Feature Story

How Your Budget Process Blocks Digital Transformation (and What to Do About It)

Process-bound annual budgeting stifles change and agility. Digital disruption might demand a revolution.

Digital transformation requires speed and agility.

But the corporate budgeting process is spectacularly resistant to those qualities.

In order to improve predictability and reduce risk, companies lock down budgets before the fiscal year starts. New projects compete for small discretionary pools, and the procurement function is a spider web of multilayered approvals and stringent requirements.

Anders Olesen, a financial management consultant and director of the Beyond Budgeting Institute, enumerated problems this traditional budgeting process creates:

  • the process is very time-consuming;
  • the link between allocations and strategy is often weak;
  • spending decisions are made too early and at too senior a level;
  • assumptions built into budget decisions are quickly outdated;
  • once budgets are set they can prevent actions that could add value;
  • and they are often a bad yardstick for evaluating the performance of managers and organizations.

“This is not a new problem. Unfortunately, it’s extremely widespread,” and one that impedes corporate performance, Olesen said.

Terry Bennett, a partner at Fortium Partners and an Institute for Digital Transformation fellow, said that short-term thinking – such as focusing on the next quarterly earnings report – has handicapped many C-suite executives from moving beyond traditional budgeting processes.

“They are not looking long-term as much as they need to. If you continue to look at the short-term, you won’t see the disruption coming and you won’t be able to respond to it,” he said.

This is a recipe for ending up as the next Blockbuster to someone else’s Netflix. Or like the taxi company standing at the crosswalk as Ubers and Lyfts cruise past.

Because the traditional budgeting process governs so much activity – from spending on staff, to investing in new initiatives, to determining performance bonuses – it also serves as an excellent focal point for efforts to bring more agility to an organization.

Experts cite the following steps leaders can take to make their budgeting more adaptive and innovative.

1. Decentralize decisions; replace policies with priorities.

Bennett and Olesen speak of the need for leaders to establish an organizational culture in which priorities are clear and decision-making is distributed.

Centralized decision-making and budget-setting sends a message by design to managers and employees carrying out company strategies in their daily tasks: we don’t trust you to know what to do. And in an age where speed is king, the time required to run decisions up and down the chain of command can be deadly.

Instead, Bennett said that leaders have the chance to tell their organizations ‘here’s where we are going as company’ and invite employees to contribute ideas for reaching the goal. In such a culture, he said, “each individual can measure and see how they are providing value.”

This theme enables companies to break the cycle of relying on the budget books published in January to determine decisions in October. Instead, guidelines can give every employee the authority to determine courses that will serve the company from their position. Bennett said that moving decisions about budgets, especially IT spending decisions, to business units (away from headquarters) is a concrete step that promotes business agility and engenders trust for both business and IT leaders.

The key is to be clear, and then to let people make choices based on the directives. Oleson points to Netflix’s culture of spare policies. For example, the streaming content company’s expense policy has five words: 'Act in Netflix’s best interests.' “You want to hire smart people, give them direction and then get out of the way,” Olesen said.

What executives don’t want to do, Olesen added, is to “assert that ‘we’re agile and want to move fast and be innovative,’ and then manage the company with detailed budgets that pencil in how much to spend on petrol in September 2018 in Turkey.

“That doesn’t leave a lot of room for flexibility.”

Olesen said agile and fast-moving companies must create alignment between the organization’s purpose and values on the one hand, and its day-to-day management processes on the other. This is referred to as having a coherent management model. “Without such cohesion,” he said, “the former lose their credibility, and frustration and ineffectiveness will prevail.”

Olesen points to Handelsbanken, a Swedish bank with operations in 25 countries, as a leading practitioner of distributed decision-making.

Instead of setting budgets, the bank’s goal (since the early 1970s) is to achieve a shareholder return that is above the average of its peers. The bank puts decision-making into the hands of its branch managers to serve customers; it focuses on profitability rather than volume. Bank branches share experiences and expertise with each other. The strategy is successful — the company says it has achieved its goal for 45 consecutive years.

2. Use better mechanisms for innovation investment.

Changing the traditional budgeting and procurement process is a useful vehicle for directing innovation, said Jame Healy, managing director at consultancy Alescent. He advocates for what he calls a lean approach to innovation using standard portfolio theory.

How this plays out in practice: A company can distribute small cross-functional teams across the company, like seeds in a field, each with an emphasis on specific outcomes and organizational priorities. “The seeds that ‘take’ to the environment are the ones that require rapid investment and executive support,” Healy said.

In this scenario, Healy said that companies can set up two pools to pay for these activities. One pool is a formal innovation investment plan aligned to current priorities (like a traditional R&D budget). A second, unstructured pool can go to fund anticipated priorities.

As an example, Healy points to the auto industry’s race to develop self-driving cars – a contest in which technology giants and disruptive startups are also engaged.

“Companies that are only now seeking to invest in autonomous cars are almost literally too late to the game, and as a result are exposed to the market shift,” he said. “However, some, like Volvo, have anticipated the future of automotive transport and initiated unstructured investment over a decade ago. As a result, they are not exposed to the Teslas of the world in the same way others are.”

Volvo’s investments include semi-autonomous systems that steer and brake cars automatically, to keep a car in its lane (some models now offer this technology for low-speed traffic). The company also announced partnership with Uber to develop self-driving vehicles.

3. Build capabilities to sense and respond.

Companies that set clear direction on spending and commit to innovate also need fresh eyes on the changing world to identify opportunities and risks – and determine what to do next.

Healy argues that companies “can no longer outsource the observation of market trends,” and must instead increase the depth and breadth of their sources. Said another way: You can’t set aside money to invest in “anticipated priorities” if you don’t develop the organizational ability to foresee the possibilities.

This means going beyond internal R&D staff, analysts and consultants to engage field workers, customers, suppliers, investors, supply chain vendors, as well as observing close and distant competitors, Healy said.

While the resulting data is overwhelming, “a strategy to parse this data for actionable insight must come through modern approaches to machine learning, predictive analytics, and automation,” Healy said."Executives must be prepared to make funding decisions faster, and defunding decisions even faster."This is the sensing part, which can tell a company where to invest innovation dollars. Executives need to be ready to act quickly to take advantage of identified opportunities. At the same time, these investments require careful monitoring. “Executives must be prepared to make funding decisions faster, and defunding decisions even faster,” Healy said. “Change is difficult in any type of organization, but a culture of adaptability is critical to making this work. That is the ‘respond’ part of ‘sense and respond.’”

This situation is not unique to companies adapting to digital disruptions, but examples show the dynamic of this approach, Healy said. In the mining industry, for example, companies can stop certain projects if a commodity’s market price falls below a set figure. Healy said he’s worked with CFOs who set up scenarios for changes in spending based on different potential outcomes. If A happens, it means one action. If B happens, it means a different course. In such situations, it’s important to set expectations within the organization about potential changes.

4. Dedicate resources to processes, rather than budgets.

Another approach to move to a more agile planning process involves splitting up the traditional budget like an antitrust crusader breaking up a monopoly. This is a method Olesen advocates.

The budget has several important but different purposes: target-setting, forecasting, and resource allocation.

Setting targets is about motivating people to strive for higher levels of performance by providing direction and ambitions. Financial forecasting, however, is about predicting the most likely outcome in order to make better informed decisions. Using the same number both as a target and a forecast does not make sense, Olesen said; it will either be an unambitious target or an optimistic forecast, and neither of these are any good.

Resource allocation is about ensuring that the organization spends its limited resources in the best possible way, which again is different from both target-setting and forecasting.

And then there is the inherent element of uncertainty. A company’s decision-makers can’t know what competitors will do in the middle of a budget period, and can’t predict revenue performance in advance, even with projections in hand. “The problem is that before the year starts, we have already pre-allocated all of our expected spend into literally thousands of buckets of money, and allowed people to spend when we don’t know what will happen next,” Olesen said.

Accordingly, the Beyond Budgeting Institute recommends to replace the annual budget process with three separate processes: target-setting, financial forecasting and resource allocation. Olesen said experience shows this approach leads to higher levels of quality in all of the processes: better decision-making, more meaningful targets, unbiased forecasts, and lower costs.

The quality rises because the managers can allocate resources in response to a competitor’s move, or some other market condition or company priority. This approach also avoids the common “use it or lose it” occurrence, spending the remaining department (or team or project) budget at the end of a fiscal cycle. “This leads to unnecessary spending. Instead, you do exactly what is needed,” Olesen said.

Instead of comparing the monthly expenses with the arbitrary target, managers should monitor the development of expenses (with a trend analysis) and, on a regular basis, determine if the level of spending is appropriate.

Companies that make this shift are more precise in their actions and ability to make changes, Olesen said.

Furthermore, he noted, “very often companies need far fewer targets and forecasts than what is produced in a traditional budget process, so the total workload is likely to go down.”

5. Slash costs in every area not related to strategy.

An additional opportunity embedded in the “sense and respond” step above is the discovery of new ways of obtaining needed labor and services.

Bennett said when he advises CIOs or helps enterprises reshape their IT operations, he is working with them to find ways to buy as much as possible as a service. While this is a well-established option for IT services, Bennett said it’s worth applying the same idea to other functions including human resources and marketing. Any area not integral to the company’s strategy and growth should be open for exploration.

In the past, he said, competing meant watching whether a competitor across town changed prices and needed a response. “Today, that competition could be coming from across the world. Two guys in a garage don’t have to pay for all the fixed costs I do if I built up my company with heavy machinery,” he added.

“I don’t have to do that anymore. I can get things as a service. If you need heavy machinery to run, instead of going out and purchasing the machinery using capital dollars, or instead of leasing it, find someone who will allow you to pay by the operating hour based on the machine’s variable cost to you.”

It’s a metering concept Rolls Royce has used with the jet engines it manufactures, just as IT cloud providers do with their services.

A Potential Advantage for IT Executives

When he talks to IT executives about his budgeting ideas, Olesen said he finds them signaling recognition. The concepts he cites feel to them like echoes of the agile software development movement. Empower teams to make decisions. Collaborate. Test approaches. Make adjustments based on genuine feedback. Try again to improve the result.

The “beyond budgeting” approach that Olesen advocates is like “agile on a corporate level,” he said. In this way, IT executives familiar with agile techniques are usually more comfortable than others in changing their thinking about budgets.

Just as agile development is designed to work across many software projects, a more adaptable and directed approach to budgeting can help with more than the front-burner concerns about digital disruptions. Healy noted that the sense-and-respond approach to budgeting is valuable in volatile economic conditions, as well as planning for regulatory changes and responding to geopolitical events.