A Not-So-Simple Challenge for Your CFO
“What is the cost of a proposed strategic initiative?” Think you already know the answer? Not so fast. Sometimes the indirect costs are larger than at first thought. Here’s one way to help sort it out.
February 16 2014 by N. Dean Meyer
What goes into costs? It’s an obvious question. But it’s not as simple to answer. Direct costs are generally clear. One knows the price of an acquisition, the costs of a new regional office, the investment required for a new product’s development and launch, etc.
But any such initiative puts a burden on the entire enterprise. Efforts ripple through all the support functions, and they in turn consume more support services. For example, most initiatives need IT support; IT will need support from Procurement; and everybody leans on HR. In some way, every function in the enterprise may be engaged.
These are not “fixed” costs. Nothing is fixed in the long term. Indirect costs grow as the enterprise grows, but in a step function rather than linearly. Even if you happen to be in the middle of a step and have unused capacity, consider the opportunity costs of using that available resource for this initiative rather than another.
To make informed strategic decisions, you need to know the full costs of each option – direct costs plus a fair share of all indirect costs. Only a full-cost view is sustainable in the long term.
The facts might reveal that a strategy which looks good on the surface is actually less desirable; perhaps the direct costs are reasonable, but the indirect costs are huge. Meanwhile, a less glamorous alternative may offer better returns.
Two Ways to Get the Facts
There are two ways your CFO might answer your question.
One way is a special investigation, asking an analyst to chase down the ripples for a given strategic initiative. This may seem expedient. But a manual effort such as this is costly. There’s no leverage, since each new investigation takes another manual effort. It’s often incomplete, since analysts may not have time or knowledge to chase every ripple. And analyses may not be consistent, making it tough to compare the numbers across options.
The other way is systemic. It takes an initial investment; but after that, you’ll have the facts you need for strategic decision-making now and in the future.
The systemic approach treats every function within your enterprise as a “business within a business,” funded to produce products and services for customers, be they others within the enterprise or external customer.
In that entrepreneurial world, a budget is not just a forecast of what the function plans to spend. It’s a forecast of the costs of all the products and services the function might deliver in the year ahead. This is termed “investment-based budgeting.” Many of the deliverables in a budget may be necessities – the proverbial “keep the lights on” activities. But this kind of budget also costs discretionary projects and services, including support of those strategic initiatives.
To implement investment-based budgeting, each function must define its products and services, forecast its “sales” (whether or not money actually changes hands), and associate all its costs with those sales (direct and indirect). Then, you can add the costs of all deliverables, across all functions, necessary to a strategic initiative and get a clear picture of the real cost and impact on your organization.
This change in your budget process not only gives you the facts you need. It builds an entrepreneurial culture, breaks down stovepipes and enhances teamwork, reveals cost-savings opportunities, encourages innovation, and more. An investment in your budget process may turn out to be your most strategic initiative.