Breaking Free from Budgets
Over the past 15 years, Bill Kling has built Swiss-American Products Inc. into a consumer-products juggernaut, with 52 employees manufacturing and marketing 21 medical skin care products. This year, he expects sales of sterilized dressings, eyewashes, and the like to approach $10 million. Keeping tabs on the company is a complex juggling act. At any given moment, the Dallas entrepreneur must stay abreast of the impact of the falling dollar on the cost of European imports; monitor more than a dozen production lines; devise new ways to market to super-sophisticated consumers in the medical community; and ensure that the numerous regulatory filings required by the Food and Drug Administration are up-to-date and accurate. And all the while, just like any business owner, Kling must handle such chores in a way that ensures that expenses don't overwhelm his profit margins.
All managers, of course, are obsessed with controlling costs and protecting profits.
But the unusual thing about Kling is that he does these things without the most basic tool that is available to business owners--a formal, written budget. "A budget," Kling says, "has nothing to do with whether or not we perform."
Managing a growing, 52-employee, $10 million company without the guidance of a budget? It sounds crazy. After all, it's an article of faith that you sit down at the beginning of each fiscal year and draft a budget, in which you allocate resources, set priorities, establish production goals and sales targets, and provide incentives for employee bonuses. Fail to budget properly, managers are warned, and insolvency looms around the corner.
But a growing number of managers like Kling are taking a tough new look at the way most companies go about budgeting. And they don't much like what they see. Call it the Beyond Budgeting Movement.
The strict cost-containment efforts that are embodied in many budgets, they say, prevent managers from thinking on their feet, shifting strategy, and tackling new opportunities. Inflexible budgets, they insist, create a "use it or lose it" mentality, which leads to the absurd spectacle of department heads scrambling to spend every last dime of their travel or marketing budgets in the final months of the year--regardless of whether that last-minute spending generates revenue--lest their allocations be cut next year. Even more ominously, they argue that budgets can lead to book-cooking and even outright malfeasance because pay and bonuses are often linked to the ability to meet or exceed budgetary goals. Look no further, they say, than the recent scandals at places like WorldCom and HealthSouth--where bonus-hungry executives turned to fraud to cover up billions of dollars in losses.
"Being budget-free doesn't mean you don't know the numbers," argues one entrepreneur.
To be sure, no one is advocating the idea of abandoning financial discipline altogether and simply letting the money flow. But they are suggesting that there may be better, more flexible ways to run a business. "I'm not opposed to a budget as a financial statement, but to the way it's used as an almost fixed performance contract on which employees have to deliver," says Jeremy Hope, an accountant, former venture capitalist, and co-founder of the Beyond Budgeting Round Table, an international research consortium that wages the battle against the budget from its headquarters in Yorkshire, England. "The pressure to deliver on [budgets]," Hope says, "drives a lot of the irrational, stupid, and crazy behavior you see within businesses."
Hope is convinced that the kind of centralized planning that characterizes budgeting at most companies actually hampers the ability to cut costs, improve relationships with customers, develop new products, and respond rapidly to changes in the business environment. In his recently published book Beyond Budgeting (Harvard Business School Press), Hope and co-author Robin Fraser argue for a system of management that replaces annual planning and resource allocation with a system that encourages managers to adjust to short-term fluctuations in demand by making resources available when they are actually needed. The message, they add, is perfectly suited to small companies, which thrive on the ability to adapt to rapidly changing conditions on the ground.
So far, the evidence supporting the think tank's theories is largely anecdotal, based on a dozen or so case studies, mostly of companies in Europe where the Beyond Budgeting Movement began. Later this year, Hope and Fraser will launch a more rigorous quantitative study in conjunction with IBM designed to measure how companies that have dumped traditional budgets have performed relative to their peers who cling to them. But even without hard data, the idea seems to be gathering momentum. The group offers how-to seminars and workshops in Europe and North America, and it held a first-ever "summit" in London in July.
Kling, for his part, only recently learned of Beyond Budgeting. But he's been running Swiss-American according to many of the group's principles for years. Rather than relying on a formal document to guide his company, Kling manages with what he calls an "intuitive budget"--essentially, a running mental tally of resources, priorities, and expenses that is constantly subject to change and revision. In some ways, Kling is making things extra hard on himself. For the system to work, he must be familiar with all the numbers that affect his business: the cost of raw materials; production expenses; sales volumes and prices, etc. He requires the same of his managers--and, in fact, recently invested $200,000 in a new accounting system that provides company decision-makers with the most up-to-date information available. "Being budget-free doesn't mean you don't know the numbers," he says.
What it does mean is the ability to be flexible when circumstances demand it. Last April, for example, Kling was surprised to discover that the costs for testing new products had ballooned to $22,000, compared with $6,000 in a typical month. In other words, the testing department had busted its budget, big time. The problem? Swiss-American had been developing several new products simultaneously, with the goal of getting them to market as early as possible. If Kling had been managing the company with a traditional budget, the testing might have been spread over a number of months. The department would have remained within budget, but the products would have taken longer to get to market--which is unacceptable, says Kling, who was able to shift costs elsewhere to cover the overrun. "It would have been nice to keep costs within range," he admits. "But not if it means micromanaging our business" and delaying the rollout of new products.
The trickiest part, Kling says, has been crafting a compensation system, especially in the sales department. At most companies, it's simple: Bonuses are tied to the ability to meet sales call quotas and targets spelled out in the budget. Kling takes a more subjective, qualitative approach. The biggest rewards go to those who are best at explaining Swiss-American's often complex products to the company's medical-industry clientele. For Kling, selling is about the ongoing relationship between the salesperson and his or her customers. The stronger that relationship, the more robust sales will be over the long haul. "The person who makes the most calls is not always closing the most deals," Kling says.
Kling's intuitive approach is riskier than traditional budgeting, but there are potential payoffs, says Al Osborne, director of the Price Center for Entrepreneurial Studies at UCLA's Anderson School of Management. Osborne is a big believer in budgeting. "If nothing else, budgets force individuals to think about the resource requirements of different activities, and the assumed or potential returns of those activities," he says. Budgets also have a way of focusing managers on the financial consequences of the decisions they make.
But problems arise when companies cling too tightly to their budgets. After all, no manager considers a company's business plan as being set in stone for a calendar year. There's no reason for a budget to be set in stone either. "Part of my job working with entrepreneurs is trying to make them understand that budgets shouldn't be thought of as inflexible or constraining," Osborne says.
He is particularly dismayed at the way budgets are applied to compensation. "The minute a budget sets revenue targets--and ties compensation to hitting those targets without thought of whether those targets are achieved in a way that is in the company's best interest--you have a problem," he notes.
The most valuable of Beyond Budgeting's principles, in Osborne's view, are those that call for financial planning to be continuous and inclusive, and that make resources available as needed rather than allocating them in advance. "A lot of people end up spending dollars simply because, under the budget, they can," Osborne says. The worst question a business owner can hear from a manager, he contends, is: "What's my budget for this?"
That's not a question you'll hear too often at Omgeo, a Boston-based outfit that processes financial-market trades. Kevin Ennis, chief financial officer, traced his decision to abandon traditional budgeting to the implosion of the bull market--which occurred at about the same time as his company, a joint venture of Depository Trust & Clearing Corp. and Thomson Financial, was founded.
The way Ennis sees it, just as a long line in the coffee shop or a late train derails your plan to get to work by a specific time, unforeseen events in the business landscape have a way of rendering budgets irrelevant. In Omgeo's case, Ennis had drafted a budget based on the volume of financial trades he expected the company to execute--only to find that his painstakingly drafted numbers bore little resemblance to the post-crash market reality. His budget in tatters, he thought about writing a new one. Then he heard about Hope's Beyond Budgeting Movement. While the idea of running a company sans budget seemed bizarre--"Like something out of Star Trek," he says--he was intrigued by a strategy that would allow him to guide Omgeo through a world that was frustratingly fast-moving and unpredictable. "We felt that this was something we could use to create a new culture and address the new realities of our business," he says.
Omgeo made the shift last year while planning for 2003, replacing its traditional budget with what's known as a "rolling forecast." Much has remained the same: Companywide and departmental goals are set for the next 12 months, and resources are allocated accordingly. But rather than institutionalizing those targets and requiring all managers to stick to them, goals are reviewed monthly in an effort to account for any changes in the client mix or the general business climate. Some months, nothing at all may change. But the system lets Omgeo easily shift gears if, say, a new marketing opportunity presents itself or it makes sense to hire a supertalented employee. "The bottom line isn't hitting budget targets," Ennis says, "but adding to shareholder value."
What's more, because there are no fixed goals, no one has reason to manipulate or fudge the numbers. Rather than basing compensation on the ability to meet specific budget targets, Omgeo asks employees to evaluate their own achievements in meeting a variety of companywide goals--including nonquantitative targets like finding new and innovative ways to serve clients and anticipating customer needs. (The self-assessments are double-checked by supervisors.) The system requires a tremendous amount of discipline, Ennis admits. But the result is a fundamentally different kind of company. "Instead of asking, 'Did you make your sales and profit numbers?" he says, "we want to know the quality of their work: 'What did you do to save those dollars?' It becomes a question of thinking about what's good for the whole company and not just what's good for their corner of it."
Ennis recently left Omgeo, but the flexible system that he created for the company remains in place, says Kevin Cabral, Omgeo's director of planning and analysis. And while it's still too early to gauge the impact on Omgeo's revenue or margins, Cabral is enthusiastic. "It's going to help us respond speedily to the needs of our customers and therefore improve our own business," he says.
Omgeo's approach may seem unusual. But it's the way many entrepreneurs run their companies--at least in their early days. Then, as small businesses mature, according to Hope, their attitudes about budgeting begin to change. "The big organizations become their role models," says Hope. The business owner "starts thinking, or being told by investors or a new CFO, that having a strict budget is the right thing, the professional thing to do."
Not that there isn't a good reason for that. Nate McKelvey, founder and CEO of CharterAuction.com, a Quincy, Mass., company that matches unused private jet capacity with well-heeled business and leisure travelers, looks at companies like Swiss-American and Omgeo and shakes his head in disbelief. McKelvey learned from his entrepreneur father that budgeting is the cornerstone of any successful business. And so, like his dad, McKelvey has imposed budgetary discipline ever since founding CharterAuction in 1999. Each year, for example, the company's marketing manager receives a fixed amount that he can spend however he sees fit. But the spending must result in an agreed-upon number of solid business leads--and it can't be exceeded, under any circumstances. "If he wants to put money into a new kind of advertising, he can," McKelvey says. "But it has to come out of somewhere else."
We gave up budgets, says a CFO, "to create a new culture and address the realities of our business."
And he sees no reason to change. CharterAuction, which now has 25 employees and about 350 clients, just turned its first profit. This year, the company is projecting revenue of about $15 million, up from $6.7 million in 2002 and $1.2 million in 2001. As his company grows in size and complexity, budgetary discipline is more important than ever, McKelvey says. When he started the company, "I was able to get involved in every decision, large or small," he says. "It's easier to operate from the gut, without a formal budget, when you're really small. But now we're outgrowing that."
But anti-budgeting forces insist that disposing of a budget doesn't mean relinquishing control of a business, as much as passing more of that control to people on the frontlines who are better able to gauge what resources are actually needed. That attitude permeates all levels of the company at Swiss-American. Even shipping department employees feel empowered to shift gears, says Ede Payne, the company's vice president and general manager.
Boxes of Swiss-American products were traditionally packed with foam peanuts--which employees found were both more expensive to purchase and less efficient to work with than crumpled brown paper. A shift was suggested and approved. It may not have been the sexiest strategic move, but since it occurred four years ago, the company's packaging costs have plunged 20% and productivity is up about 10%. Could such a shift have happened if Swiss-American had a more traditional approach to budgeting? Perhaps. But Payne, whose last job was at a company where top-down budgeting ruled the day, doesn't think so. When expenses and goals are carved in stone, Payne says, employees feel that they are expected to live according to the budget--not challenge it. "If a budget had existed, [the shipping department staff] probably would have just said, 'Well, the guys running this know what they're doing because they budgeted for this," she says. "Instead, they felt they could use their initiative to suggest a change."
Suzanne McGee is a New York City-based freelance writer.