Traditional budgets forecast spending, typically based on last year’s budgets. This has little to do with the needs of the business and the investment opportunities at hand. And the process induces unproductive micro-management – “Hey, you don’t really need to spend that much on travel/training!”
Demands to “do more with less” don’t magically improve productivity; they only force executives to make commitments they can’t keep. And across-the-board cuts cripple an organization’s ability to produce anything effectively.
Worse, traditional processes don’t support strategic decision making. A CEO may see the obvious direct costs of a proposed strategy. But any significant business initiative ripples throughout the enterprise, adding workloads to all the support functions – from sales, marketing and logistics back to IT, HR, Facilities and Finance. A CEO rarely sees the full cost of a proposed strategy. So how can you really know if the ROI is there?
Once each business unit and internal service department receives its budget, it’s expected to manage its own priorities. It has to support ongoing operations, serve internal and external customers, and contribute to enterprise strategies. As each organization independently decides its priorities, teamwork suffers. Tensions between organizations rise as leaders strive to achieve their goals with little control over critical support functions. And money is wasted as organizations replicate others’ competencies (decentralization) to get their jobs done.
As for strategies, typically each organization’s contributions are vaguely defined (based on individuals’ interpretations of written plans). How can you be sure that all the right pieces are in place – and resourced – to accomplish each enterprise initiative?
Meanwhile, managers feel overwhelmed with unconstrained demands but tightly constrained budgets. They last thing they want is more work. So they’re unlikely to suggest new, innovative opportunities to serve the business. Entrepreneurship and creativity are crushed under the weight of expectations far exceeding available resources.
And before the year is over, managers make sure they spend all their budgets for fear of them being reduced next year.
Sure, traditional financial processes control spending, but at a cost that includes unreliable delivery, inefficiencies, missed opportunities, and a defensive (not entrepreneurial) culture.
The alternative is familiar to us all: market economics. Think of every organization within your enterprise as a business within a business. It’s funded to produce products and services for customers, whether they’re inside the enterprise or external.
This paradigm changes the way you budget. When you go to a store, you don’t care about the cost of labor, rent, and cost-of-goods-sold; you want to know the price of products and services. Similarly, budgets should describe the costs of the projects and services each organization plans to deliver. This is termed an investment-based budget, since it allows you to allocate scarce resources to the best investments.
And when every organization in the enterprise submits an investment-based budget, you can see the full cost of each strategy, including the impacts on all the support functions.
Loren Carlson, chairman of the CEO Roundtable in Boston, said, “This is not a rehash of old ‘profit center’ and ‘cost accounting’ theories, but a bold new approach to making crucial resource-allocation decisions.”
Furthermore, once you’ve approved a strategy, execution is far more reliable. In an entrepreneurial culture, one organization is your “prime contractor” responsible for delivering a given strategic initiative. It “buys” what it needs from supporting organizations, who in turn buy what they need from other support functions – an internal value-chain. Teamwork ripples through the enterprise, with clear individual accountabilities (in the language of specific internal products and services) and a clear chain of command. And since all the impacted organizations are funded to deliver their respective pieces of the puzzle (line items in an investment-based budget), people have the time to help one another.
Cost control is built into the fabric of an entrepreneurial organization. Managers strive to be the best value, and their rates (unit costs) for products and services can be benchmarked against external sources. To remain competitive, they improve internal processes, manage headcount, make smart use of outsourcing, and spend money only when it helps them deliver the products and services that their customers have bought.
Managers are also frugal about what they buy from internal suppliers; they only buy the support services they really need. This “demand management” further controls costs.
Bernie Campbell, CIO at Sonoco Products Company, explained, “Clients have come to recognize they can control their IT spending, as opposed to having it imposed on them. With the challenges in the current economy, Sonoco’s divisions have to make trade-offs among competing projects and services. It is still a tough environment, but GMs now have the facts to make decisions for their businesses.”
As customers reduce their demand, internal suppliers can cut costs surgically, keeping funding intact for the fewer things that customers choose to buy. “We were able to cut costs fairly dramatically without jeopardizing our ability to keep the enterprise running,” Matt Frymire, CIO at Riverside County, California, reported.
Internal market economics has a tremendous impact on your culture. Managers learn to manage their little businesses within the business. They’re accountable for keeping their catalog of products and services up to date and cost competitive, and for satisfying their customers (internal and external).
With internal customers controlling their demand, support functions are no longer responsible for constraining their customers’ purchases. If their customers wish to buy more (because their services are a good value), internal entrepreneurs are free to expand their supply (e.g., hire contractors and vendors) to meet funded demands. They’re managed to break-even, not traditional budget variances. As a result, they’re not afraid to propose innovative ideas, since they know that incremental work comes with incremental funding.
Lars van der Haegen, president of Belimo Americas, cited internal market economics as a way to “reintroduce the entrepreneurial spirit and a ‘can do’ culture within organizations.”
You Don’t Need Chargebacks
Internal market economics does not require a complex system of inter-organizational charges and transfer prices. Budgets can still be given directly to organizations. But then, the money is treated differently – as “pre-paid revenues” to buy the organization’s products and services (rather than given to managers to pay their costs).
Internal service providers price their products and services (at cost); and their customers decide what to buy with those pre-paid revenues. This approach to governance produces all the benefits of market economics without the overhead of chargebacks.
The Bottom Line
Internal market economics aligns priorities enterprisewide. It empowers business units to manage all their costs. It unleashes everybody’s creativity, improving operations and revealing new, potentially strategic, opportunities. It teaches managers to think like entrepreneurs, breeding the next generation of business leaders. And it provides comprehensive cost control, without the need for micro-managing spending or for using support functions to control business unit spending.
As Sergio Paiz, CEO of the PDC Group, said, “Budgeting and planning will never be the same in our firm.”
Internal market economics can be one of your highest-payoff strategic initiatives. It not only leverages all your other business strategies. It leaves the legacy of an organization that performs well and generates new strategic opportunities, forevermore.