Financial Planning & Analysis: Why Most Firms Have Got Their Budgeting All Wrong

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Corporate finance teams often think that the biggest challenge about running the annual operating budget process is the time it takes. This is understandable given the hundreds of hours that go into it each year, but there is a bigger problem that many firms are yet to iron out: budgeting does not make the corporate center smarter about costs.

The average head of financial planning & analysis (FP&A) cannot confidently answer a question about expense levels between reporting or forecasting periods. And, even if he or she could, decision makers would neither understand why expense levels are where they are, nor feel comfortable making decisions based on interim cost information in the middle of the plan year.

These are all symptoms of a company with low “Cost IQ” — the ability (at the corporate center) to understand, trust, and make decisions based on interim cost information (see chart 1). And, for most of the world’s big companies, the primary cause of this is their budgeting techniques.

Only 35% of the companies surveyed by CEB have the confidence to provide updated expense information in the middle of the plan year without asking their business partners. Less than a third of decision makers trust decisions made off interim expense information, and only 13% understand why the company ended up with the cost profile that it did.

Low Cost IQ has a significant effect on both revenue and profit growth. Companies with low Cost IQ sacrifice as much as 17% of potential revenue and profit growth because they are unable to make good decisions about allocating resources (see chart 2). This effect is even more costly in the low growth environments that so many firms are operating in right now.

Three manifestations of low cost IQ

Chart 1: Three manifestations of low cost IQ  Percentage of companies exhibiting low Cost IQ; n=79  Source: CEB analysis, CEB 2016 Budget & Forecast Assessment Tool

Revenue and profit growth potential sacrificed due to budgeting

Chart 2: Revenue and profit growth potential sacrificed due to budgeting¹  As estimated by FP&A heads; n=53  Source: CEB analysis, Standard & Poor’s Compustat Database, CEB 2016 Budget & Forecast Assessment Tool

¹Assessed by response to question: Q: If perfect budgeting leads to 100% achievement of your revenue and profit growth potential, how much revenue and profit growth are you sacrificing due to your current budgeting approach?

How to Improve Cost IQ

Those companies with a high Cost IQ tend to exhibit four hallmarks.

  1. Continuous visibility at the corporate center into current cost information tied to growth drivers, not cost centers.

  2. High confidence in current year spending decisions that affect the future.

  3. Explicit understanding of cost relationships (e.g, in environments with high cost allocations).

  4. Ability to make unbiased mid-year resource reallocation decisions.

CEB’s research into those companies that have these hallmarks, shows that if FP&A wants raise the firm’s Cost IQ, it needs to champion and implement multi-model budgeting (the use of three or more budgeting models) across the company. Companies in the top quartile of Cost IQ are 11 times more likely than those in the bottom quartile to adopt at least three budgeting models (see chart 3).

This is because the combined use of multiple budgeting models — historical, rolling forecasting, driver-based, and zero-based — helps companies adapt to the complexity and nuances of their cost structure by looking at corporate activity thorough additional lenses.

For instance, the addition of driver-based approaches helps FP&A understand how operational variables affect expenses. Tacking on a rolling-forecast-based budgeting approach makes them smarter about costs as it enables a more precise understanding of next year’s resourcing needs. Finally, zero-basing expenses in certain businesses or functions creates significant activity-level transparency, making the team smarter about the most leveraged areas to spend (see chart 4).

The value of multi-model budgeting

Chart 3: The value of multi-model budgeting  n=79  Source: CEB analysis, CEB 2016 Budget & Forecast Assessment Tool

Types of budgeting

Chart 4: Types of budgeting  Source: CEB analysis

Why Most Firms are Still Stuck in Traditional Budgeting Mode

Although the multi-model budgeting approach is the most effective way to drive up Cost IQ, most companies aren’t using it: 70% of companies use one to two budgeting models across the company, while only 30% using multi-model budgeting (see chart 5).

The Venn diagram in chart 5 shows how the 30% of companies that use multi-model budgeting combine the different approaches:

  • 12% use a mix of historical, rolling, and driver-based models

  • 4% use a mix of historical, driver-based, and zero-based models

  • 3% use a mix of historical, rolling, and zero-based models;

  • And the remaining 11% (in the middle) use all four budgeting models

Percentage of companies using three or four budgeting models

Chart 5: Percentage of companies using three or four budgeting models  n=79  Source: CEB analysis, CEB 2016 Budget & Forecast Assessment Tool

Click chart to expand

The idea of multi-model budgeting runs against certain preconceived notions, such as the perception that the approach will prevent FP&A from standardizing and streamlining budgeting processes. However, CEB’s recent research shows this isn’t the case. There will be more on this, along with details of how to select the right budgeting for different business units and functions, in future posts.



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