Best Practices: Developing Budgets

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A budget is a systematic method of allocating financial, physical, and human resources to achieve strategic goals. Companies develop budgets in order to monitor progress toward their goals, help control spending, and predict cash flow and profit.

The central challenge that budget developers face is mapping out the future, something that can never be done with perfect precision. The fast pace of technological change and the complexities of global competition make developing effective budgets both more difficult and more important.

Best Practices
Note: Arthur Andersen has studied the leading companies that are high performers in the process of developing budgets. It has also tapped the knowledge of experts, consultants, and industry leaders. The insights that Arthur Andersen has gained from these extensive studies are the focus of this executive summary.

Important benefits of improving the budgeting process include better companywide understanding of strategic goals, more coordinated support for those goals, and an improved ability to respond quickly to competition. A discussion of best practices used by leading companies to develop budgets follows.

Link to strategy
Design procedures
Incentives
Link to costs
Reduce cycle time
Accommodate change

• Link budget development to corporate strategy.
  Because the budget expresses how resources will be allocated and what measures will be used to evaluate progress, budget development is more effective when linked to overall corporate strategy. Linking the two gives all managers and employees a clearer understanding of strategic goals. This understanding, in turn, leads to greater support for goals, better coordination of tactics, and, ultimately, to stronger companywide performance.

  But how is such a link created? Companies that apply best practices find that communication plays an important role. Top management must take the lead in developing and communicating strategic goals. But to develop those goals, top management needs information about customers, competitors, economic and technological change - information that must come from customer-contact and support units. Companies that establish effective channels for communication find it easier to set challenging yet achievable strategic goals.

  Setting goals before budgeting begins makes it easier for budget developers at all levels. When this happens, budget developers create from the start budgets that support strategic goals and that, therefore, need fewer revisions. Budget development then becomes not only faster and less costly but also far less frustrating.

• Design procedures that allocate resources strategically.
  Within any company, competition for resources is inevitable. Every function and business unit needs funding for both capital and operating expenses - usually in excess of the actual resources available. This makes it critically important for companies to design procedures so that resources are allocated to support key strategies.

  Best practice companies find that resource allocation is part science, part art. Fortunately, following certain best practices leads to better results. One such practice is coordinating the review of operating and capital budgets. Doing this gives managers insight into the ways in which changes in one budget affect the other. Another practice is to develop sophisticated measures for evaluating proposed budgets. The measures used tend to vary by industry, but most take into account the company's weighted average cost of capital. Many measures also assess the degree of risk involved in competing plans of action, the costs or advantages associated with deferring action, as well as factors such as expected developments in interest rates. By using such measures, and by using cross-functional teams to examine action plans, companies can better select plans whose benefits will produce desired results. Finally, by monitoring the results of allocation efforts, companies can refine and improve their procedures.

• Tie incentives to performance measures other than meeting budget targets.
  Many companies still evaluate managers primarily on how closely they hit budget targets. While this may seem logical, in reality this type of one-dimensional evaluation tempts managers to "win" by playing games with budget targets. Such game playing isn't always in the company's best interest.

  At best practice companies, meeting budget targets is secondary to other performance measures. Such companies use a balanced set of performance measures to chart progress toward strategic goals, and use the same measures in their incentive programs. This reinforces the importance of key strategies and communicates what results will be rewarded.

  At many companies, business unit managers are involved in identifying the measures that are most relevant for their operations. Typically, some measures are financial, while others track progress in other efforts. For example, an appropriate nonfinancial measure for one business unit may be product defect rate; for another, speed to market for new products. Once the measures are identified, higher-level management clarifies what targets each manager is expected to meet. Managers and employees receive training on the company's incentive program so that they understand the reason behind the rewards.

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