Why do we invest time, sweat, and frustration in the traditional annual budgeting process? Think about it.  What does your organization commit to its annual budgeting process? It is estimated that the average $10 Million sales company spends over 250 man hours per year in the budgeting process.  These are key individuals pulled from the operation of the company to create the budget.

Think about all the deception, the managers who sandbag their estimates or who simply cut numbers because “that’s how we’ve always done it.” Think about how they either use last year’s figures or next year’s hopes to produce a “best guesstimate.” Then think about how all of this deception and guesswork gets transformed into the document that is supposed to guide the success and profit of the company for the next 12 months.

Many managers will diligently plan their opening moves in this Annual Budgeting Dance – at times more than they plan their actual job. Their goal is to submit something that is sufficiently credible to avoid outright rejection yet remain low enough to be easily reached. They plan strategies so that, when the totals are all compiled, the result will be sufficiently above whatever the magic number that is needed to please, well, themselves, the owners or the board.

The Annual Budgeting Dance is an annual rite of passage.  It is musical chairs but not nearly as much fun. It explains why managers will float trial balloon after trial balloon.  Managers in the field will gasp in exasperation, “Just tell me what you want the number to be. I am tired of guessing.” The Owner will reply, “I want to empower you.  It needs to be your number. You need to own it.” The manager quickly lets him know, “It quit being my number long ago.”  Or the owner will accept the last budget submitted because the company is already three months into the operating year.

In many ways, the Annual Budgeting Dance explains why budgets can destroy motivation and ultimately be disempowering. Many managers use budgets as a crutch: If the amount is in the budget, he has to do it; if it is not in the budget, that he doesn’t have to do it. He never has to make a decision on whether he should do it.

So again, why do we keep doing this Annual Budgeting Dance???

Because in most organizations, incentive compensation is based on reaching budget targets. They want to “pay for performance.” In reality this is one of the worst practices in management, because companies end up rewarding managers who successfully negotiate low expected performance and execution - to “under promise and over perform”, instead of rewarding the best achievers. Forget about “being all that you can be”,  I have had managers tell me that they “would never agree to a budget that could not be easily reached; it’s just not done.”

This negative effect compounds year after year. When the low bar is reached, the mechanics of plan design often limit the upside; they have financial incentives to slow performance so that next year’s target will also be easily reached.  If they over-perform this year, even more will be expected next year when the bar gets reset for incentive compensation.  Who is to blame? Your budget process bears that blame.

What should you do instead? Use a long term strategic plan that sets a direction with intermediate target objectives. These objectives should be realistic so progress toward the goal can be tracked even though reaching the objectives in a year is unlikely. The objectives should reflect the environment and the industry that you operate in. There should be a comparison to your competitors, to your peers, and to world-class performance. EVA is one sort of commonly used metric.  Switching to a rolling forecast to instead of annual budgets changes the type and number of objectives measured.  And attaining those objectives should be the basis of incentive compensation.

This frees up the rolling forecasts to better reflect the changing environment, enabling you to better steer your organization. But avoid the devastating practice of “paying for forecast accuracy.”   The forecasts are intended to clearly show direction, not land at a specific spot.  Rewarding or penalizing based on accuracy is one of the dumbest things owners can do.

The only time a forecast could always be absolutely accurate is if none of the forecasted processes had any variability. Reality a company consists of thousands of variables constantly interacting with each other. Management needs to measure and understand them, but paying people to consistently hit certain forecasted numbers driven by those variables is a disincentive.  To hit those forecasts, managers would have to constantly manipulate or misreport the operations of the company, ensuring that management never gets an accurate, unbiased measurement. So they never understand the system’s variability, nor improve the processes to reduce variability. So any improvements are illusionary and unsustainable.

None of this should be tied to incentive compensation. Why not? Because people should be paid for what they actually achieve, not for what they hope or promise to achieve. When you separate the two, you get a better idea of what can be achieved, what investment and what risks are required.  But also you get honest input on what alternatives should be considered. You want real results that put an end to the Annual Budgeting Dance.