In a series of articles, Shaun Gillanders, a freelance Finance Director and Interim Manager, explains the tools available to produce a plan and manage its implementation in order to ensure a business can generate value for its principles. In this the final article he examines how the budget can be used to ensure the strategy is on track and the value is being created.
In the first article in the series I discussed the return that a business needs to really create wealth. The subsequent articles then looked at the techniques available for designing a business strategy and implementing it. However, the best strategy in the world, brilliantly executed should not be embarked upon if the profit generated by the strategy doesn't add value to its investors.
Whilst this is eminently sensible, it has one crucial flaw. When we set out on a new venture or strategy we do not know what profit we will make in order to be able to decide whether to embark or not. Instead we rely on budgets to decide whether the strategy will add value. But we might embark on a strategy that should add value only to find out at the end of two years that we haven't added value (or that we haven't even made profits). This article deals with ways to manage this financial risk.
Time and Tide
Financial risk comes in two parts: the length of time we wait until we test our financial return, and the accuracy of the financial model that we start with. To reduce the risk that our great strategy actually loses us money we must create a sound financial model and frequently test our actual financial performance against this model. However, this alone will not improve our profitability. The point of a budget is to provide control. Budgets should either confirm that what we are doing is actually working or else quickly let us know we are doing something wrong, provide us with a clue as to what that is and then let us know when we start doing it right. A budget by itself is simply a list of numbers; a budget becomes useful when it informs our organisation's behaviour.
The evolution of man(agement)
The development of a budgeting process within an organisation goes through a series of evolutionary steps. The rate of evolution is determined by the amount of combined financial knowledge that an organisation has and is limited by the effectiveness of the accounting system to generate numbers. Like evolution there is no finishing point, just continued improvement; however, there is a current ideal that many experts believe an organisation should aim for. The stages of budgeting can best be described as follows;
Annual inflationary budget - last year's actual figures are increased by ______??? and then the new total is divided by 12 to generate a monthly budget without any seasonal adjustment. This is often done for the whole organisation. Whilst quick to produce, this can only provide insight into business performance once the year is finished, by which time it is too late.
Divisional inflationary budget - exactly like above but the finances are broken down by division or business unit. These last two budget types focus more on what you can realistically foresee than what is important for profitability. Great emphasis is placed on accurate predictions of salary costs and other overheads and very little is done to accurately predict what the income will be or the profit margin on different business or service lines.
Rudimentary business model - the external market conditions are used to estimate underlying numbers (like number of sales and average selling price). This is used to generate a budget based upon the expected level of business and sometimes the costs associated with running the business at that level. The business model will be seasonally adjusted.
Budget and reforecast - a business model is used to budget for the year but the actual performance against budget is assessed partway through the year and the finances are reforecast based upon what level of business the organisation is experiencing. The aim is to predict what the profit will be at the end of the year by adjusting the assumptions through the year.
Beyond budgeting - the business knows what its key drivers are for profitability and focuses on them. This can result in the organisation doing away with an annual budget and relying instead on ongoing Key Performance Indicators. The time taken to prepare an annual budget can be saved and the business can focus on delivering the results that will add value.
For example, in a law firm the largest cost will be staff costs; increased profitability will arise by increasing the fee levels without adding additional staff. The important thing for a client facing division is to measure the efficiency of the team in converting staff available hours into fees raised. Three important measures are average hourly fee rate, the teams chargeable to non chargeable hour ratio and the average chargeable hours per team member. Increasing all three will result in increased profit contribution and, provided someone is managing the fixed overhead costs, increased profitability.
A flexible friend
So where does budgeting fit into the strategy jigsaw? Ideally budgeting should be the final stage in a virtuous circle where a business identifies what return it needs to generate, identifies a strategy that will enable it to do this and builds operational plans that turn the strategy into a reality which it confirms by monitoring its financial performance against a budget which naturally moves with the business.
To do this the budget needs to be flexible and adapt with each passing month. Given that in most companies the annual budget process begins 4 to 6 months before the start of the new financial year it is easy to see why most businesses cannot hope to achieve the final part of the jigsaw.
Budgets are dead, long live the budget
In order to achieve the flexibility required of a budget some progressive organisations are actually stopping budgeting to replace it with adaptive performance management. This is an ongoing process that doesn't start and end with a financial. It is based upon 6 key adaptive processes, aspirational goal setting aimed at continuous improvement, reward for shared success based on relative performance, planning as a continuous and inclusive process, control based around relative key performance indicators and trends, resources made available as needed, not through annual budget allocations, and finally co-ordination of cross-business dynamic interactions and not through an annual planning cycle.
The product of the adaptive performance management tool is rolling forecasts. These forecasts are created every few months and roll beyond the year end and therefore have no fixed "finish line". The rolling forecast is based on a few key variables (key performance indicators or KPIs) that can be compiled quickly and accurately. The KPIs are predictive in nature and allow the forecast to be quickly updated based on the actual performance experienced and the forecasts therefore show what will happen based on the current state of the business. Management can then compare this rolling forecast against the business targets and goals, ascertain the gaps and determine how these are to be managed.
This then provides management with an accurate forecast of profitability that is regularly updated and so allows a business to easily and effectively monitor its financial performance and so more easily identify when the strategy is going off plan and deal with it before a hiccup becomes a disaster. In this way a business should know what profits it needs to make, how it believes it can do it and can see how well it is doing.
Over the past four articles we have had a whistle-stop tour of financial returns and value creation, run through a pile of strategy development tools, compared different methods for benchmarking your business against others and finally found a way of making sure that when all that is done well, the business actually generates the profits that you wanted in the first place. Simple really, the trick now is to set aside enough good thinking time, put the phone on divert, brew up a strong coffee/tea/hot chocolate/raspberry leaf fruit infusion and, as the sportswear company says "Just do it!".
Shaun Gillanders is a Scotland based freelance Finance Director. Following a successful career as an FD of one of Scotland's leading growing private law firms, he has begun advising a wider range of law firms on strategy, financial management and operational development. If you wish to discuss any issues raised by this or any of the other articles in this series then please feel free to email him at firstname.lastname@example.org