Almost all companies prepare a budget, or annual operating plan. And almost all companies do it wrong.

That shouldn't come as a surprise to managers, many of whom are highly critical about both the way budgets are prepared and the way they are subsequently used. The typical budget process, they say, mainly serves to distract managers from doing their jobs and to discourage them from taking risks. It undermines integrity, distorts information and leads to bad decision-making from mailroom to boardroom.

They complain, for instance, about the endless meetings where managers crunch and discuss numbers that have long since gone out of date. They complain that budget targets are almost universally defined in backward-looking financial terms and as a result don't reflect what successes—or failures—an organization may currently be having.

At the same time, they say the budget processes too often serve as opportunities for self-aggrandizement—and enrichment—by undeserving and unscrupulous managers. Those who earn the best performance ratings are often the most skilled in negotiating easily achievable budget targets for themselves. Even more damaging, many will manipulate numbers in their budget reports to inflate results and artificially achieve short-term targets. And others will spend money wastefully so as not to see a reduction in next year's budget allocation.

Can the problem be solved?

To a large extent it can, if companies can only recognize that the annual budget process is too inflexible, too infrequent, and too easy to manipulate, to accomplish all of the functions it is expected to—including strategic planning, resource allocation, evaluating performance and determining compensation.

Organizations need to blow apart the traditional budgeting process, become more dynamic and refocus on crucial management functions individually. Here's a blueprint for doing that.

1. Start Dynamic Planning

Stop using annual budgets for strategic planning. Many important business decisions should be based on a realistic business plan. But the traditional annual budget quickly becomes obsolete. Some planning assumptions in such budgets inevitably turn out to be wrong. Managers need to update their plans whenever something happens to change their business unit's prospects in a material way. For most organizations, updating plans annually, or even quarterly, is not frequent enough. When relevant factors such as interest rates, oil prices or competition change, business plans have to adapt immediately. Local line managers are usually in the best position to know when their plans have become obsolete. Trust them.

2. Allocate Money Where It's Needed, When It's Needed

No business unit or department should have to wait until next year for more resources when an unexpected and important need arises. That discourages managers from taking risks or otherwise deviating from the actions proposed when the budget was prepared. After all, managers who miss their budget targets could lose their jobs.

Additional budget allocations should be made whenever they are requested. Since it isn't feasible for an appropriations committee to meet constantly to review each request, senior executives should move to relax the financial constraints. They should trust managers to make good decisions, and use minimal oversight only over large commitments. If performance and incentive systems are effective, managers will be highly motivated to make good decisions because they know they will be held accountable later.

3. Don't Use Budgets to Evaluate Performance

Budgets are notoriously poor evaluation standards. It makes little sense to judge performance based on target numbers and assumptions that become quickly out of date. What's more, basing pay on budgets that the managers themselves help create encourages them to sandbag—that is, lower expectations—to give themselves a better chance of meeting their goals.

The solution is simple: Performance evaluations must be kept separate from the planning processes. Managers should be judged based on how their organizations or business units performed in the actual conditions faced in the given measurement period. Thus, compare performance with that of peer organizations facing the same, or similar, operating conditions. If no such peers exist, come up with a standard based on historical performance, adjusted for changes in economic conditions, size of market, interest rates, price of oil and other key factors.

4. Devise a Richer Set of Performance Metrics

Compensation and other management committees shouldn't rely solely on financial results, such as profits and returns, when measuring the performance of business units and managers. Such measures are backward-looking and aren't reliable indicators of performance in the short-run. Companies should supplement the financial measures with metrics specific to each organizational segment, some of which are leading indicators of coming financial performance. Depending on the company, these could include attaining significant new customers, successes in research and development, or improvements in production, customer satisfaction or employee morale.

5. Make Bonuses Incremental

Managers often are tempted to manipulate their performance metrics because of the way they are compensated. At most companies, budgets define a level of performance below which no bonuses are paid. Many also set an upper threshold, above which no additional bonuses can be earned. Such thresholds encourage managers who otherwise would be "out of the money" to manipulate their unit's results. If companies aligned bonuses in direct relation to measured performance, with no thresholds, there would be less temptation to manipulate results.

These five steps will result in a more adaptive and innovative organization that responds quickly to new opportunities and threats; managers who won't be motivated to lie about their prospects or manipulate their numbers; and better decision making because of more up-to-date and unbiased information.

Yes, the new processes may be just as time-consuming as the old budgeting system was. But there will be a big difference: The time spent will no longer be largely wasted.