This article also appeared in Finweek Magazine in their 16-Aug-2012 issue

In my previous life in corporate, one of the biggest time-wasters was the budgeting process. We would write off three months preparing budgets for the next year. Invariably we tweaked last year’s numbers, added some inflation and extra for contingency, and there you had the new spend which you had to defend.

Why is this exercise destructive for your business?

1. Excessively detailed budgeting destroys business agility. By focusing on minute detail in the new budget, big companies overlook the new opportunities and threats that the coming year holds. Corporates get so caught up in planning for years ahead, and all the bureaucracy around this, that they lose their nimbleness. They are fixed on the path the budget dictates, and even if the market moves in a completely different direction, they cannot change direction. We’ve all heard corporate staff say: “This looks like a fantastic opportunity, but we just don’t have the money for it in this year’s budget”. Or even better: “This project isn’t working, but we can’t stop it now, otherwise we won’t get the budget for it next year!”

Start-ups, by contrast, plan high-level rather than down to the smallest detail, and thus can respond much more quickly to changes in the market. They can change strategy tomorrow if they need to. Why does this spell disaster for big corporates? Because the quickest mover gets the reward. Business is full of examples of the large, sluggish market leader being slow to adapt to market changes, while the lean, agile start-up takes the gap and disrupts the market to become the new market leader. Think of Discovery Health reinventing the medical aid market, the digital camera bankrupting Kodak, and very recently Kickstarter began disrupting the traditional business fund-raising space with its innovative crowdfunding model. Even if you’re the market leader, your business needs to think and act like a start-up. So plan high-level like start-ups do, and don’t get bogged down in excessively detailed budgeting that wastes months of your company’s time, money and resources.

2. Rigid budgets kill innovation. None of us can predict with 100% certainty what the market will do in the next year or two. Things will happen that you could not have foreseen. When I started MBAconnect.net, I remember being asked to write detailed business plans outlining exactly how much capital we’d need in the next three years and every little item we’d spend it on, right down to stationery and how much printer toner we’d need. It was a thumbsuck at best.

More importantly, very little of those plans came true.

Having a flexible high level strategy with contingency budget for unforeseen events is a much more effective driver of innovation. Why? Because it gives your company the space to test the market’s reaction to new products and services, to scrap the things that aren’t working, and do more of the things that your customers want and that are working. This trial and error approach can only work if your company isn’t tied down to a rigid budget.

3. Historical budgets anchor your decision-making. When creating next year’s budget, invariably you’ll be swayed by last year’s figures. Even if you question every assumption and explore every number, you’ll probably come up with figures that differ only marginally from the previous year. Why? Because those numbers anchor you, overly affecting your decisions. Anchoring is the psychological tendency that makes a piece of information or a number stick in your head and influence your decision-making — as much as you think you’re ignoring it.

Even irrelevant numbers can anchor you. In a fascinating study by psychologists Amos Tversky and Daniel Kahneman, the father of behavioural economics, research subjects were asked to guess the percentage of African nations that are members of the UN. Those who were asked “Was it more or less than 10%?” estimated lower values (25% on average) than those who were asked “Was it more or less than 65%?” (this group answered 45% on average). Bringing this back to a budgeting example many of us are familiar with, the number of units the team sold last year, becomes the anchor that sales managers use to set sales targets for this year. So last year plus 10%, even if you have fewer sales staff and other products to sell. To overcome this, Prof. Dan Lovallo of Berkeley, and Olivier Sibony of McKinsey, came up with a revolutionary approach of re-anchoring. This involves countering the anchor of history (i.e. this year’s targets) and convention, with a new, stronger anchor based on a different group of facts. Develop a set of non-historical, fact-based criteria. Explore objective competitor data, for example headcount or other benchmarking. Then construct a new model focused on these criteria. Answer the key question: what targets would you set if you used only these objective criteria, and you didn’t know what your company’s targets were for this year? With the new model’s output, you can defy the status quo and change the discussion completely.

So what are you waiting for? Lose that 100-page budget document and reinvent the way your business does business.