Most companies use the calendar year as their fiscal year and have recently been through an often tortuous, bottoms-up internal budgeting process. Management is now preparing to seek approval from the board of directors. Ugh!
From the outside, budgeting appears to be a straightforward numerical planning and accounting task. But for many it is a nerve-wracking negotiation, replete with extensive and repetitive posturing, suspicion, defiance, stubbornness and bravado. For a few it is a game filled with excitement and thrills, while most simply view it as the nastiest season of the year.
Despite the game-like atmosphere, budgeting is tremendously important. At stake are the plans for important business decisions on matters such as marketing initiatives, capital investments and new employee hiring. These critical facets of business planning require careful thoughts and judgments about market-demand trends, industry capacity, competitor strategies, technologies and a whole host of other critical inputs and projections.
But overshadowing that is the regrettable reality that for most companies the budget will be used during the year as a benchmark against which to measure performance. This comparison will determine bonuses, so managers have a vested interest in negotiating an attainable budget. The lower the budgeted profit, the easier it is to beat the budget and earn a bonus.
At any reasonable level of performance, having a lower profit budget will make the bonus higher. So we are, in effect, encouraging managers to budget low. That is, we are paying them to plan for mediocrity. It is hard to excel in business, sports or any competitive activity when one aims to perform to as low a standard as possible.
Every manager has a boss and indeed even the chief executive officer has the board. Those bosses understand the game, so when the manager submits a budget for the coming year, the boss naturally expects that the manager has biased that budget toward lower revenue and higher cost so the profit budget is more achievable.
The manager’s biases can be conscious decisions. But in many cases, they can be subconscious too. We all have a natural preference for risk reduction, so we overstate bad things (costs) and understate good things (revenue) even when we think we are being balanced. Layer on top a desire to earn as much as one can, and it is easy to see how the low-profit budget materializes. The technical finance term for this is “sandbagging.”
Since the boss knows all about sandbagging (the boss is, in fact, probably even better at it) the response is: “How can you put forth this plan with a straight face? Where are all the growth initiatives? Why do you expect prices to decline so much? Where is all this extra cost coming from?”