11 The Budgeting Process

Budgets have multiple distinct roles in managing an organisation which means that organisations will have multiple budgets for different purposes (e.g. the operational budget or the capital budget) or for different divisions within the organisation. The goal of this part on budgets is not to provide a comprehensive overview of all possible ways a budget can work in an organisation. A budget can be a plan for the entire organisation, for some division of the organisation, or for a one-off project. It can be for the long term or the short term. It can be an operational budget or a capital budget.

In this chapter, I will focus on two archetypes (or stories) of implementing a budget because they explain how organisations can deal with the fundamental tension at the heart of a budget: (1) the organisation wants to use as much information as possible when setting the budget and (2) also use that information to set targets for employees. Unfortunately, that gives the employees an incentive to not reveal their specific knowledge because they want to avoid that the information is used to set more challenging targets. This chapter describes the budgeting process as it is often presented in textbooks as one approach to manage that tension and a practitioner’s example of a start-up implements budgets. There are significant differences between these two approaches that be explained by the tension between collecting information and managing incentives of the employees that provide the information. Both these approaches are viable ways to organise a budgeting process and in the final section of this chapter I will reconcile their differences.

The textbook approach

The textbook approach is the typical decision making approach: First gather all the relevant information, based on the information make a plan, execute the plan. Typically, the budgeting process will require the following steps.

1. Identify the main organisational problem and uncertainty

2. Obtain information

3. Make predictions about the future

4. Make decisions by choosing among alternatives

5. Implement the decisions, evaluate performance, and learn

Based on Horngren (2012)

In the case of an annual operational budget, in the first stage, the organisation has to decide what the overall profit target is for the year and what the important competitive factors will be. Is the organisation able to increase sales and maintain a targeted profit margin or will competitors enter the market? The organisation will also investigate potential increases in its costs such of labour and raw material or services. In the second stage, the organisation collects information about customer demand, its suppliers, and competitors to reduce the uncertainty in its estimates. The organisation will use publicly available information, historical internal data, general knowledge from consultants, and specific knowledge from employees to estimate customer demand, production volumes, costs, and customer price sensitivity. Consultants, for instance, can share benchmarking data from comparable organisations. An example of internal knowledge is the market insights of sales staff who have a better understanding of customer preferences and customer demand than top management.

In the third and fourth stage, top management will use this information to make predictions about future costs and revenues. These predictions will also guide which investments, projects, and new products are worth pursuing, and which products or services might have to be cancelled. Finally, the decisions will be made explicit in the form of budget allocations and budget targets for different departments, geographical areas, product lines, or employees. In the fifth stage, these decisions that are implicitly embedded in the budget are implemented by all employees. The organisation will communicate the budget and should explain how the targets and allocations are determined. During the course of the year, the organisation will compare the actual performance to the predicted performance in the budget. The organisation will learn which projects are performing as planned and which ones will need additional attention. How exactly organisations can learn from comparing the actual results to the budget is something I will explain in the chapter on variance analysis.

This idealised textbook process emphasises the importance of using all available information to intelligently coordinate the different functions in the organisation. In this approach, the budget adds most value through better coordination of the organisation where the cost of gathering the information and managing the incentives to truthfully reveal specific knowledge is a necessary transaction cost. This process also acknowledges that not all information is available at the start of the budgeting cycle and based on new information during the cycle, the budget might need to be adjusted. This is reminiscent of the trial-and-error process I discussed in the chapter on chapter on implementation issues.

A practitioner’s perspective

I derive the practitioner’s approach from an essay by Ben Horowitz on budgeting in a start-up firm. He is a partner of the venture capital firm Andreessen Horowtiz and co-founder of three start-ups in Silicon Valley. In the essay, Horowitz discusses how the textbook approach can lead to a bloated budget in a start-up firm because it gives the engineers the opportunity to ask for more budget then they need. He proposes the following, more top-down budgeting process.

1. Determine the goal of the organisation and the resulting resource constraints and reduce the available budget by 10%-25%
   • Based on increase in sales compared to last year
   • Based on aspired profit or acceptable loss
   • Based on engineering growth rate
2. Communicate the budget to the team
3. Encourage the managers to do the best they can with the allocated budget.
4. If one group can perform more with more money, allocate more from the 10%-25%.

Based on Horowitz (2015).

The budgeting process should start from certain constraints on the new budget. The constraints are necessary to limit the growth rate of the firm’s operations and thus its costs. The growth rate can be in terms of the actual budget numbers or the employee count of the previous year. In this budgeting process, the primary concern is to avoid using the potentially unreliable specific knowledge of the employees with the cost that the organisation is not using all relevant information.

The next step is to communicate the budget to the employees in the company and motivate the employees to perform as good as possible within the budget constrains. Importantly, the rank-and-file employees are far less involved in setting the budget compared to the textbook approach. Only a limited amount of the total budget is allocated based on the input from the employees and this allocation is treated as an exception in step 4.

Reconciling the differences

The differences between the two approaches reveal some important features of budgets. First of all, there is not necessarily one budgeting approach that works for every firm and every approach has its own set of advantages and disadvantages. The textbook approach is likely to be more appropriate in larger established firms while the Horowitz approach is more apt for start-up firms. Here, I will go into more detail why this is the case.

The textbook approach is more vulnerable to budgetary slack creation and budget gaming because employees can distort their true knowledge to get easier targets or more budget. The distortions make it more difficult to assess different investments and plan for the next year. To limit budget gaming, organisations sometimes opt to not evaluate the employees based on budget targets which takes away the incentives for employees to create budgetary slack. Planning and coordinating the budget of different divisions is often more important in larger firms with multiple business than in a start-up. The former have more activities and investments that need to be coordinated. Similarly, the more diverse the organisation, the more difficult it is for top management to be involved in every aspect of the business. As a result, the local, specific knowledge will be more valuable for planning the following year’s operations and it is more more important to gather that information in the budget.

In contrast, in a start-up firm, the future of the company is even more unpredictable than in an established firm. Planning one-year ahead might be a difficult task because the product, the market, and the organisation are still rapidly changing. For such an organisation, guiding the behaviour of the employees is more important than planning for the next year. Start-ups are often more cash constrained and any serious budget overrun can have disastrous consequences for the survival of the firm. Oversimplified, the start-up only has two goals: not run out of cash and bring a product to the market. The most important part is that the employees work towards those two goals.

Established firms have also more tools they can use to avoid budget gaming. For one, they can create a culture where employees are committed to the budget process. In Johnson & Johnson, employees are often promoted internally which means that managers have worked with the employees they are supervising and they have experience with and trust in the budget process. In other words, managers have sufficient knowledge of the day-to-day process to understand when budget demands by subordinates are not realistic. They have experienced and absorbed the norms that make the budgeting process work (see p. 202 in Horngren (2012)). We have seen before that promotions are used by organisations to find employees that have a good understanding of the internal processes and that are a good match with the organisation. The fit between the budgeting process and the internal promotions at Johnson & Johnson is a concrete example of this argument. Other organisations solve the incentive problem directly. They provide incentives to managers and employees for accuracy in their budget proposals. They pay a bonus for budget estimates that are difficult and accurate (see p. 202 in Horngren et al. (2012)). These bonuses are a direct application of the principle that incentives should be congruent with the goal of the organisation. If it is important for the organisation to incorporate all information in the budget, they should reward employees for accurate budget estimates.

Start-up firms will have difficulty to develop such tools because they will often not have the opportunity to only promote current employees when they have to hire new people to expand their operations. In the short lifetime of a start-up, it is not always possible to develop and maintain the norms that are necessary for a positive budgeting culture as in Johnson & Johnson. Furthermore even for established firms, there are transaction costs involved in establishing a culture or using incentive contracts to secure honest budget proposals. Johnson & Johnson has to exclude a lot of potential employees because they prefer to recruit managers from inside the firm. The transaction cost of an incentive contract for honest budget proposals is that firms have to pay a bonus for when employees submit honest budget proposals.

In this chapter, I explained how budgets can be used to coordinate the strategic investments but that this coordination comes at a transaction cost to manage the incentives of employees to ensure that they do not misrepresent their local knowledge. Some organisations forego these benefits of budgets because the transaction costs are not worth it. Instead, they use the budget to set boundaries and guide the behaviour of employees. Nevertheless, no matter the specific goal of the budget, an organisation wants to track during the budgeting period whether the organisation and its employees are completing the plan or stick to the boundaries set in the budget. The organisation can check for deviations from the budget to adjust the plan and to reward employees who stick to the plan or punish the ones that break the boundaries. In the next chapter, I explain how organisations can use variance analysis to analyse the deviations.

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