Renowned industry expert Paul Sharman sits down with Prophix to discuss the evolution of budgeting. In this blog, Paul reflects on how the purpose of budgets and budgeting has changed.
Prophix: Because Prophix helps Finance professionals optimize budgeting processes, it is critical to have a thorough understanding of how budgets are used. Of course, budgets have taken on different forms for centuries. What was the original purpose of budgets?
Paul Sharman (PS): Budgets were originally intended to manage expectations – specifically about how scarce or finite resources would be allocated during a particular time period. That meant clearly articulating: (i) what resources would be used; (ii) how resources would be deployed; (iii) how success would be measured; (iv) who would use the resources; and (v) how those responsible for deploying resources would be incented. Budgeting aimed to address these issues up to the 1990s.
Prophix: When Prophix launched in the early 1990s, the fundamental assumption underpinning budgeting was shifting away from the original intent of holding business managers accountable for ensuring predictability. The world was becoming a far more dynamic place. Certainly Financial professionals’ needs to anticipate, and plan for, unpredictability have evolved. What are your thoughts?
PS: You have hit on a key element: the world is far less predictable than it’s ever been. As a result, the time horizons over which businesses must budget have also changed. So, while the purpose of budgeting has not dramatically changed, the context in which budgets exist has changed dramatically. For example, stock market value and business valuation have moved from being related to historical financial performance to being based on economic profit. And, economic profit is ultimately based on anticipated future cash flows spread over a number of years into the future – as compared to the traditional single year of a budget.
Prophix: That speaks to why it’s critical for finance professionals to effectively balance short-term needs and longer-term strategies. At the same time, the speed at which business conditions change also leads Finance professionals to rely on tools and processes for developing robust budgets that are readily actionable.
PS: That is certainly part of the new reality facing Finance leaders across the globe. The pace of technology innovation alone has led to an environment where business risk and business volatility are always increasing. As a result, a one year budget planning period is too long if a company wants to be nimble and too short if they want a budget to reflect an adequate time horizon for achieving desired economic profit. That means for budgets to continue to play a vital role in shaping businesses they must be combined with forecasts and ‘what-if’ analyses that can be updated on the fly. That allows decision makers to effectively mitigate risk while ensuring long-term goals are achieved. And ultimately, that’s the new purpose of budgeting.
In upcoming blogs, Paul will reflect on how budgeting has evolved in terms of their drawbacks, outcomes, processes, and technologies.