a major contribution to business effectiveness.

    The critical missing element in budget making is the frame of reference. What is an optimum level of budgeted expenditure? And how do you know?

    There are two traditional approaches to budgets. One is to take the previous year and demand slightly better net results. In the other the desired end result is chosen and the budget is tailored to fit. Both approaches are essentially the same. Both are in effect compromises between past performance and hope.

    The obvious defect in this lies in the highly uncertain realism of either past performance or future hopes as a standard of reference. Under rapidly changing circumstances this evaluation becomes little better than a crude guess. The process becomes a struggle to satisfy the boss, not an effort to optimize performance.

    The facts of business life and organization behavior usually force even the most objective and candid supervisor into a game of deception. This takes the form of overstating budgetary needs and forcing the initiative in reducing budgets to start at the top. The middle manager is caught between the ambitions and expectations of his subordinates and the conflicting ones of his supervisors.

    There are few organizations which have not at some time imposed an overall cut in budget. Almost always this affects the efficient and the inefficient alike. The operation which is already optimal is degraded while the inflated operation is merely trimmed. After one such experience, few managers will fail to anticipate the possibility of such a broadly applied budget cut.

    The nature of leadership and supervision over a complex organization makes the individual manager the spokesman for his group's demands on the earning resources. If he fails to advocate his group's aspirations eloquently, he weakens his acceptability as their leader. There is no reasonable way for the manager of a subordinate part of the organization to resist their demands except by reference to restraints clearly imposed by the central management.

    Yet, how does the central management distinguish between too much, enough and too little?

    A well run business is a very fine balance between a large number of related activities. Too much or too little of anything can be damaging to competitive performance. Many of these expenses – like research, advertising, and sales effort – are directly subject to management choice.

    Under stable competitive conditions, the optimum combination is often approximated by trial and error. In the absence of competition or some equal restraint, these costs tend to multiply indefinitely in accord with the well known Parkinson's Law. But under competition each competitor can use others as his reference.

    When the competitive environment or market shares are changing, it is possible to make gross errors in budget standards with the short term consequences.

    The truly difficult part of budget setting is that a large part of the benefits and other consequences of a given expenditure level are delayed in time. The problem would be relatively simple if all cause and effect were immediate. Because this is not true, there are many business opportunities which are dependent upon actions that appear dysfunctional short term.

    In fact, budgets are set by feel and by guess rather than logic, except when there are specific constraints imposed by competition on strategy. The ultimate logic must be based on cost versus value analysis. This in turn depends on a factual appraisal of benefits. Benefits can be evaluated only with respect to investment returns.

    All expenditures are investments even though some have very quick return and some take years. Operating budgets are characteristically treated as short term investments with immediate payout within the accounting period. Obviously, this is rarely true. They are treated this way because of the considerable difficulty in coupling cost and revenue when the benefits are indirect.

    Difficult as it may seem, this is not an impossible task. For this to be feasible, however, budgets must start from a strategy with a specific plan of competitive action translated into sequence and timing of commitment of resources.

    With a strategy base the overall budget becomes an investment analysis. Cost effectiveness becomes meaningful. Budgets set without a strategy base become mere exhortations to try harder. Budgets based on strategy demand far more than cost control. They also specify what the money buys, and when. Therefore they can be investment analyzed.

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