Imagine, if you will, that your family has just decided to run their finances like a public company, including the following controls:
- the financial plan for the family is now agreed annually, in advance of the financial year covered by the plan
- the plan has capital expenditure (capex) and operational expenditure (opex) budgets
- budgets are sacrosanct and shall not be changed throughout the year (expect when income does not meet forecast – see next control)
- operational expenditure is planned quarterly, and is adjusted down in the next quarter if income does not meet forecast
- capex and opex shall never be confused or traded off
So let’s just play that out:
The Jones family starts the year with the following (admittedly very simplified) plan:
- Cash at hand (capital): $50,000
- Forecast income: $100,000
- Forecast operational expense: $80,000
- Savings (retained income before capital expenditure): $20,000
- Planned capital expenditure: $20,000
According to this plan, the family will end the year pretty much where is started financially (although with an additional asset(s) valued at $20,000 – note that we are also ignoring asset appreciation/depreciation, for the sake of simplicity).
And so the year starts.
Income in the first quarter is $25,000 and expenses are $20,000, so everything is wonderful. Given things are going so well, the Jones spend $15,000 of their capex budget and install a new kitchen.
But then, in the second quarter, Ken Jones loses his job. Income falls to $15,000 for the quarter, and operational expense is commensurately cut to $10,000. New jobs are not easy to come by and the family is really starting to suffer.
By the third quarter, things are getting desperate. The drop is operational expense means the family is now eating instant noodles very night and lights go out at 8pm to save on electricity.
Out of the blue, a great job opportunity comes up for Ken. The only catch: it’s in the next town, and he needs his own transport to get there. The capital budget only has $5,000 left, so buying a reliable car is a real stretch – but finally Ken finds one and the deal is done. He starts his new job, and the expense budget goes back to normal.
Well, for two weeks, that is – then Ken’s car is stolen.
Unfortunately, given the operational expense budget in the third quarter could only afford the minimum third-party insurance, the theft is not covered and the capital is gone.
Unable to get to work, Ken loses his job (for the second time!) and the family must now live out the final quarter of the year on the reduced operational budget. More instant noodles and early nights…
The family is not totally despondent, however, as the new financial year is just around the corner! They all know that that means a new capital budget (which will allow them to buy a new car!). Ken’s most recent employer already said he could come back anytime he had the means to be there reliably, so all they need to do now is wait for the first day of the new financial year. Thank goodness for annual financial plans!
It may seem that this story is a bit trite and condescending, but it actually mimics the financial ‘discipline’ that is used for budgets and funding in many public companies.
- capital budgets are fixed and shall not be exceeded (even if, as in Ken’s case, there is a significant economic cost to the family that could be easily avoided by releasing additional capital to buy a new car)
- retained income (earnings) are sacrosanct – we’d rather the family (employees) starve than admit to the neighbours (market) that we can’t manage our money
- the financial year is also sacrosanct – should a great opportunity to make even more income appear, if the budgeted capital is spent, the family must wait until next year to invest
The message from this tale: you wouldn’t do it if it were your own money.
The problem is not that there should be no financial controls in public companies (even individuals and families run a budget of some kind or another), but rather that controls should be managed within the context of the objective of the public company: to make an adequate (or better) return on investment for shareholders.
If the opportunity to make more money exists now, surely waiting until the capital budget is ‘refreshed’ is not only sub-optimal – it could also mean the opportunity is lost.
Similarly, the cost of idle resources (Ken in the case above) is also an operational cost (either opportunity or cash). While ludicrous in the case above, this is exactly what happens in public companies when capital projects are stopped (due to funding cutbacks) and the employees working on them are put on ‘other duties’ until the new capital year.
The next article in this series will discuss why public companies operate like this, and the changes they can adopt to focus more on value creation and less on ‘keeping to budget’.