While small businesses and not-for-profits need an annual financial plan, can the traditional method of following a budget and highlighting the variances be counter-productive? QuickBooks ProAdvisor Lance Fennell explains…
Back in the mid-80s, at the beginning of my career as a bookkeeper, I worked for an arts charity and was asked along with the director to prepare a budget for the forthcoming financial year. The process will probably sound familiar: take the current year’s forecast and add an amount roughly equivalent to inflation to all lines except where there was specific information to say otherwise. The budget would then go to the trustees for approval, after which it was set in stone.
One of the trustees, a man who had risen to great heights in industry, explained it was then our job over the forthcoming year to use the budget to control the finances by making sure they didn’t stray any further from the budget than was absolutely necessary. “If all the income is at least as much if not more than the plan, and the expenditure is contained to the budget, then success is guaranteed.”
I believed him and espoused this view up until about five years ago when I realised it was cobblers.
Problems with budgets
The basic idea is that if there is an annual budget of say £1,200 for postage and after six months there has been £700 of expenditure that means there is £500 in the pot. The finance manager then tells whoever spends the money that they have to cut back to bring things into line by the end of the year.
The problem is that while it’s a great theory, it almost never works like that. Instead a kind of game arises, whereby justifications for the ‘overspend’ are worked up and offsets are made against other budgets that may be underspent. In some places, huge amounts of expensive time and energy and even a few tears are wasted on this exercise, despite the reasons behind a particular overspend being perfectly logical and necessary in relation to the big picture. Nine times out of ten, the problem is not the expenditure itself, but the arbitrary way which the original budget figure was arrived at.
Worse, and far more pernicious is where budgets are underspent a defence mechanism kicks in. Budget-holders, whose own budgets can only be described as totemic, and who haven’t felt the need to spend much in the first half of the year, start to fear that if there is an underspend their budget will be taken away the following year, and so to avoid this they start spending on anything they can get away with, however inappropriate. So the budget that’s apparently meant to limit expenditure is actually driving exactly the opposite kind of behaviour.
At the root of the problem is a confusion about costs, why they arise, and their place in finance control. Costs are a consequence of activities. Do those activities well and costs come down, because waste is minimised. Do things badly and they go up along with the waste.
This may seem like stating the blindingly obvious but just flick through any day’s paper and you can almost guarantee that you’ll find at least one politician or CEO trying to buff up their macho credentials by talking about ‘driving down costs’ – shorthand for setting an arbitrary limit on an area of expenditure and then bullying those at the coalface if these limits are exceeded, and regardless of the consequences elsewhere in the enterprise.
Furthermore, it’s not just that budgets can drive the wrong kind of behaviour, it’s that they tend to hide where the biggest savings can be made. Any bookkeeper with experience of the service sector knows that upwards of 70% of cost is personnel, sometimes much more. And yet it’s amazing how little attention is given to how to improve the return on this spend compared to the other 30%, and specifically how work is designed. Personnel can be continually browbeaten into improving their ‘performance’ but unable to challenge the way their work is constructed in the first place – the main reason behind good and bad performance.
One great example of this was a charity I know that provides courses for delegates. They had purchased an expensive fundraising and events software package to process the bookings. It took a million clicks (I exaggerate, but only a little) just to get one delegate booked. No one had ever thought to ask about this aspect – the flow of work – seduced as the management were by the (unused) bells and whistles highlighted in the brochure. (For what it’s worth I calculated that the same job could have been done far more effectively using QuickBooks and in a tenth of the time).
The point, though, is that the excessive costs of both the software and the time taken to do the job was entirely down to badly designed work and yet this failure would almost certainly not show up in any budget variance. Just hit the numbers and it’s a success, right?
What does all this mean for budgets?
This is not to say that there aren’t aspects of a budget that can be useful. Having a plan and knowing where the money goes obviously makes sense.
However, with budgets it’s not just that the map is not the territory, it’s that if what you want is control and to minimise waste, your best bet is to throw the map away and concentrate on studying how well the work flows through the system.