• James Richard

Retrospectively Understanding the Art of the Budget

When we consider how to move forward with an improved budgeting and forecasting strategy, we are always forward thinking and have our minds on the future. And who can blame us? The whole goal of budgeting and forecasting is to predict the future and anticipate the hurdles that may come our way. But to to truly comprehend budgeting and forecasting, one must take a broader view at the history of this indispensable facet of FP&A, how it has developed over its 250+ year history, and what this arc of history means for finance professionals in the age of Excel spreadsheets and fancy new software solutions.

Understanding The “Why” of Budgeting

Why were budgets invented? When organizations are originally created, managing spending is fairly straightforward. With the passing of time, the number and variety of their products and service lines change as well as the needs of their customers. This introduces complexity and results in more indirect expenses and overhead to manage the newly created complexity.

Following an organization's initial inception, all of the workers are reasonably focused on fulfilling the needs of whatever created the organization in the first place. In spite of early attempts to maintain flexibility, organizations slowly develop into separate functions. As the functions form their own staff and identities, they appear to become fortresses. In a number of such teams, the work becomes the jealously guarded property of the occupants. Inside each fortress, allegiances grow, and people speak their own languages; an effective way to spot intruders and confuse communications.

As time passes, organizations then become internally hierarchical. Such a structure exists even though the transactions and workflows that provide value and service to the ultimate customers pass through and across internal and artificial organizational boundaries. These now-accepted management hierarchies are often referred to, within the organization itself as well as in management literature, as "stovepipes" "smokestacks", or “silos”. This structure moves managers towards self-serving behavior, placing their functional needs above those of the cross-functional processes to which each function contributes. In sum, the managers place their personal needs above the needs of their co-workers and customers.

At this stage in its life, the organization becomes less sensitive to the sources of demand placed on it from the outside and to changes in customer needs. In other words, the organization begins to lose sight of its raison d'etre. The functional silos compete for resources and blame one another for any of the organization's inexplicable and continuing failures to meet the needs of its customers. Arguments emerge about the source of the organization's inefficiencies, but they are difficult to explain.

By this evolution point, there is poor end-to-end visibility about what exactly drives what inside the organization. Some organizations eventually evolve into intransigent bureaucracies. Some functions become so embedded inside the broader organization that their work level is insensitive to changes in the number and types of external requests. Fulfilling these requests were the origin of why their function was created in the first place. They become insulated from the outside world. This is not a pleasant story, but it is pervasive.

Tracing Roots Back to the Industrial Age (1760-1920)

Budgets were invented in the Industrial Age as an efficiency management tool. “Budget” is derived from the Latin word “Bulga” which means a leather bag for carrying food or supplies. Later, it became not only a container, but included the thing or stuff that was contained. In 1760, the art of the budget commenced in England. The Chancellor of the Exchequer presented the national budget to Parliament at the beginning of each fiscal year. The objective of the first budget was to establish checks and balances upon the king’s power to levy burdensome taxes and control spending of money by public officials. In 1837 the budget was made effective by the Reform Act.

This indispensable strategy made its way across the Atlantic to the US with the Taft administration in the 1910s, when President William Howard Taft was the first to lobby for a proper US government budget. Shortly following the US political implementation, the business budget as we know today was first practiced by Donaldson Brown. Brown did this as CFO at both General Motors and perhaps more recognizably at DuPont, where Brown developed the “DuPont formula”. The formula involved breaking down items such as plant and other fixed investment materials, in addition to amounts tied up in working capital across various categories like raw materials, finished product, work in process, accounts receivable and required operating cash balances.

Groundbreaking Technological Developments

What is arguably the most watershed development in budgeting that followed the DuPont formula was Microsoft Excel’s debut in 1987. In the 1970s and early 1980s, financial analysts would waste weeks running advanced formulas manually or on programs like Lotus 1-2-3 (beginning in 1983). Excel’s launch in 1987 empowered budgeting with complex modeling in minutes. Most users know that Excel can add, subtract, multiply, and divide, and can do so much more with advanced IF functions when coupled with VLOOKUP, INDEX-MATCH-MATCH, and pivot tables. This perennial application’s powerful influence continues today where courses on business budgeting describe Excel as vital to the process.

Budgeting Solutions & Alternatives in a Contemporary Context

Shortly following Excel’s debut, criticism against traditional budgeting grew as the corporate landscape became increasingly complex from the 1990s and onward. Such criticism, and even abandonment of this business strategy occurred due to the acknowledgment of the following:

  • Business numbers don’t arbitrarily stop at year end

  • Annual budgets (even ones put together well) can become out of date and completely irrelevant as quickly as 3 months after their creation

  • Traditional budgeting can promote gaming targets

In light of such understandable criticisms, many organizations gravitated towards “Beyond Budgeting”. Beyond Budgeting aims to reduce traditional budgeting, and find ways to do business budgeting at greater frequency. It also utilizes a greater variety of techniques, such as rolling forecasts and market-related targets in its place. Given the greater volatility of the market today (or, it at least commonly perceived this way) in comparison to the relative predictability of the corporate landscape prior to the age of digitization, the utilization of rolling forecasts and real time data is only becoming increasingly relevant.

Reflecting upon the history of this business tenet, it is critical to maintain budgeting as part of your finance function despite the criticisms of its static nature, and not to abandon it entirely. Rather, it is to be coupled with newer more dynamic techniques, while still being held as the bread and butter of ensuring that cash and investments land in all the right places.

10 views0 comments