Rethinking the Annual Budgeting Process

Human beings are creatures of habit. Once they have mastered certain habits, especially bad ones, it is extremely difficult to let go. Even though we are fully aware that the immediate, medium-term or long-term consequences of our bad behaviours are dire, we still cling unto them. Could this be because of our ignorance or maybe lack of understanding of what is at stake?

The annual budgeting process has been around for a very long time, and organizations across the globe have been using budgets to allocate scarce resources, monitor and manage performance. In a perfect stable world, the annual budget process works. Unfortunately, a stable economic environment is a thing of the past.

Volatility is the norm today

In the majority of organizations that operate an annual budgeting cycle, the final budget is fixed in nature, covering a specific time period. Finance executives and business managers spend a significant amount of time inputting and debating the final budget. As soon as the final budget figures are agreed, IT department uploads the budget on the company’s accounting and finance system. Nothing changes after this, except comparing actual performance to budget.

The challenge for many finance executives is which approach to use to prepare the budget. Base plus or zero base? Many make the grave mistake of using prior year’s actuals as the base for formulating the current year’s budget and then make arbitrary adjustments. This approach is acceptable in an environment where market conditions are stable, predictions are easy to make and key budget assumptions remain valid for the entire budgeted period.

Unfortunately, volatility is the norm in today’s global economy. Increasing global pressures, uncertainty, ever-changing consumer behaviours and disruption are all rendering initial key budget assumptions invalid by the time the final budget is completed.

The result is often an outrageously inaccurate budget with little management commitment and minute relevance to the organization’s strategic plan.

This new dynamic global economy calls for modern approaches to budgeting, planning and forecasting. Organizations need to be adaptive, ever ready for unpredictable events and quickly responsive to changing marketing conditions.

In his book Thinking, Fast and Slow, Daniel Kahneman talks about the Knowing Illusion.

The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact we understand the past less than we believe we do. What we see is all there is. We cannot help dealing with the limited information we have as if it were all there is to know. We build the best possible story from the information available to us, and if it is a good story, we believe it. Paradoxically, it is easier for us to construct a coherent story when we know little, when there are fewer pieces to fit into the puzzle.

The fact that we think we have a clearer understanding of the past does not automatically mean that we are capable of comfortably predicting and controlling the future. Learning from the past is a reasonable thing to do, but it is also important for us to understand that this can have some dangerous consequences.

If we lack knowledge of all the information there is to know, the limited information we have on past performance can mislead us during budgeting and planning processes and negatively affect future outcomes.

Link Budgets to Strategy

Despite the widespread challenges of the annual budgeting process and prominent rise of the beyond budgeting proponents, the annual budget still has a place in the hearts of many finance executives.

They are not yet ready to ditch the budgeting cycle completely, it is too risky for them to run the business without a financial plan.

Rather than ditching the budgeting process entirely, implementing driver-based budgets and rolling forecasts can help organizations address the challenges of the traditional budgeting approaches.

Although most of the variables in the budget are financial, it is important to also take into consideration non-financial information as this is key to developing an understanding of business performance drivers and constraints.

Very few organizations make an attempt to link budgets with their strategy, in fact the planning process is influenced more by politics than by strategy. Leading organizations are using the Balanced Scorecard to strategically allocate resources.

Linking budgets to strategy helps management and their subordinates identify the organization’s critical success factors and how they relate to the KPIs used to measure company success. This in turn, will help them design initiatives needed to close the gap between current performance and desired performance.

Aligning spending with strategy also helps fund only those initiatives deemed strategic and with the potential of propelling the organization forward. This is in direct contrast to the base plus and zero base approaches which allocate resources on the basis of chart of accounts line items, resulting in the funding of non-strategic initiatives and wastage of resources.

Implement rolling forecasts

Compared to traditional budgets which cover a fixed period, rolling forecasts allow organizations to get a vision of the future and support improved decision making. By using rolling forecasts, the company will be able to project performance four to six quarters ahead.

Each quarter the plan is reviewed, and key decision makers are able to understand problems, challenges and trends sooner than later, and change directions or fund strategic projects based on current economic conditions. Instead of reacting to changing business conditions, executives will become more proactive in their approach.

One of the advantages of rolling forecasts is that they are driver based. Drivers help eliminate detail when creating a realistic expectation about the future resulting in managers focusing on what is vital for the success of the organization.

With time, the drivers are evaluated to determine if they are still a key predictor of higher performance. If not, new drivers will be identified and selected for monitoring.

As volatility and uncertainty continue to increase, organizations need to be prepared always in order to navigate successfully towards the future.

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Leading in Uncertain Times

One of the biggest challenges facing business leaders today is making the right decisions that will ensure their organizations succeed, survive, and remain competitive in an increasingly uncertain and complex environment.

A recent post, The best way to lead in uncertain times may be to throw out the playbook, by Strategy+Business has several good points.

The article is about the COVID-19 pandemic, how global companies navigated through the crisis, and how best to prepare for future disruptions. Here are some key points and my comments.

  • Rather than follow a rigid blueprint, executives must help organizations focus on sensing and responding to unpredictable market conditions.
    • Comment: Senior leaders play a vital role in providing clarity about the organization’s strategic direction, creating alignment on key priorities to ensure the achievement of enterprise objectives, and ensuring the business model is continuously evolving to create and capture value in the face of uncertainty. They must not rest on their laurels and stick to the beliefs and paradigms that got them to where they are today and hope they will carry them through tomorrow. Regulatory changes, new products, competition, markets, technologies, and shifts in customer behavior are upending many outdated assumptions about business success. Thus, the businesses you have today are different from the ones you will need in the future hence the importance of continuously sensing changes in the global economy. Employees and teams often feed off the energy of their leaders and tend to focus their attention where the leader focuses attention. If the leader is comfortable with current business practices and rarely embraces the future or challenges the status quo, then the team is highly likely to follow suit.
  • When it became clear that supply chains and other operations would fracture, organizations began scenario planning to shift production sources, relocate employees, and secure key supplies.
    • Comment: Instead of using scenario planning to anticipate the future and prepare for different outcomes, it seems most of the surveyed organizations used scenario planning as a reactionary tool. Don’t wait for a crisis or a shift in the market to start thinking about the future. The world is always changing. As I wrote in The Resilient Organization, acknowledge that the future is a range of possible outcomes, learn and develop capabilities to map out multiple future scenarios, develop an optimal strategy for each of those scenarios, then continually test the effectiveness of these strategies. This does not necessarily mean that every change in the market will impact your business. Identify early warnings of what might be important and pay closer attention to those signals. In other words, learn to separate the signals from the noise.
  • The pandemic forced the organization’s senior management team to re-examine how all decisions were made.
    • Comment: Bureaucracy has for a very long time stood in the way of innovation and agility. To remain innovative and adapt quickly in a fast-changing world, the organization must have nimble leadership and an empowered workforce where employees at all levels can dream up new ideas and bring them to life. Identifying and acting on emerging threats and potential opportunities is not the job of the leader alone but every team member. To quote Rita McGrath, in her book Seeing Around Corners, she writes, “Being able to detect weak signals that things are changing requires more eyes and ears throughout the organization. The critical information that informs decision-making is often locked in individual brains.” In addition to the internal environment, the leader must also connect with the external environment (customers, competitors, regulators, and other stakeholders), looking for what is changing and how.
  • It’s worthwhile for leaders of any team to absorb the lessons of sense-respond-adapt, even if there is no emergency at hand.
  • Sensing: Treat the far-flung parts of your enterprise as listening stations. The question leaders must ask is, “What are we learning from our interactions beyond the usual information about costs and sales?” Train your people to listen for potentially significant anomalies and ensure that important information is not trapped in organizational silos.
    • Comment: Cost and sales data are lagging indicators that reveal the consequences or outcomes of past activities and decisions. Although this information can help leaders spot trends by looking at patterns over time, it doesn’t help understand the future and inform what needs to be done for the numbers to tell a different story. In addition to lagging indicators, pay attention to current and leading indicators and understand the relationship between these indicators and outcomes.
  • Responding: Improve communication across intra- and inter-organizational boundaries. Leaders should view business continuity as an essential function that acts as connective tissue for the enterprise.
    • Comment: In addition to creating mechanisms that allow the free flow of information both inside and outside the organization, decision-makers should also be comfortable receiving information that challenges their personal view of the world, even if it’s not what they want to hear. Create a culture of psychological safety where people are not afraid to share bad news for fear of getting punished, but rather are acknowledged and rewarded for speaking up. Leveraging the diversity of thought enables leaders to anticipate the future as an organization, decide what to do about it collectively, and then mobilize the organization to do what’s necessary.
  • Adapting: Challenge assumptions, and question orthodoxies. There’s always the temptation to mitigate threats simply by applying existing practices harder and faster. One way to get at those deeper issues and encourage double-loop learning is to ask, “What needs to be true for this to be the right approach?”
    • Comment: In an increasingly uncertain environment, it’s difficult to survive and thrive with an old business model or outdated technologies. Many businesses fail because they continue doing the same thing for too long, and they don’t respond quickly enough and effectively when conditions change. As a leader, stay curious and connected to the external environment, look for market shifts, understand what needs to be regularly refreshed and reimagined, adopt new technologies and capabilities, and adapt in ordinary times but also during times of transition. Unfortunately for many leaders, it’s just more convenient for them to continually downplay the fact that conditions are changing than take the appropriate course of action that drives business success.

How are you preparing your organization for potential future disruptions?

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The Collaborative Organization

These days the term collaboration has become synonymous with organizational culture, creativity, innovation, increased productivity, and success.

Let’s look at the COVID-19 pandemic as an example. At the peak of the crisis, several companies instructed their workers to adopt remote working as a health and safety precautionary measure.

Two years into the pandemic, they are now asking their employees back to the office full time or are planning to adopt a hybrid model.

The need to preserve our collaborative culture and accelerate innovation are two of the top benefits being cited by organizational and team leaders for bringing workers back.

Collaboration is indeed essential for the achievement of team goals, functional objectives, and the overall success of the organization.

Today’s breakthrough innovations are emerging from many interacting teams and collaborative relationships.

When teams, functions, and organizations collaborate, the whole is greater than the sum of its parts; group genius emerges, and creativity unfolds.

But, what makes a successful collaboration? What are the key enabling conditions?

  • It extends beyond the boundaries of the organization. Business success is a function of internal and external relationships. Instead of viewing your business in vacuo, understand that you are part of an ecosystem. External to your organization, who do you need to partner with to enhance your value creation processes, achieve/exceed your objectives, or successfully execute your strategy?
  • Ensure the objectives are clear and there is shared understanding by everyone. Unclear objectives are one of the topmost barriers to team and organizational performance.
  • Foster a culture that encourages opinions and ideas that challenge the consensus. People should feel free to share their ideas and not hold back for fear of others penalizing them or thinking less of them. Collaboration is hindered when one or two people dominate the discussion, are arrogant, or don’t think they can learn anything from others.
  • Groups perform more effective under certain circumstances, and less effective under others. There is a tendency to fixate on certain topics of discussion amongst groups which often leaves members distracted from their ideas. To reduce the negative effects of topic fixation, members of the group should be given periods to work alone and switch constantly between individual activity and group interaction.
  • Effective collaboration can happen if the people involved come from diverse backgrounds and possess complementary skills to prevent conformity. The best collective decisions or creative ideas are often a product of different bodies of knowledge, multiple opinions, disagreement, and divergent thought processes, not consensus or compromise.
  • New technologies are making collaboration easier than ever, enabling us to increase our reach and broaden our network. Although new technology helps, it will not make your organization collaborative without the right culture and values in place. First, define what you want to achieve through collaboration then use these tools to promote creative collaboration.

How else are you championing collaboration within your organization to create value and succeed?

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Preparing for Geopolitical Shocks

Geopolitical instability has steadily increased over the past years, and uncertainty in the global economy is at an all-time high. Thanks to globalization and advances in technologies, we now live and work in a tightly interconnected world, one in which the boundaries that previously separated domestic from global issues have disappeared.

Threats are no longer confined to traditional political borders, social structures, and geographic boundaries. Geopolitical shifts have dramatically altered the global economic landscape and brought politics and business together.

The rise of China as an economic and politically influential power has threatened the dominance of the United States as the world’s largest economy. Although the opening of China and a market of 1.4 billion people have benefited both countries, it has also intensified competition and sparked U.S. economic and technological espionage accusations against China, leading to strained relations between the two giants.

U.S. companies operating from China have felt the impact of this tense relationship. The opposite is true for Chinese companies in the U.S.

Across Europe, national populism is on the rise and now a serious force. In 2016, the United Kingdom shocked the world when it voted to leave the European Union, generating reverberating effects across markets.

Banks and financial services companies that once benefited from the EU passporting system have had their cross-border banking and investment services to customers and counterparties in the many EU Member States impacted, causing them to reimagine their value proposition models.

The recent invasion of Ukraine by Russia is another example of a geopolitical event that has had devastating effects on human livelihood and businesses. Although the conflict between the two countries has risen over the years, I think it’s fair to say that few political analysts, governments, and businesses predicted a war to happen.

The war has created a humanitarian crisis, rattled global commodity and energy markets, caused prices to soar, and forced many international companies to temporarily suspend their Russian activities or completely cut ties with the country.

Global supply chains which are already fragile and sensitive due to the COVID-19 pandemic are now facing new challenges in the aftermath of the Russia-Ukraine crisis. Multilateral economic sanctions have been imposed on Russia. A state of affairs that was unthinkable months ago and is now threatening to derail the nascent global economic recovery from the COVID-19 pandemic.

Given the global domino effect of geopolitical events and the shrinking of the distance between markets and politics, the need to better understand and more effectively mitigate geopolitical risk has become more urgent. The business impacts, whether direct or indirect, vary by company type and industry sector.

Your company may not be able to prevent wars between nations, but you can anticipate and better prepare for geopolitical shocks:

  • Integrate strategy, risk, and performance decision-making. Consideration of risks to business success is an important part of the strategy selection and execution process, not an afterthought.
  • Develop a better understanding of geopolitical trends and how they are changing. For example, what are the megatrends in business, politics, and technology that are making geopolitical risks more diverse, prevalent, and consequential?
  • Assess the links between these geopolitical events and business performance. What are the events that matter most to your business? For example, how might current global political trends pose physical, business, and reputational risks to your parent organization?
  • Anticipate how these trends are likely to play out in the short, medium, and long terms, and develop mitigation strategies for each geopolitical scenario. Proactively anticipate and plan for radically different worlds, instead of reacting to problems as they arise
  • Review your mitigation strategies as the world changes. Are they effective enough in case of a major shock?
  • Develop capabilities for continuous learning to anticipate, address, and recover from geopolitical crises.

What do you think?

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