Chapter 7

Innovations in Target Setting

Introduction

“Budgets are time consuming and irrelevant to the strategic management of my business.” “Budgets are out of date in a rapidly changing environment and are just a game for accountants to play.” These views are common and valid as often a budget is just last year’s numbers tinkered with so that managers can get on with the real business of generating value.

We examine two recent innovations in target setting: activity-based budgeting and the Beyond Budgeting approach. Activity-based budgeting advocates argue that budgets should be more closely connected to operations and process improvement. In contrast, the Beyond Budgeting group proposes that the annual, fixed budget-setting process should abolished and replaced with a new management approach that includes empowerment, rolling forecasts, and relative performance evaluation. These innovative ideas to improve budgeting require changes in the way performance is managed in organizations. The Leahy quote sums up the challenge for managers—to accept that it can be a trial-and-error process to implement innovative practices.

Why Are Companies Looking at New Ways to Improve the Budgeting Process?

Just about every article you read on budgeting talks about problems: Budgets are static and out of date as soon as they are prepared; budgets are focused on financial control rather than strategic and operational control. Managers find it difficult to use this information to manage their businesses. By the time the actual quarter results are out and compared to the budget, you are well into the next quarter. Budgets are outdated. In addition, linking fixed budgets to performance evaluations and incentives often results in managers attempting to game the system, and these actions usually have detrimental impacts on the organization. Here are some of the growing criticisms of budgeting:¹

One of the ideas that have been proposed to improve budgeting is the activity-based budgeting approach.

Activity-Based Budgeting

Activity-based budgeting is an innovative approach to budgeting that starts at the operational level and links operations with the financial numbers. It is future orientated as it helps identify what processes, activities and costs should be in the future. Activity-based budgeting builds on the concepts of activity-based costing (ABC). Activity-based budgeting is an attempt to combine process improvement with product costing and financial management. The activity-based budgeting approach is useful in manufacturing and service organizations to highlight inefficiencies, bottlenecks, and resourcing needs and to improve communication at the lower levels by providing a better link between operations and financial numbers.

The next section provides a brief overview of time-driven activity-based costing to provide the necessary background to understand how time-driven activity-based budgeting has developed.

What Is Time-Driven Activity-Based Costing?

ABC is one of the most innovative developments in costing in the past century. It is an attempt to completely change the way companies cost products and services. ABC has promoted different ways of thinking about costing and has received a lot of attention by the business schools and practitioners. ABC is included in most textbooks on costing, and numerous consultancy businesses sell the ABC concept.²

Kaplan and Anderson have recently proposed time-driven ABC to simplify the process while still getting the main benefits of the ABC system. The aim is to address some of the limitations of ABC, which was seen as too expensive to develop and maintain, took too long to implement, and did not capture the complexity of the operations.³ In contrast, managers taking a time-driven approach use their own estimates (e.g., resource demands for transactions and activities) in order to overcome the problems with getting employees to identify the time spent on all their activities. Time-driven ABC focuses on two issues: “the cost per time unit of supplying the resource capacity and the unit times of consumption of the resource capacity.”⁴ The steps required are as follows:

The main idea is that time-driven ABC provides the missing link between operations and the balanced scorecard.⁵ Kaplan and Norton recommend using time-driven ABC to assist with resource capacity planning and to help organizations estimate what resources they will need to implement their strategic plans. The process involves using past trends to make estimates about resource usage to assess capacity (what the requirements are), leading to an estimate of capacity utilization. The lack of operational focus and ignoring capacity issues has been a limitation of the balanced scorecard.

The benefits of time-driven ABC are that it is a more simplified version of ABC and easier to develop because it calls for less involvement of lower level employees to specify their activities and more estimates by senior managers. The emphasis of time-driven ABC is to get better estimates, recognizing that accurate costing is not possible until after the period being analyzed. As with all costing systems, however, time-driven ABC is still complex and costly to establish and maintain. Also, there has been little independent research to assess the benefits and implementation issues of adoption of time-driven ABC.

How Does Activity-Based Budgeting Work?

Activity-based budgeting (ABB) has been developed by Cooper and Kaplan to change the focus from costing to linking ABC to operational budgets.⁶ ABB links operations and costing because it focuses on planning and controlling value-adding activities and processes.

Taking a time-driven approach to ABB provides another way to decide on the future resources needed to meet forecasted sales and production. The focus is on identifying resource usage and capacity of processes and activities, not line items as in traditional budgeting.⁷ Kaplan and Anderson’s time-driven ABB approach is to analyze all activities and processes and to make decisions as to what costs are going to be covered in the period. It is an adaption of zero-based budgeting approach, rather than assuming that most costs are fixed in the short term (as discussed in chapter 4). They provide an example of a fictitious case called Sippican Corporation to illustrate the benefits of ABB. These are the steps they recommend taking:

The following case capsule provides a simple example that shows how activity-based budgeting is different from traditional budgeting.

Case Capsule 7.2 describes an ABB implementation and the implementation issues raised here explain why Kaplan and colleagues are promoting the simpler time-driven ABB approach.

Activity-based budgeting links operations to the financial numbers, and the benefits include that ABB matches resource demands with unused capacity; provides important operational information enabling monitoring of actual usage and spending against budgets. It also gives managers more control over their cost structure, for example, the traditional fixed costs, such as equipment, people, and facilities. ABB also takes an important step towards improving budgeting by focusing on resource constraints, capacity utilization, and capital allocations at the operational level—before preparing the financial budgets. ABB information provides managers with information they can use to plan, coordinate, monitor, and control their operations, rather than looking at the type of costs or line items usually presented in traditional budgets.

Activity-based budgeting information together with the use of enterprise resource planning systems enable what if analysis and scenario analysis on the impact of different mixes of sales, activities, and capacity. This information enables managers to work backwards from forecasts for sales and production in order to work out the activities needed and to ensure resources are available to meet the needs of these activities.

While time-driven ABB is in its early development, some types of organizations would benefit from this approach. For example, ABB may be more useful in stable operating environments rather than those involved in innovative or flexible environments.¹⁰ While most of the ABB implementations seem to be in manufacturing, advocates believe that service organizations could benefit from ABB as well. Organizations who match these requirements are more likely to benefit from activity-based budgeting that is

While the ABB and balanced scorecard advocates have focused on making budgets more contemporary, another group advocates the abandonment of budgets.

Beyond Budgeting and No Budgets

The Beyond Budgeting Roundtable Group recommends the development of a new management model, which focuses around four areas, including leadership, radical decentralization, rolling forecasts, and relative performance evaluation with the benefit of hindsight.¹¹ The Beyond Budgeting Roundtable was initially formed as part of the Consortium of Advanced Management, International (CAM-I) by Jeremy Hope and Robin Fraser in 1997 and they have around 100 companies as members.¹² They have contributed to the budgeting debate by showcasing some companies that have cut the link between budget targets and incentive compensation, starting with the approach championed by Jan Wallander, CEO of Svenska Handelsbanken (a Swedish bank), in the 1970s.¹³

Different Targets for Different Purposes

The Beyond Budgeting approach to target setting is to have separate targets for: performance evaluation, forecasting, and resource allocation process (as elaborated on in chapter 5).¹⁴ They argue that this avoids the problems in traditional budgeting systems where managers tend to manipulate the forecasts as they know they are going to be used for resource allocation, evaluation, and rewards. Traditional forecasts are so biased that they cannot be used for predicting the future. In contrast, the Beyond Budgeting proponents argue that performance targets need to be ambitious and longer-term focused, whereas forecasts should reflect expected outcomes and signal when problems need corrective action.¹⁵ (We discuss forecasting techniques in chapter 4.)

Relative Performance Targets

Relative performance evaluation is the benchmark used for a range of key performance indicators (KPIs), such as profit and customer satisfaction. These relative performance targets are either benchmarked internally (e.g., with teams or branches in the same company) or externally (e.g., with leading competitors). Performance targets are expected to be achieved in the medium term. The target-setting approach is based around continuous improvement and giving managers a reasonable period of time to meet the benchmarks. The managers at Borealis (an innovative provider of plastics solutions) argue they use ABC systems, and the result of their extensive benchmarking process is that performance targets are usually tougher than when they were negotiated.¹⁶ League tables are also used to publicize the rankings to provide a competitive spirit to encourage people to make improvements in their operations to improve their rankings.

Having good comparative data is important. In the Svenska Handelsbanken they use relative KPIs to compare performance across regions and business areas.¹⁷ However, finding good relative data can be difficult. In Statoil where it is difficult to measure market share percentages, they use market share rankings, and production regularity percentages can be replaced with internal league tables if there are no external peers. If benchmarking data is not available, Statoil uses past performance.¹⁸ We elaborated on the issues with external and internal benchmarking and relative performance targets in chapter 4.

Rolling Forecasts

The use of rolling forecasts is to map out expected future performance. Focus on a few critical KPIs (e.g., orders, sales, costs, profits, cash flows) so the organization can get a quick forecast of what is predicted to happen. The rolling forecasts are continually updated every few months (usually quarterly) and cover the same period (usually 5–8 quarters ahead) (as shown in chapter 3). There is no finish line, and so the forecasts are more accurate as they are constantly updated with recent events. Learning is important. In addition, planning is more accurate as the forecasts are not biased. The reason is that under the Beyond Budgeting approach the forecasts are disconnected from performance targets and resource allocation processes, as discussed earlier.¹⁹ The performance targets for KPIs are not specially linked to the forecasts, and so the gap between the targeted performance and the forecasts needs to be investigated and managed. In Borealis, for example, they use rolling five-quarter forecasts for a range of performance targets including return on capital, profit, and volumes.²⁰ Managers argue that the forecasts are more accurate since they are not linked to performance evaluation and incentive compensation.

Resourcing

Strategy is everyone’s business, and strategic planning is informal and continual. Resourcing the strategic initiatives is critical. Beyond Budgeting organizations have processes to fast track operational and capital investment funding processes to enable strategic opportunities to be taken quickly, rather than waiting for the next annual planning round. This means that resources are available on a timely basis. Key performance indicators are aligned to strategy, and regular performance reviews identify risks and opportunities.

The aim here is to give managers boundaries that provide the flexibility they need to operate effectively, providing processes that allow for fast tracking major projects and delegating responsibility for smaller projects. Rather than the “spend it or lose it” mentality that is promoted by the traditional budgeting, they make funds available to managers as the resources are required. This reduces managers’ need to put up buffers (e.g., slack).²¹ Interestingly, Bogsnes, who was in charge of the Beyond Budgeting implementation at Borealis, argues that costs actually reduced when they abandoned budgets in 1996, partly because people took more responsibility for their actions.²²

To illustrate how forecasts can be disconnected from the targets used for performance evaluation and resource allocation, a case of a Norwegian oil company, Statoil, is presented in Case Capsule 7.3.

Clearly, Statoil has established a continuous program that questions the role of the traditional budget. Bogsnes, a senior executive in Statoil and part of the Beyond Budgeting movement, argues that using the same target for evaluation, resource allocation, and forecasting is guaranteed to destroy the quality of the forecast. The Statoil case highlights that the purpose the targets are being used for needs to be considered when deciding the level of difficulty required in the target, and the time horizon (e.g., performance targets require a medium-term horizon). Bogsnes claimed that Statoil “abolished the budget in 2005.”²⁷ However, budgets are still required by Statoil’s external partners for large projects, which is confusing for managers.²⁸ Clearly, managers who did not use budgets for internal purposes now had to prepare and rely on budgets for external partners for large and strategic projects. One senior manager notes, “It is hard to be dynamic if our partners are not also dynamic. Most of them want to see an annual budget.”²⁹ Perhaps the view that Statoil and the Beyond Budgeting advocates are more dynamic than their partners warrants attention.

The Beyond Budgeting advocates provide little advice on how to select measures (and gain agreement from employees), how to set the targets, how to manage the implications of different levels in target difficulty, how the measures should be weighted, and how to link them to incentive compensation. The examples given in their case studies take different approaches.

In addition to the technical changes, Beyond Budgeting requires a change in the mind-set of managers.

Radical Decentralization

Fundamental to the Beyond Budgeting approach is what they call radical decentralization, that is, empowering employees to promote a high performance climate. This requires changing an organization’s performance management philosophy and processes towards using relative KPIs, tighter target setting through internal and external benchmarking, continuous monitoring of KPIs, continuous improvement of processes, and empowering employees. Beyond Budgeting organizations have baseline performance expectations for KPIs, and financial information is distributed frequently and openly with the focus on trends rather than actual figures. Financial budgets are still used by the Chief Financial Officer, but are kept at that level for managing cash flows and financial control; they are not used in performance evaluation and rewards.³⁰ There is also more monitoring and control at the front line and across the interrelated parts of the organization. While radical decentralization empowered managers to strive for excellence, a related issue is how to evaluate and reward performance.

How Are Relative Performance Targets Used for Evaluation and Rewards?

Performance to relative targets is done with the benefit of hindsight using information available at the end of the period, although managers will know in advance which performance targets they will be assessed on. The idea is that performance evaluation will be based on actual operating conditions and the economic circumstances faced in the period. This means that people are evaluated on their performance relative to their peers who had to deal with the similar issues (e.g., currency, interest rates, oil prices). The Beyond Budgeting advocates relate this to a car race, where everyone knows what is expected, but the results are not known until the end.

The relative performance contract requires employees to trust senior management to fairly assess their performance by peer review based on a manager’s performance compared to peers, and with the benefit of hindsight.³¹ The relative performance evaluation may be challenging to implement because it relies on getting benchmarks that are agreed upon and considered fair.³² It is also important that managers have a clear line of sight so that they understand the criteria they are being evaluated on, what performance standards are expected, and how they can influence the performance targets (see chapter 1).

Evidence has shown that the use of relative performance targets for incentive compensation is increasing.³³ However, there is little practical advice on the best way to do this. For example, the Beyond Budgeting case studies all take different approaches to setting performance targets and linking them to incentive compensation. Some firms provide a preagreed formula that shows the weightings to be attached to different measures for performance evaluation and incentive compensation. Rhodia, a large chemical company, used a combination of individual, business unit, and company performance measures. Svenska Handelsbanken, a Swedish bank, used a company-wide plan and league tables to keep the pressure on continue improvement. The profit-sharing plan at this bank pays bonuses into a pension fund, and the bonuses are not paid out until retirement or the person leaves the firm. At Statoil all employees have individual performance goals that cascade down the levels, as well as annual and biannual reviews. This is similar to personal scorecards or Management by Objectives (MBO) except that they use relative performance targets rather than preset fixed targets.³⁴ Statoil also has a group bonus scheme and an employee share-purchase scheme.³⁵

Borealis have connected bonuses to a scorecard with capped performance targets (as discussed in chapter 5).³⁶ Initially, the measures were not weighted, but then they selected “golden KPIs” that received higher weights. Some of the problems Borealis has experienced include too much scorecard-based attention on KPIs, with less effort put into strategy development (e.g., strategy maps) and improving the measurement of some KPIs. At Borealis, they also recognize that too much of the focus was on negotiating the level of difficulty for the KPIs. These problems are similar to problems with traditional budgeting systems.

Rather than abolishing budgets, most organizations are being more flexible in their target-setting approaches.

How Are Organizations Changing Their Budgeting Systems?

Organizations still use budgets as an important part of their performance management system, despite all the discussion about problems with budgeting systems. Most organizations are adapting their budgeting systems, rather than abolishing them.³⁷ Recent research from the United States, Australia, Canada, and Finland suggest that many companies are adapting their budgeting systems by updating budgets more frequently, using subjective performance evaluations, and using rolling forecasts.³⁸

One approach is to revise the budget targets more frequently. In the United States, 59% of companies revised the budget targets and of these 27% were at the next budget review, 53% on an ad hoc basis, and 20% were revised when the next rolling budgets were prepared. Similarly, the Canadian survey found that 56% of budgets were revised, and of these, 47% of the revisions occurred at the next budget review, 33% were on an ad hoc basis, and 20% when the next rolling budget was prepared.³⁹ Survey evidence shows that fewer organizations are using fixed budget targets. A survey of budgeting practices in the United States and Canada has shown that half the companies in the sample were using fixed budgets,⁴⁰ and an Australian survey finds that only 34% used annual fixed budgets.⁴¹

Organizations are using rolling forecasts to adapt to unpredictable environments.⁴² A U.S. survey reports that 23% of organizations use rolling budgets, and 62% of these rolling budgets were revised every three months.⁴³ Similarly, an Australian survey found that 63% of organizations used some type of rolling forecasts. Interestingly, of the Australasian companies that used rolling forecasts, only 3% used rolling forecasts exclusively, whereas 60% used both annual budgets and rolling forecasts.⁴⁴ Rolling forecasts are also being used in Finland.⁴⁵

Another common approach is to allow more subjectivity and taking into account other factors (e.g., uncontrollable factors). Some organizations are basing performance evaluations on items within managers’ control and then adjusting the budget at the end of the year by actual values using a preagreed formula (we discuss subjective evaluations and controllability issues in chapter 3).⁴⁶ Fewer organizations are linking bonuses solely to fixed budgets (9% of firms in the United States and 5% of firms in Canada) and are allowing some subjectivity in performance evaluations for uncontrollable factors instead.⁴⁷

Few companies are implementing the Beyond Budgeting or activity-based budgeting ideas for a number of reasons. It can also be difficult to abolish annual budgets when your external partners require them, as found at Statoil. Another reason is that activity-based budgeting and Beyond Budgeting requires a radical change in the management philosophy. In Borealis, for example, they say they still have balanced scorecards and rolling forecasts but have reverted back to a more traditional management culture brought in by new managers, and so it has gone back on many of the Beyond Budgeting principles.⁴⁸

Summary

Recent innovations in budgeting techniques have been discussed in this chapter. The activity-based budgeting approach focuses on linking operations to the financial plans, a missing link in traditional budgeting systems. Time-driven activity-based budgeting may provide the missing link to operations necessary for a successful balanced scorecard implementation.

In contrast, the Beyond Budgeting advocates argue it is better to abandon budgets and replace them with a completely new management model that focuses on relative performance evaluation with the benefit of hindsight, rolling forecasts for a range of KPIs (not fixed budget targets), empowerment of lower-level employees, and strong leadership. Whether Beyond Budgeting can be successfully implemented appears to depend on senior managers’ ability to bring in the new management philosophy.

In practice, organizations are adapting their budgeting systems to make them more flexible by continually updating forecasts and allowing some degree of subjectivity in their performance evaluation processes. What is important is that innovations to target setting occur, be it incrementally or radically. As the quote at the start of the chapter sums up, be ready for failure along the path of innovation. If fear of failure is paramount, then there will be no innovation in the process of target setting or improvements in business performance. Such fear of failure can draw unduly on the science of target setting and ignore the art of balance and harmony.

Key Learning Outcomes