If families were funded like public companies…

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.

Specifically:

  • 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’.

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Historical Budgeting kills Business Agility

Ever been on a project where everyone (including the project sponsor) has come to the realisation that the project will never deliver the value that was promised? And despite this common understanding, the project just carries on regardless?

Blame historical budgeting.

Traditional (historical) budgeting, whether bottom-up or top-down, typically involves taking last year’s revenue and expenses and adding a growth factor to each side of the ledger (usually a higher growth factor on the revenue side than the expense side).  This then sets the playing field for the year ahead (i.e. the revenue that the business needs to bring in and the expense that it is permitted to spend, with the planned profit as the remainder).

The expense is further broken down into capital expenditure (capex) and operating expenditure (opex).  Capital expenditure, in particular, may span over multiple years.  Further complicating matters is that both types of expenditure have rules that dictate what can be categorised as capex or opex (as the categorisation can have a significant impact on financial performance reporting and tax liabilities).

While I understand that many of you reading this article will know most of this already, where I’m heading to is the adverse behaviour that this budgeting approach results in, and what can be done to change it.

So, what are the problems with this approach to budgeting?

The major drawbacks include:

  • Internal Focus
  • Budget Hoarding by Silos
  • “Use It or Lose It”
  • Annual Planning Mindset

Internal Focus: as the key determinant of the size of the budget is “what we did last year”, the plan is almost totally determined by the organisation’s past performance (an internal measure), not market dynamics (e.g. changing preferences, entry/exit of major competitors, substitution, innovation, etc.).  To be fair, most organisations do a “reality check” on the numbers, by comparing with sales forecasts and other leading indicators, but the key driver of this year’s plan is nonetheless last year’s performance.

Budget Hoarding by Silos: given the self-reinforcing nature of the historical budgeting cycle, departments/divisions/teams hold on dearly to any expenditure budget they are allocated.  By way of example: if my division gets $1m to spend this year, and we then find that $0.5m can be invested elsewhere for a higher ROI, that should be seriously considered, right?  The problem for me is that then means I only ‘spent’ $0.5m this year (which becomes the baseline for next year’s plan – $0.5m less than the year before!).  Which also leads to…

“Use It or Lose It”: Similar to the example above, if I underspend my expenditure budget this year, I am actually penalised under the historical budgeting model for saving money! For example, underspending $200K on a $1m budget this year means that $800K becomes the new baseline for next year.

Annual Planning Mindset: Perhaps worst of all, historical budgeting means revenue and expenditure plans are reviewed and agreed only once a year.  Given that the process often begins 6 months before the start of the new financial year, this means that the impact can stretch over 18 months!  This effectively creates a huge damper to business agility, with organisations unable to move quickly to adapt to new opportunities and rapid changes in the business environment.

So what to do about it?

Beyond Budgeting is a good place to start.  The Beyond Budgeting Roundtable articulated 12 principles underpinning an alternative management model, including making “planning a continuous and inclusive process; not a top-down annual event” and making “resources available just-in-time; not just-in-case”.  (A full list of the principles can be found at: http://www.bbrt.org/beyond-budgeting/bb-principles.html).

Ultimately, the key to Business Agility from a financial perspective is flexibility in implementation.  It’s not that the original plan is necessarily wrong, but more that the plan itself becomes “the written word”, instead of being a starting point that is continually adapted as new information becomes available.  The greater the flexibility in implementation, the more responsive the business can be to market shifts and (often fleeting) opportunities in the marketplace.

© Eric Jansen 2012. All rights reserved.

Business Agility Defined

The term ‘Business Agility’ gets a lot of airplay these days – but what does it actually mean?

Much as the term agile has been increasingly used (abused?) in the IT industry to describe a high-performing software development team, Business Agility is now also becoming a term that is increasingly heard in business circles.  Like the term agile, however, people often find it difficult to be specific when describing what business agility actually means.  Responses are usually of the kind: “being flexible”, “capitalising quickly on new opportunities”, etc. – which is fine, but how does an organisation actually do this?

The following diagram depicts six key components of an organisation that exhibits Business Agility:

  • Adaptive Planning: Above all, the organisation needs to be able to plan and execute simultaneously.  Sequential planning leads to a very rigid implementation approach, whereas adaptive planning allows (indeed, encourages) many course-corrections along the way.
  • Focus on Time to Value: There is an almost obsessive focus on getting new products/services/features to market as soon as possible.  This enables a shorter feedback cycle and, equally importantly, an quicker timeframe to earn a return on the investment made.
  • Decoupling: This is where a lot of businesses (particularly larger enterprises) find it very difficult to move quickly to exploit new opportunities.  The more each business process is intertwined (coupled) with others, the harder it is to implement change quickly.
  • Low Latency: While this attribute could be consider an underlying theme, it is worth calling out as a specific component.  The quicker a decision can be acted upon, the sooner the business knows whether the decision was right and what else needs to be done to achieve the underlying goal.
  • Economic Efficiency: A lazy, bureaucratic organisation will protect its turf at the cost of progress and innovation.  Lean operations that minimise waste have the added incentive of promoting new and innovative ways of doing things, and being able to implement them quickly.
  • Rapid Adaptation: While similar to Adaptive Planning, this component really refers to the mindset of continual monitoring of, and adaptation to, changing market conditions.  It is the ultimate feedback mechanism that ensures the product/service offering is continually refined to best meet the needs/constraints of customers, suppliers and partners.

Focusing on how you can introduce/expand the above disciplines in your organisation will bring real meaning to the term Business Agility.  As a result, the business will be better placed to exploit new business opportunities in today’s rapidly-changing competitive marketplace.

© Eric Jansen 2012. All rights reserved.