WHY BUDGETS ARE BAD FOR BUSINESS They encourage dumb moves and

discourage smart ones, like investing for growth. But some companies are breaking
away from this crazy numbers game.

(FORTUNE Magazine) – YOU HAVE AN INSPIRATION -- a microdemagnetizing

digital doodad, say, or a new way to organize the business, like making the technical
support guys report to the sales director. You sound out a couple of colleagues and
customers, estimate costs, and take it to your boss. ''I like it,'' he says. Then he utters
the most dismal sentence in corporate life: ''But it's not in the budget.'' Those words
signal problems far bigger than frustration. Budgets, say experts, control the wrong
things, like head count, and miss the right ones, such as quality, customer service --
and even profits. Worse, they erect walls between the various parts of a company and
between a company and its customers.

A.T. Kearney consultant Robert Gunn says, ''When you're controlled by a budget,
you're not controlling the business.'' Donald A. Curtis, a senior partner at Deloitte &
Touche, goes further. Reliance on budgets, he says, is ''the fundamental flaw in
American management.'' That's because they assume that everything important can be
translated into this quarter's or this year's dollars, and that you can manage the
business by managing the money. Wrong, he argues: ''Just because a budget was not
overspent doesn't mean it was well spent.'' Budgets, forecasts, plans -- whatever you
call them, you cannot escape the annual ritual. For tracking where the money goes,
budgets are dandy. They become iniquitous when they are made to do more -- when
the budget becomes management's main tool to gauge performance, or when it
distorts long-term planning or blocks managers from shifting resources when they
need to. Then the budget becomes an end in itself. Managers lock their radar onto the
signals it sends out. ''Making the numbers'' becomes their overriding goal. The result
can be madcap or maddening, depending. Managers, says A.T. Kearney's James
Morehouse, ''do incredibly stupid things'' to make budget, especially if incentive pay
is at stake. They woo marginal customers. They cut prices too deeply. They overload
distributors with goods -- then take them back or shell out for costly promotions to
sell them. Riding that merry-go- round, RJR Nabisco overstated profits by some $250
million before it stopped last fall (FORTUNE, December 4).

Says David Nadler, president of Delta Consulting Group: ''We once found a guy who
made his sales budget by selling stuff to a dummy company. He put it in his basement
and returned it the next year.'' And who hasn't endured a fourth-quarter spending
freeze that cost more than it saved? Then there's the manager whose problem is
running under budget. Consultants swap tales of late autumn spending sprees as
executives realize that a penny saved is a penny lost from next year's budget. Nadler
had a client whose managers used to pay in December for consulting time that they
did not want until the next year. Use-it-or-lose-it is still a fact of life at many
companies. ''My phone rings off the hook in November and December,'' says
Columbia business professor Kathryn Rudie Harrigan, a sought-after consultant.

Expensive or silly budget games end sooner or later. Not so the pressures that
engender them, whose damage is subtle but greater. Over time, says Morehouse,
''cost-center managers may do what's in the best interest of their budgets, even if it is
to the detriment of other cost centers or the rest of the company.'' Manufacturing,

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which benefits from economies of scale, resists tooling up for new products or
demands long production runs before the size of the market is clear. Marketing, by
contrast, wants new stuff, the more the merrier, and phooey on the cost in the lab or
factory. In these turf wars, managers may spend more time arguing over who pays for
what than trying to serve customers. The result ends up in the warehouse: Big stacks
of slow-moving inventory are often a tip-off that each department has its own agenda.
Ironically, when the finance department notices that too many assets are tied up in
inventory, it makes matters worse by putting its priorities above all others. Explains
Morehouse: ''Out goes a memo telling all unit managers to cut inventory 25% in six
months. But only the hot items move out fast. The rest sits there. When it's all over,
inventories are down 10%, the CFO declares victory -- and the only items left are the
ones nobody wants, so customer service goes to pot. You wouldn't believe the
alligators that slither up on the newly exposed rocks.''

The great budget game is the result of trying to control negative behavior, like
spending too much, while largely ignoring positive behavior, like building the
business. ''The problem with that,'' says Donald Curtis, ''is that it works, and it works
for a long time if the business is in decent shape when you get it. Anyone can
manipulate the figures to make, say, $6 a share this year. The question is what else
you should be doing so that it's easier to make $6 next year.'' Adds Pillsbury chief
operating officer Paul Walsh: ''It's easy to extrapolate a trend. Management's job is to
damn well change the trend.'' The worst failure of budgets is what they don't measure.
Budgets show what you spend on customer service, but not what value customers put
on it. They count noses, but not brains: In the arithmetic of the budget, Curtis points
out, the day Seymour Cray left Control Data to go out on his own, nothing happened.
In many companies, budgets actually discourage spending to protect market share or
improve products. ''It takes a real hero to invest in off-the- balance-sheet assets,'' says
Curtis, ''especially when the guy can sit at his kitchen table and calculate exactly what
it'll cost him in his bonus.'' THINK OF A BUDGET as being like a detailed golf
scorecard: It can tell you what clubs you used, how far you hit each drive, whether
you made par on the ninth hole, and whether you shot a 72 or an 84. But it cannot tell
you if your backswing is lousy or your grip is wrong -- knowledge you require to help
you play better next Saturday. For that information you need other measures. They
exist, of course -- financial measures like returns on invested capital, and nonfinancial
data on quality, market share, and customer satisfaction.

The trick is to base the control system on them, not on budgets. Companies as diverse
in style as 3M, Emerson Electric, and Digital Equipment Corp. have done just that.
Here's how:

-- Measure output, not input. The worst budgets set cost targets only, leading
managers to control how much their operation spends and to ignore how much it
earns. Says Jason S. Schweizer, a professor at the American Graduate School of
International Management (Thunderbird): ''It's easier to control the money going in
than to control something like P&L.'' But the simplicity is costly. It turns an
organization inward, values rules above initiative, and may lead controllers to query
every little variance in a department's budget.

Not at Emerson. Profit, not spending, is the key measure, and it is tallied in operations
as far down on the organization chart as possible. As a result, says President Al Suter,

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''if a division president has an opportunity to gain market share, he can go out and buy
all the steel he needs. No one has to ask.'' What about operations like R&D, billing, or
personnel, which have only expenses and no revenues? They need other relevant
measures of achievement -- like percentage of company sales that come from new
products, age of receivables, and employee turnover. Well designed, such measures
not only forestall capricious liposuction, they also motivate staff units to support
operating units rather than obstruct them.

-- ''Plan first, budget later.'' So says Ronald Mitsch, a 3M vice president. Without a
plan, you are doing last year's budget, not next year's. Some traditional budget items
are better handled in the long-term planning process. At Emerson, for example, cost
reduction is part of the five-year planning cycle, not the annual budget. Why?
Because real savings come from investment in new processes or equipment. Quick
fixes don't so much cut costs as defer them. And, says vice chairman Robert Staley,
''because cost reduction is important in good years too.''

-- Budget for managers, not accountants. Sure, FASB and the SEC tell you which
figures to report, and how, but who says management reports have to be the same?
''Those numbers are irrelevant internally,'' says Bruce J. Ryan, controller at Digital
Equipment Corp. DEC has a dazzling new information system that can slice and dice
the company more ways than a Cuisinart. Designed to cut paperwork -- quarterly
closings had become an Augean mess of over 1,700 pages of documents -- the system
allows DEC to customize a business plan for each division. One might shoot for
return on sales, another return on assets, a third market share. The choice is part of
strategic planning and depends on factors like the maturity of the business and the
state of competition. Making sure the shoe fits is especially important when business
is tough, as it is now for DEC. Says Ryan: ''It would be easy for me to tell everyone,
'Cut your numbers by 10%.' We are working the cost issue, but at the same time we've
got a planning process going on. If you do that right, you've got a list of all the
possible investments -- and that's how you pull it back to reality, as opposed to saying,
'Everybody's got to cut.' ''

-- Design against turf wars. Divisions intent on making budget are always trying to
foist work and costs onto each other. That's an excellent formula for enraging
customers. Says Curtis: ''An excuse like 'It's not my fault, it's the credit department's
fault' is a non-answer to a customer.'' To make it a non-answer to a manager, too, look
for ways to link budgets together horizontally, not vertically. Xerox has restructured
field operations to combine sales, service, and order-entering in geographical units
rather than run them up through parallel hierarchies that might fight over funds. At
Emerson there are good reasons for all operations in a division to pull together
because it is held to account for its profits, not its costs, and because incentive pay is
based on the unit's performance as a whole. By contrast, 3M's 46 divisions are neatly
stacked in 16 groups within four sectors. The orderly pyramid is deceptive. The group
that makes tape for disposable diapers also makes reflective material for stop signs.
(''Damned if I know why,'' says Mitsch, the group's former head.) At 3M, people,
technology, and money cross more borders than a Cook's tour. Salesmen who sell
Scotch tape, for example, report to the Commercial Office Supply Division but sell
the wares of eight others. That matrixlike structure could easily breed Pyrrhic budget
warfare. But creative financial management and ingrained cultural habits keep
squabbling to a minimum. When a sales force sells for a division other than its home

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unit, the income shows up on the internal report cards of both. To sweeten the deal,
says group VP Robert Hershock, ''I might throw in marketing money, or some people-
support off the books'' -- a flexibility 3M encourages. Managers who need extra cash
usually find it in their own pyramid, but they can dip into bags of money that are
cached all over the company. Last year a unit making industrial filters had a chance to
expand its international business, but the effort would have consumed virtually all of
its budgeted resources. It got extra money from the company's area management for
Europe, which serves all 46 divisions.

-- Build budget busting into the system. The value of an annualized budget
depreciates fast. Simply revising it every few months may tighten the budgetary coils
instead of releasing managers to act strategically. Contingency plans and even some
purposefully fuzzy thinking can help. 3M CFO Roger Roberts asks operating
managers to include in their strategic forecasts a line labeled NIGOs --
''nonincremental growth opportunities.'' These are products that might pop out of the
lab in the coming year, or potential entries into new markets -- items whose costs and
revenues are hard to predict. Emerson executives budget for bad news by writing
three different plans for varying contingencies. ULTIMATELY, says consultant
David Nadler, ''people can figure a way around any control system.'' Budgets can tell
you who runs a tight ship, but a good admiral demands more: captains who know the
difference between a reef and a tail wind, for example. 3M CEO Allen Jacobson told
his division general managers in November, ''I never want to hear anyone put down a
project because it isn't in the budget.'' Fine words like those have been uttered as often
as the dismal ones with which this story began. But opportunities to toss out the
budget won't work unless managers feel safe to act on the knowledge that the world is
not on a fiscal year. Says Hershock, who was promoted to his group vice presidency
four months after he heard the boss speak: ''I've overrun budgets -- overrun them
pretty good sometimes. I was never criticized if I could justify it.''