28/08/2015

By Julie Windsor, Managing Director at Talentia Software UK

Intrinsic to every financial professional’s way of working is the annual budget, a strategy that structures business spend across a 12-month period, but has the time come for financial reform?

Annual budgets are essential to a number of businesses because of how well they motivate managers and improve their performance. Budgets are said to be at their most effective when they are demanding, yet achievable, and when managers have participated in setting their own targets.

Making funds available to cover future investment and growth plans is a fundamental element of any sound financial strategy, but only when it follows the careful evaluation of business performance. Unfortunately, annual budgets can also restrict financial flexibility and this can be at odds with the quickening pace of modern commerce.

Governmental departments are renowned for their ‘March madness’ fervour – where annual cash allocation is spent in full during the financial year, normally towards the end, in case future funding is reduced. Most recently, the Department for International Development (DfID) stood accused of rushing money out the door in order to meet a looming foreign aid target. March madness is not restricted to government. It occurs throughout corporate organisations across the world too.

The challenge of annual forecasting

Forecasting revenues and expenditure at the start of a financial year is at the root of the annual budget’s need for improvement. A company’s finance department must predict revenues for the 12 months that follow. The process can constrain a business and restrict potential growth spurts.

Finalising a whole-year budget reduces innovation and blue-sky thinking because of that perceived lack of agility inside the company. It can be to the detriment of business growth when exceptional business ideas are delayed or never even presented to management for fear that they will be outside of the pre-determined budget’s original guidelines.

Along with the use it or lose mentality, a way of describing March madness, there is another disadvantage worthy of note. Thanks to short-term purchasing decisions, future business development is sometimes overlooked in favour of raising spend levels and this can have more of an adverse effect than executives originally intended.

A report by Jeffrey B. Liebman and Neale Mahoney found that end-of-year spending is generally of a lower quality. The two researchers were able to demonstrate that the rush to get projects over the line before the end of the financial period will frequently result in a drop in standards.

Focus on spending agility

A growing number of organisations have looked at supplementing the annual budget with alternative approaches to spending. Against the backdrop of big data’s meteoric rise and the always-evolving corporate environment, rolling forecasts are growing in popularity. They enable targets to be adjusted in real time by taking into account corporate progression and up-to-the-minute data insights.

In addition to rolling forecasts, where the most popular approach is to review and revise each of the budgets for the months ahead, there is also flexible budgeting. Here the budget is constantly adjusted to reflect activity levels in the period that has just passed. Of course, as credible as these alternatives are, it is worth cautioning against completely overhauling the annual budget with either option.

Instead, macro industry issues and market share must both be examined to allow for flexible budgets, while rolling forecasts should be compared against budgeted performance. Using an annual budget as the primary performance measurement method is not enough for fast-growing businesses. Looking at a business’ numbers in isolation can mask corporate challenges and the preparation required to meet the future.

Robust tools are essential to ensure figures stand up to scrutiny and inform long-term organisational strategy. To accurately assess a company’s health, the redefined annual budget demands reporting solutions that adjust financial targets and allow a business plan to be reviewed throughout the year.