The term “budget” tends to conjure up in the minds of many managers images of inaccurate estimates, produced in tedious detail, which are never exactly achieved but whose shortfalls or overruns require explanations. And that is what budgets are like for many smaller businesses. This wasteful way of using budgets overlooks important managerial objectives that budgeting can help achieve. Growing Concerns presents a view of budgeting in this issue of HBR different from that presented in the May–June issue by Jerry Viscione, who argued that managers of small ventures must pay particular attention to the targets they set when formulating budgets. While not disagreeing that targeting is important, Neil Churchill maintains that budgets should be considered from a broader perspective. He views them as having two primary functions: planning and control. Managers must decide which function is more important and then resolve a number of formulation issues. These include the initiation process, implementation, the period covered, whether the budget should be fixed or flexible, and how it should be used to evaluate performance. He concludes that large companies concerned about operational efficiency should focus on the coordination and control aspects of budgeting while small and innovative companies should be concerned with planning aspects. Whatever the focus, budget preparation and implementation are important in carrying out company strategy and in professionalizing the smaller company. I start my classes on budgeting by displaying two situations on the blackboard: Then I ask the class, “Which budget is better, assuming in both cases that the manager gets the job done in time, that the end result is the same quality of performance and customer satisfaction, and that the manager doesn’t develop ulcers in the process of implementation?” A heated argument usually follows. Most class participants eventually choose Budget 2 after being assured of equal results. A minority, however, hold out for Budget 1, which seems to them the “most reasonable.” These opposing views come together when I ask, “Which would be best for borrowing money on a one-loan-a-year basis?” In this case, the choice is almost always Budget 1. And when I ask, “Which would be best for motivating performance?” the majority of participants usually select Budget 2. As this example shows, budgets can be used both for planning (Number 1) and for control (Number 2), although the same budget is not always optimal for both purposes. Occasionally a company uses a budget with “stretch” in it for motivating performance—sales, for instance—and a more “realistic” budget for planning—expected sales, for example. More commonly, companies use the same document for both purposes.1 Large companies tend to use budgets mostly for control and smaller entrepreneurial companies use them primarily as planning tools. But no matter whether it is used for planning or for control, a budget is more than a forecast. A forecast is a prediction of what may happen and sometimes contains prescriptions for dealing with future events. A budget, on the other hand, involves a commitment to a forecast to make an agreed-on outcome happen. Budgets come in several variations. Cash budgets are especially important to new and growing businesses, whereas capital budgets are widely used if capital expenditures are important and recurring. Human resource or “headcount” budgets (the capital budgets of service companies) serve as means of control in labor-intensive companies. But generally when the term budget is used, it refers to an operating budget containing an organization’s detailed revenue and expense accounts grouped either by operating units, such as divisions or departments, or by products and product lines. Such a document is a central part of the management control system of many companies. In preparing a budget, a company can proceed in a number of different ways. Some companies use a top-down and others a bottom-up approach in budget preparation. Some revise their budgets quarterly and others never change them. Some use flexible budgets to evaluate managerial performance while others compare results against original estimates. These and other differences in budget structures and processes largely determine the effectiveness of budgeting and whether it accomplishes management’s objectives. In this article I consider eight managerial concerns in preparing budgets (see the insert for a checklist of these). The concerns vary according to whether the company intends to use its budget primarily for planning or for control. Budget Choices Planning Issues From a planning perspective, a budget is the glue that makes the different parts of the organization fit together. It harmonizes the enterprise’s strategy with its organizational structure, its management and personnel, and the tasks that need to be done to implement strategy. When well done, it translates the strategic plans of the organization and its implementation programs into period-oriented operational guides to company activities. Initiation and Participation Who should initiate budgets? What should be the role of top executives? Should they start the process with tightly specified objectives? Or should they set forth the basic planning premises, competitive assumptions, economic forecasts, and so forth, and then play a relatively passive role in formulating the budget? And what should be the role of operating managers? Should they fill in the blanks of a tightly specified budget structure or take responsibility for initiating budget assumptions and calculations? One of the first issues to be settled is the extent to which budget formulation involves all management levels. Both the top-down and bottom-up approaches have advantages whose importance varies in accordance with the nature of the business and the company’s stage of development (see Exhibit 1). Exhibit 1 Top-down and Bottom-up Budgeting The top-down approach allows the owner-manager and others at the top to put forward their comprehensive views of the organization and its economic and competitive environments. Top management knows the company’s goals, strategies, and available resources. Indeed, in a small company the owner-manager may be the only one with such knowledge as others are almost totally involved with day-to-day operations. Several situations call for a top-down approach—when business unit managers must be given explicit performance objectives because of economic crises, when unit managers lack the perspective to participate in budget setting, and when the nature of the business requires close coordination between units. In these situations, the knowledge necessary for good budget preparation usually resides at a managerial level one or two steps above that of unit managers. The bottom-up approach, on the other hand, makes use of operating management’s detailed knowledge of the environment and the marketplace, knowledge that is available only to those who are involved on a daily basis. The more responsibility unit managers have for innovation, the more their inputs are needed in budget formulation, for they are best able to decide courses of action and targets for their units. They know what must be done, where the opportunities lie, what weaknesses need to be addressed, and where resources should be allocated. Furthermore, a budget prepared at the level at which it is to be implemented is more likely to evoke commitment than one imposed from on high. Moreover, only when unit managers contribute to budget preparation can they be held accountable for the long-term performance of their operating units. For companies requiring quick responses to competitive pressures, top-down budgeting can be disastrous. But companies with a considerable degree of interdependence among operating units need top-down budget guidance for coordination. Perhaps this is why the extensively integrated smokestack industries have found it so difficult to adapt to the rapidly changing environment in which they find themselves. They may have to adopt a different set of budgets and other management controls in order to prosper—or even to exist. Implementation Simple top-down or bottom-up approaches to budgeting are rare. The decision is not either-or but rather how much of each type of approach is appropriate. Blending the overview of top management with the experience of business-unit operating managers presents a major challenge in budget preparation. A cyclical process whereby the initial budget formulation is done in broad terms, with details added after everyone agrees on planning assumptions, can be quite effective. The cycle for companies without a strategic-business-unit (SBU) structure has six steps. (If the company has a SBU structure, a cyclical approach entails additional steps involving SBU management.)2 These six steps are as follows: 1. Top management sets forth in broad terms, and sends to the operating-unit managers, an overview of the environment, the corporate goals for the year, and the resource constraints. 2. Each operating-unit manager formulates in broad terms the unit’s operating plans, performance targets, and resource requirements. 3. Top management collects, combines, and evaluates information from all the operating units. 4. Top management assesses and revises targets and resource availabilities, and assigns preliminary estimates to each operating unit. 5. Operating unit managers plan their activities in detail, determine their resource needs, and prepare their final budgets, which are sent to top management. 6. Top management combines these unit budgets, tunes them where necessary, approves them, and sends them back to the operating-unit managers for implementation. This type of budgeting provides initial top-level input into the process and allows top management to retain overall control. It also permits operating-unit managers to make contributions before detail has been built into the budget and before all management levels are committed to estimates that no doubt will be revised anyway. Timing Most operating budgets are based on the passage of time, with revenues and expenses related to calendar periods. In the uncertain atmosphere of start-up companies, the budget might better be related to important actions or events because the organization often takes longer than anticipated to get products perfected, to land the first big order, or to get financing in place.3 In other than start-up situations, budgets are related to time periods in the following way: For budgets based on calendar periods, the length of the operating period is usually a month, although smaller companies often prepare budgets for calendar quarters, particularly when they first begin the process. One common variation in monthly budgeting is dividing the year into thirteen four-week periods both for budgeting and reporting. This reduces inequalities in sales or production days between periods within the year and between similar periods in consecutive years. There is no one best budget period or interval—the period should fit the needs of a company, in terms of its planning horizon, the difficulties of budget preparation, and the link of the budget to strategic planning. The period covered can range from three to six months in very small companies to two or three years in large corporations. Operating budgets usually cover one year, although some companies also include a general forecast for the second year. Such forecasts normally do not involve the same commitment as operating budgets. Budget preparation should begin as near the start of the period as possible while still allowing enough time to do a thorough job. A participative process takes longer than a top-down budget. A small company using the top-down approach might initiate the budget process one or two months before the start of the fiscal year, whereas a large company might start six to nine months earlier. The more complex the company’s products, processes, and environment, of course, the longer the whole process takes. As companies grow and change the nature of their budget processes, they may find that more time is needed for formulation.4 While small companies usually do not have formal strategic planning, this procedure may develop as they grow and decentralize. In such cases, the longer the period covered by the operating budget, the closer will be its links to the strategic plan and the greater the pressure to synchronize at least the first year of the plan with the budget. Moreover, if the budget and the strategic plan are prepared during the same time period, the links between them will be close. Usually, however, the strategic plan precedes the budget and the linkage is less pronounced. Control Options Large corporations with sophisticated formal planning systems use budgets extensively for control—first for coordinating dispersed business units and later, for evaluating units’ performances. Small company managers have less need to use budgets in this way since they control their businesses informally and personally. But small companies also need up-to-the-minute planning since they must react to events. Having less control over their environment than large corporations, they are more prone to seize opportunities than to make them. Thus, many of them stress the planning side of budgeting and revise their budgets while also rolling them forward on a monthly, quarterly, or semiannual basis. Rolling Budgets and Revision Companies can choose to budget annually for the year ahead or opt for a “rolling budget” always looking ahead 9 to 12 months. The latter system involves budgeting an additional quarter at the end of each quarter, and then adding this on to the existing budget. As shown in Exhibit 2, on April 1, 1984, a three-month period, “Quarter 5,” is added to the 1984 calendaryear budget to extend it to April 1, 1985. Another quarter is added on June 30, 1984. In this way, management always has a twelve-month budget at the beginning of each quarter. Exhibit 2 Rolling Budget The advantage of a rolling budget is its coverage. As one company president stated in early 1983: “We would have cut our inventories and production early last fall if we then had a budget that looked out into the first quarter of this year. As it was, we moved too late and it cost us a lot of money. That’s why we’re changing to a rolling budget as of next July 1.” On the negative side, a rolling budget takes more of management’s time to prepare and, moreover, operations are disrupted four times a year, rather than once, for planning. Those who prefer rolling budgets argue that managers get better at budgeting with practice, and therefore need no more time to do quarterly budgets than one annual budget. And, as operating managers should always be engaged in planning, budgeting four times a year is not a disruptive process for them. While a company could have a rolling budget without revising its existing fixed-period budget, most companies that use rolling budgets revise their budgets at least once during the year as they roll forward. Budget revision, however, is a highly controversial issue. Should a company revise its annual budget during the course of the fiscal year as conditions change? Revised budgets are more accurate, since they embody the best knowledge available, but revision makes a budget a rubber yardstick that cannot accurately measure performance or evaluate management. Consider the budget program of Corcom, an electronics manufacturer with $ 30 million in sales and owning four plants, one in the United States and three offshore. The company sells three-fourths of its products to American manufacturers of electrical and electronic equipment and the remainder abroad. For competitive reasons, it tries to maintain an inventory of finished goods of seven and ten weeks of sales. It uses skilled labor, and since it is subject to restrictions on layoffs and terminations, it is reluctant to vary production levels more than necessary. Because of uncertainties in demand, Corcom cannot project revenues accurately very far into the future. It can only watch carefully what is going on and try to react rapidly. It depends on forecasting and quick responses throughout the organization. Management prepares an annual budget, composed of four quarterly budgets of thirteen weeks—the “original budget.” Every six months it revises the annual budget for the remaining six months and adds on a new six-month budget—the “revised budget.” At the end of each month, it also prepares a revised forecast for the next 13 weeks, altering the existing quarter budget when necessary, and adding an additional month. (For example, at the end of January, April is added to February and March to form a new quarter and estimates are revised, if necessary.) This becomes the so-called “current 13-week budget.” Results are compared with both current and revised budgets and, since Corcom is a publicly held company, with the original budget for each quarter to see if a revision of the forecasts made to the financial community is necessary. Top management also compares current budgets to check the accuracy of planning assumptions and to see if operating units throughout the company are using the same common assumptions. Both the president and the financial vice president of Corcom readily admit that having so many budgets creates confusion as to which one is most important in evaluating results. They hasten to add, however, that the benefits of having a detailed plan for action (the current 13-week budget) that is up-to-date and comprehensive and prepares managers to deal with a rapidly changing environment far outweigh the ineffectiveness of their budget system as a means of control. Companies like this electronics manufacturer, which are concerned with external developments and with seizing the opportunities that arise, use budgets mostly for planning, in order to have current thinking implemented throughout the company and to compare performance with plans. Large companies use budgets for annual planning and then for control to ensure that operations go according to the original plan. On the other hand, a trade-off exists between continually revised budgets that permit innovation but are not effective in ensuring efficient operations, and rigid budgets that exert tight controls over operations but hamper innovations. Fixed or Flexible Budgets Successful management through delegation requires a clear set of objectives for individuals responsible for the various tasks in an organization. These objectives can be production standards, sales quotas, or budgets containing estimates of the level of production and the costs and revenues involved—all variables. Periodically, results are compared against estimates to determine if corrective actions or revised plans are needed. When fastchanging markets force small companies into such uncertainty that they seldom achieve even the most precisely calculated sales and production forecasts, a flexible budget is a powerful tool for analyzing performance. This can separate the effects of variations between actual and estimated costs, between actual and estimated revenues, and so forth. For companies in uncertain environments, particularly those in manufacturing or distribution, the flexible budget is one of the most important control tools available. For an example of how it works, assume a delivery budget of $ 1,000 for a sales level of 200 units. If the delivery cost was $ 900 for 175 units, the budget would show a $ 100 delivery-cost underrun or favorable variance. But if delivery costs average $ 5 a unit, the company should have spent only $ 875 for 175 units—thus indicating a $ 25 unfavorable variance. A flexible budget would substitute results in terms of units or services produced or sold for estimates; use estimated costs and prices, thus providing a standard of comparison; and compare results with estimates on a “flexible” basis, isolating variances in terms of changes in costs, revenues, price levels, and use of resources. The advantages of a flexible budget are shown in the Appendix. Appendix : using a flexible budget Consider, for example, a company with sales, fixed costs, and variable costs as shown in the table. Planned production is 1,000 units, selling price $ 1 per unit, variable costs of manufacturing 35¢ a unit, and variable selling, general, and administrative costs 5¢ a unit. Fixed costs include $ 250 in manufacturing and $ 150 in selling, general, and administration. Planned profit is $ 200. As the table shows, selling prices and operating costs differed from those planned, with 800 units sold and profit reaching only $ 95. An analysis of results using a fixed budget shows profit before tax $ 105 less than planned. Sales expenses were as estimated but variable manufacturing expenses were $ 50 less. The conclusion seems to be that all losses were due to a decrease in sales volume. An analysis of results using a flexible budget shows that while the decrease in sales volume resulted in a $ 200 loss in revenues and $ 120 decrease in profit before tax (comparing the original budget with the flexible budget), the company had other differences between estimates and results. Sales revenues were $ 45 more than planned, variable manufacturing costs were $ 20 higher than estimated for that production level, and variable selling costs were $ 10 more than estimated for the actual sales volume. A flexible budget can help management to identify problems since it isolates the effects of changes in sales volume or production level from other performance factors. Bonuses Based on Budget Most companies use budgets to evaluate, to some extent, managers’ performance. These evaluations result in bonuses based on the attainment of targeted goals or on achieving a certain percentage of budget, with extra bonuses for exceeding estimates. While bonuses based on budgets can have positive effects, they introduce the possibility of “budget games.” Managers playing these games aim to influence the budgeting process by setting revenue targets low and costs high, thus making goals much easier to meet. If control is the thrust of a company’s budget, evaluating and rewarding performance against estimates is appropriate as long as steps are taken to detect and counter budget games. To do this effectively, top management must have considerable knowledge of the activities being budgeted to determine the extent of any games and to take corrective action. Using the budget as a basis for evaluation and compensation is very risky for managers who lack the requisite knowledge. Managers should be wary of rewarding performance against budget in a new business or where an acquisition in a new area of activity has been made. To use budgets for compensation, a manager must know the territory well. If the major purpose of the budget is planning, then using estimates as a basis for compensation, by encouraging budget games, can detract from accuracy. For a successful planning budget, compensation should be based on other criteria, such as current achievements compared with previous ones, profits, return on investment, or other agreed-on objectives. Just setting goals and measuring their achievement is itself a powerful motivational force. Evaluation Criteria When using budgets to evaluate performance, top management must decide whether to focus on final net profit or only on the revenues and expenses for which the business unit is responsible. Final net profit includes expenses that a businessunit manager cannot control. This problem is illustrated in Exhibit 3, where the performance of the managers of departments A and B can be judged on several levels: Exhibit 3 Actual and Budgeted Performance* (in thousands of dollars) * Income taxes ignored. Contribution to overhead and profit—the direct costs and revenues that each manager controls in the short run. Department profit—contribution to overhead and profit less the fixed costs that are directly attributable to each department’s operation. The department manager may control these fixed costs either by deciding to replace equipment or to move to a new location or by increasing or decreasing the department’s use of a corporate resource such as a central computer, legal department, or building space. In the latter case, allocations should be made, where possible, on a predetermined basis so that department managers can control use and costs. Corporate profit—the final “bottom line” after all costs have been deducted, including costs over which department managers have no control and for which they have no direct responsibility. In Exhibit 3, the department A manager exceeds budgeted sales by 50 % , while the department B manager falls 50 % behind the sales goal. The entry entitled “Contribution to overhead and profit” shows the achievements of both department managers if budgeted volumes, costs, and prices are constant. If fixed expenses remain within budget, the departments’ profits rise and fall by the same amount as their contributions to overhead and profit. If corporate profit is used to evaluate department management performance, however, the results are different. Because corporate overhead is allocated on the basis of either department sales or variable costs, department A’s profit before taxes is $ 20,000 higher than the budgeted sum, while that of department B is $ 20,000 lower. The higher sales of department A increased corporate overhead charges and reduced profits. If a company uses incentive compensation, then department profit appears to be a better measure of performance than corporate profit and operating managers are apt to perceive it as more fair. Yet two arguments exist for using corporate profit. This is the measure used to evaluate overall company performance, particularly that of public corporations. Thus, the company’s control system should reinforce the importance of this measure, with budgets and bonuses reflecting the economic reality facing the company. This is important when evaluating a manager responsible for a large or important business unit. The need for bottom-line orientation is not as necessary with first- and second-level supervisors and managers. Moreover, when department, division, or product managers are evaluated and compensated on bottom-line profits, they are prone to question corporate expense allocations and thus exert a control on corporate spending. How Tight a Budget? When individuals are given a goal that is a bit beyond what they initially expect, they will often accept the goal as achievable and then work hard to attain it. But if the goal is set too high, they will probably reject it as unattainable and perform poorly. In budgeting, then, a key question is how tight a manager can set a budget and still make it useful in encouraging good performance. As the example at the beginning of this reading showed, the best budget for control may not be the best one for planning. This is particularly true if only one budget is used that has considerable stretch built into it. If a budget is revised, adjusted, and readjusted until it contains the profit top management desires, it can be useless or even harmful to the business by breeding mistrust and insecurity among unit managers. There is a lot to be said for starting the budget process with an honest statement of what those at the top see as the market and what performance they think is needed. There is also a lot to be said for a corporate culture that encourages unit managers with knowledge of operations and opportunities to put together a realistic budget that takes both long-and short-run considerations into account. Unusual Uses of Budgets In addition to the purposes previously discussed—planning, communicating goals, evaluating performances, and motivating managers—budgets can be used to accomplish three other goals not normally associated with budgeting: delegation, education, and better management of subordinates. Delegation is something that few owner-managers do well. When managers grant authority to other individuals to make and implement decisions without obtaining approval beforehand, they need to be able to check that the results are what they want. Without this feedback on performance, “abdication,” not delegation, is occurring. A good budget is among the best means both for communicating instructions and for evaluating what is being done. A budget can support delegation better if the need for performance feedback is considered in its design and construction. The budget should carefully pinpoint delegated responsibilities. Its preparation should involve the managers who will assume authority to ensure that they understand the objectives, think they are reasonable, and are committed to their attainment. The educating effect of a budget is perhaps most evident when the process is introduced in a company. Operation managers learn not only the technical aspects of budgeting but also how the company functions and how their business units interact with others. Budgets enhance the skills of operating managers not only by educating them about how the company functions, but also by giving them the opportunity, and the spur, to manage their subordinates in a more professional manner. This aspect of budgeting is often overlooked because the budget is viewed essentially as a tool for the owners and top management of a company. A business unit manager can use the budget, for instance, to encourage salespeople to think about their customers in terms of long-term strategic goals. The salespeople, in turn can use a budget as an excuse to call on their customers and talk to them about their advertising needs and plans. Operating managers can, in their turn, use the budget as an excuse to accomplish distasteful things. They can, as is often done, “blame it on the budget.” A Powerful Tool A budget is an important means of accomplishing an assortment of managerial goals. Budgets also have various ramifications, some subtle and some not so subtle. For maximum effect, keep the following in mind: A budget is a plan. A budget is a control. It can guide corporate operations. It can extend the reach of top management by supporting delegation. It can coordinate company activities. It can communicate company objectives and activities during its preparation and serve as a basis for communication throughout its term. It can direct, guide, and reward operating managers and form a basis for performance evaluation. It can educate company employees as to what is to be done and assist them in doing it. It can lead to “games” involving false estimates and other counter-productive behavior. How it works depends on other management systems in place. Its effectiveness depends on the way it is used by top management. (See the Appendix.) 1. See M. Edgar Barrett and LeRoy B. Fraser, III, “Conflicting Roles in Budgeting for Operations,” Harvard Business Review (July–August 1977): 137. 2. See Richard F. Vancil and Peter Lorange, “Strategic Planning in Diversified Companies,” Harvard Business Review (January–February 1975): 81. 3. See Zenas Block, “Can Corporate Venturing Succeed?” Journal of Business Strategy (Fall 1982): 21. 4. For a discussion of the different stages of development of small companies, see Chap. 21, “The Five Stages of Small Business Growth,” coauthored with Virginia L. Lewis, HBR May–June 1983, p. 30.
