What function do budgets serve?

In a case where there are well-known basic requirements, and highly variable-solutions, a budget is essential to curb the tendency to put wants ahead of needs. Take, for example, an automobile purchase. All you need is four wheels. Maybe you need four doors if you have two kids, or a minivan if you have three kids, but you certainly don’t need a sunroof, or a hemi, or a self-parking car. These are luxuries. Maybe you can afford to splurge a bit, but the budget knows there are other needs that take priority, like food, mortgage payments, and utilities.

When we try to take this concept of a budget to the workplace it breaks down. In the workplace, budgets serve one of two purposes: (1) flagging corruption, and (2) investment payback.

Purpose 1: Flagging Corruption

When we know about how much money it should take to do a job, we give the responsible person a budget. “Marty, we’ve been attending conferences in Las Vegas for 30 years. We know it costs about $X, so you have a budget of $X and $Y for contingency.” As long as Marty stays within that budget, keeps his receipts, and can avoid having the escort service charges showing up on his company Amex, he’s good to go. If his expense report comes in at twice the expected amount, then he has to justify it.

When you know how much something should cost, this is an efficient model. It delegates spending to the individual and only requires minor oversight from the accounting department.

Note that the budget wasn’t set based on how much money was in the bank, it was based on historical data, and the company decided there was a payback to send Marty to Las Vegas. That’s a fundamental difference between home and workplace budgets: at home we frequently buy stuff with no perceived payback, but at a company every expenditure is an investment. That’s why the function of budgets at home and at work are fundamentally different.

Purpose 2: Investment Paybacks

When you don’t have good historical data on a planned expenditure, accounting still needs an estimate. Estimates feedback expected expenditures to whoever is managing the cash flow. Budgets are the present-cost of the expected payback, with interest.

When a company looks at starting a new project, whether it’s done internally or subcontracted, first they get an estimate. Then they compare the estimate to the expected payback, and if it pays back within a certain time-frame (usually a couple of years, but sometimes as short as a few months), they go ahead with the project. However, since projects are, by definition, something you haven’t actually done before, everyone acknowledges that the estimate won’t necessarily be accurate. They will generally approve a budget with an added contingency. They’ve done the calculations to make sure that if the project comes in under that budget, the payback will make the company (and the investors) money.

As the project progresses, the project manager needs to track the actual expenditures against the expected expenditures, and provide updated estimates to accounting. If the estimate goes higher than the approved budget, management has to re-evaluate the viability of the project. They might increase the budget if the payback is good enough, or they might scrap the project.

Tying Incentives to Budgets

For home budgets, it’s implied: if you stay within your budget, you’ll make sure to satisfy all your needs, and you’re less likely to find yourself in financial hardship. You have an incentive to stay on budget.

At work, lots of people have their bonuses tied to “performance-to-budget”. If we’re talking about the first purpose of workplace budgets (flagging corruption) where historical data provides a solid prediction of what something should cost, then it makes sense to evaluate someone on their performance to that budget. On the other hand, if we accept that project budgets are based on rather inaccurate estimates, then measuring someone to a project budget isn’t very efficient.

In fact, it leads to all kinds of behaviors we want to avoid. First, people might tend to over-estimate projects because that will raise the budget. This might prevent the company from pursuing projects that could have been profitable. Secondly, project managers tend to play a “numbers game” – using resources from one project that’s going well to pad another project that’s going over. This destroys the accuracy of your project reports; now you won’t know which initiatives really made money. Third, the cost will be evaluated at the end of the project, but the payback continues over a longer time-frame. The project manager will tend to make choices that favor lower cost at the end of the project at the expense of choices that offer higher long-term payback.

Everything I’ve read suggests that (a) project managers have very little influence over the actual success or failure of a project and (b) in any task that requires creativity and out-of-the-box problem solving, offering a performance-incentive reduces performance because you’re replacing an intrinsic motivation with an extrinsic one. The intrinsic one is more powerful.

So why do we tie performance incentives to project budgets? Is there really any research that suggests this works, or are we just extrapolating what we know about purchasing a car, or taking a trip to Las Vegas? As someone who is intrinsically motived, I’ve found budget performance-incentives to be extremely distracting. Surely I’m not the only one, am I?