The primary goal of an organisation is to survive – and to do that it must be financially viable. The income must meet or exceed the expenses; the bottom line must be zero or greater; your financial assets much equal or exceed your financial liabilities. So, organisations have to make financial plans to ensure finanical survival and as large organisations are usually sub-divided into smaller functional parts the common finanical planning tool is the departmental budget. We all know from experience that the future is not precisely predictable and that costs tend to creep up; and the budget is also commonly used as an expense containment tool. A perfectly reasonable strategy to help ensure survival. But by combining the two reasonable requirements intoi one tool have we unintentionally created a potentially lethal combination? The answer is “yes” – and this is why ….
The usual policy for a budget is to set the future budget based on the past performance. Perfectly reasonable. And to contain costs we say “if our expenses were less than our budget then we didn’t need the extra money and we can remove it from our budget for next year.” Very plausible. And was also say “if our expenses were more than our budget then we are suffering from cost-creep and the deficit is carried over to next year and our budget is not increased.” What do we observe? We observe pain! The first behaviour is that departments on track to underspend will try to spend the remainder of the budget by the end of the period to ensure the next budget is not reduced … they spend their reserves. The departments on track to overspend cut all the soft costs they can – such as not recruiting when people leave, buying cheap low quality supplies, cancelling training etc. The result is that teh departments that impose internal cuts will perform less well – because they do not have the capacity to do their work – and that has a knock on effect on other departments because the revenue generating work is usually crosses several departments. A constraint in just one will affect the flow through all of them. The combined result is a fall in throughput, a fall in revenue, more severe budget restrictions, and a self-reinforcing spiral of decline to organisational death! Precisely the opposite intention of the budget design.
If that is the disease then what is the root cause? What is the patholgy?
The problem here is the mismatch between the financial specification (budget available) and the financial capability (cost required). The solution is to recognise the importance of the difference. The first step is to set the budget specification to match the cost capability at each step along the process in order to stabilise the flow; the second step is to redesign the process to improve the cost capability and only reduce the budget when the process has been shown to be capable of working at a lower cost. This requires two skills: first to be able to work out the cost capability of every step in the process; and second to design-for-cost. Budgets do neither of these and without these skills a budget transforms from a useful management asset to lethal organisational liability!