Operating without a Budget (#131)
/In this podcast episode, we discuss how to operate a business without using a budget. Key points made are noted below.
In the last episode, I talked about how annoying and counterproductive the budgeting concept is. So in this episode, I’ll talk about how to get by without a budget.
The Need for a Forecast
The first issue is that you still need a forecast. Otherwise, nobody knows what’s coming. But it’s at a summary level, and it’s quick – really quick – and you update it a lot, like once a month. You don’t need to go into excruciating detail, like you would with a budget. Instead, this is simply an update on what you think might happen in the near future.
A couple of points on this. First, if you spend more than a half an hour on this each month, that’s too much time. The only way you’ll get people to issue a new forecast frequently is by making it easy to do.
Second point. How far in the future should you forecast? Only for as long as you’d use it to make decisions. So for example, if you’re building software apps, the market moves so fast that a three-month forecast is probably fine. Any longer, and you’re forecasting things that are bound to change. On the other hand, if you’re in an established industry where things don’t change much, you can extend the forecast. But not by too much. Only extend the time period out as far as the information is still useful.
Third point. Do not link it to anyone’s performance plan. If you do that, they just start messing with the numbers in the forecast to make themselves look good. All you want is a forecast that gives some warning to employees about what’s coming up in the near future. This is not designed to pay somebody a bonus.
Fourth point. You don’t actually need to revise the forecast once a month. If nothing has changed in the past month, then there’s no need for a new forecast. So in some industries where things don’t change much, just keep trucking along until something happens that warrants an update.
Ok, so a short-term forecast is the first thing you need if there’s no budget. If you have it, you get rid of all that budgeting inaccuracy that I talked about in the last podcast.
The Timing of Capital Budgeting
The second thing you need is to revise the timing of the capital budgeting process. There’s no longer a need to only review capital budgeting proposals once a year. Instead, you’ll accept proposals whenever somebody needs to buy a fixed asset. But this doesn’t mean that you eliminate the review process. Fixed assets can be really expensive, so you still need to examine the larger proposals in a lot of detail. On the other hand, if there’s a really low-cost proposal for a fixed asset, you can back off and just buy it without wasting too much time. So, there’s just a minor tweak to capital budgeting needed if you want to operate without a budget.
How to Set Goals
The third thing you need is a different way to create goals for the business. You might recall from the last episode that a standard budget is basically one gigantic set of goals. But they’re fixed goals. You’re going after hard targets that are fixed in the budget for the entire year. Instead, the new concept is that you want to do better than you did before. That’s all.
It seems pretty simple, but actually it’s a bit more complicated than that. You can use benchmarking to figure out what the best in class is for whatever you want to improve. Maybe it’s how fast you can fill an order in a distribution company, or the time required toturn around an order in a fast food restaurant, or inventory turnover. Whatever it is, just figure out how well the better companies are doing it, and set up a goal.
You don’t have to reach the goal right away, but you want to do better than you’re doing now. The reason for leaving this so vague is that there’s no reason for anyone to game the system anymore, because there’s no internally-derived target for anyone to mess with. Instead, you could say that the internal average fulfillment time for an order is five minutes, and the best in class companies can do it in three minutes. And eventually, we’d like to get there. But we don’t have to reach that goal this year. We’ll get there when we get there, but there has to be progress.
The Need for a Reporting System
And you reinforce the goal setting with a really good reporting system. So pretty much everyone in the company sees reports that show current performance, and the goal that the company is shooting for. And along with that reporting system goes more responsibility.
Who Sets Strategy
Senior management still does strategic direction work, but most of the tactical-level decisions get pushed down much lower in the organization. That way, local people know what the current performance is, and they know what the goals are, and they can decide on how to get there. And that allows them to make changes really fast, if that’s what’s needed.
Changes to the Performance Compensation System
And that brings us to the fourth and final point, which is that you have to restructure the performance compensation system. Under the old approach, there’s a specific performance agreement with each manager, under which they’re paid a bonus if they meet certain very specific targets.
What you should do is eliminate all of those performance contracts. Instead, there should be one big bonus pool for everyone in the company, which is probably based on a chunk of the full year profits. And there’s a bonus administration group that figures out who gets how much of the pie, which is based on a fairly basic allocation formula.
So why would this approach be better, and why does it work if there’s no budget? First, everyone gets involved in the performance of the company, because everyone can get a bonus. And if you think that managers come up with all the good ideas in a company, think again.
Second, if the bonus pool is based on a chunk of profits, then improving performance means there’s going to be a larger bonus pool. And also, the size of the bonus pool is only known at the end of the year, so if the company has a bad year, no bonuses. That’s quite a bit different from the traditional approach, where a company may be required to pay out bonuses even if the company as a whole did poorly; and that’s because it signed off on specific bonus agreements that promised the payment of very specific bonus amounts.
And another reason for this type of compensation. What do you think the control environment would be like if every single employee was counting on getting a bonus? I think you end up having every employee acting like an internal auditor, and they’re all making sure that operations are done right, and that money is not wasted. Kind of an interesting concept.
Parting Thoughts
These concepts might sound idealistic, but they do get around all of the issues that I described in the last episode. And some companies are using them right now.
To do it, they’ve made some pretty major changes. Senior managers have to keep their hands off of day-to-day decisions, lower-level people need to be trained to run operations themselves, and there’s a whole different way to pay bonuses that might not sit too well with those who were paid a lot before. And you have to dismantle all of that bureaucracy that went with having a budget.
So that covers budgeting. In case I haven’t made it clear enough yet, I’m not entirely happy with the traditional style of budgeting. I think it wastes an amazing amount of time, and it’s inaccurate, and it supports a top-down style of management that doesn’t work very well in a lot of companies. Instead, trying cutting loose and operating without a budget. You might like the results.