If the budget cycle is so central to every company’s financial management process, why do virtually all companies have so much embedded unprofitability?
Over years of experience with Enterprise Profit Management (EPM)—a transaction-level SaaS profit improvement system that creates a full P&L on every invoice line—we have found that virtually all companies have a characteristic pattern of profit segmentation:
• Profit Peak customers—typically about 20% of the customers generate 150% of a company’s profits;
• Profit Drain customers—typically about 30% of the customers erode about 50% of these profits; and
• Profit Desert customers—typically the remainder of the customers produce minimal profit but consume about 50% of a company’s resources.
The same pattern occurs in a company’s products, suppliers, sales reps, stores and most other company dimensions.
The basic problem with budgeting today is that the core budget categories, like revenues, gross margin and costs are aggregate measures that show whether a company is profitable, but not where it is making and losing money.
Because the budget process in most companies is based on these categories, it is doomed to miss the mark, no matter how much time and effort is devoted to it. Simply maximizing revenues and minimizing costs do not maximize net profits—and gross margin does not predict net profits. For example, bringing in more large, money-losing Profit Drain customers will reduce profits, and cutting service to service-sensitive Profit Peak customers is the fastest way create a profit plunge.
Yet most budget processes are simply based on the old “more revenues, less costs” paradigm, rather than being rooted in the company’s actual profit segments—each of which has completely different profit-producing capability and completely different characteristics, and each of which requires a fundamentally different management game plan, metrics and resources.
Transform the budget cycle
One of the most important, but difficult, problems that CFOs face is explaining and remedying budget variances. This is hugely important to every C-Suite officer, to every board of directors and to every company’s shareholders. It is also critical for setting the right company direction, management process goals and resource allocation.
Yet in most companies, the core budget process is based on revenue maximization and cost minimization by organizational units, and is neither differentiated by profit segment, nor by integrated segment-serving process. This fundamental flaw is an enormous deficiency and drag on resource productivity and profitability.
An effective, well-structured budget process needs to enable a CFO to do four key things:
• Explain precisely where and why the budget variances are occurring, and how specifically to correct them.
• Make operating corrections in near-real time to prevent budget variances, especially to integrated programs (e.g., vendor-managed inventory) based on meeting the differentiated needs of a company’s profit segments.
• Create task clarity throughout the organization, with clear profit-segment based objectives.
• Identify and prioritize emerging profit opportunities, and ensure that they are fully resourced and managed in an integrated way—while reducing losses to fund the new initiatives.
The problem is that the existing budget process in most companies is so embedded in both the company and in the financial community that it is hazardous to flash-cut to a new budget system. A three-step process will enable a CFO to transition to true profit-driven budgeting (basing the budget cycle on the company’s profit segments and subsegments, which, of course, would later be summed into the current aggregate financial reporting metrics like revenue, gross margin and cost).
Step 1: Granular budget variance analysis. In this first step, the CFO bases the budget process on traditional aggregate categories, but uses EPM to identify the underlying sources and reasons for the variances. Because EPM creates a full P&L on every transaction, it will show exactly where the variances are occurring.
For example, one beverage distribution company budgets its revenue by brand and geographic branch. It has a budget tracking system that produces actuals in these buckets. The problem is getting to the detail within the buckets to show what is really happening at a grass-roots level.
EPM can easily produce an analysis of where a revenue variance occurred by customer, by date (e.g., July 4 holiday), by sales rep, by type of account (on-premises or take-out) and so on. Similarly, it can pinpoint the specific operating situations, like excessive unbilled expediting, excessive returns, supplier cost issues, which caused the cost variances.
This provides the detail that the CFO needs to identify and explain the specific causes of variances, and to initiate actions to accelerate the positive situations and remediate or eliminate the negative ones.
Step 2: Blended budgeting. In this second step, the CFO budgets in the traditional categories. However, two enhancements make this process more effective.
First, the CFO can create much more granular budget categories, like tracking beverage sales for specific liquor stores on July 4, or for specific taverns near campus at the onset of a university semester. This provides much more granularity, and it can tie into the account and product planning process. Importantly, this offers the possibility of granular budgeting and actual tracking down to the level of detail of a particular brand in a specific venue on a particular day or season.
Second, the CFO can enrich this budgeting process with the needs and objectives of specific profit segments. For example, a distributor may want to selectively allow higher costs reflecting the higher service needs of important Profit Peak customers (e.g., running vendor-managed inventory) because this is a great investment. Conversely, the CFO might want the budget to reflect a reduction in uncompensated expedited deliveries to large, money-losing Profit Drain customers, or to reduce excessively frequent ordering by these problematic accounts.
While these initiatives are translated into the traditional budget categories, they facilitate the company’s efforts to provide differentiated service to the key customer and product profit segments. The CFO can track the actuals by these more granular budget categories.
Step 3: Profit-driven budgeting. In this process, the budget cycle starts with the company’s profit segments. Each segment has both opportunities and concerns, and these are the result of the interplay of customer or product revenues and costs. For example, the EPM system might identify overly frequent ordering to be a key issue in a subsegment of Profit Drain customers, and project that if this problem were fixed, the accounts would quickly turn into Profit Peaks.
While this is a highly targeted cost issue, it would have a huge impact on profits. A simple initiative to reduce order frequency across the board, on the other hand, would cause serious problems for some Profit Peak customers that base their business on quick response to their customers’ needs—and are willing to pay for this extra fast and frequent service.
The key to this highly effective budget-management process is to start by viewing each profit segment, or subsegment, as a “profit river” that flows through the company generating revenues and costs. The EPM system is structured to reflect this view, picking up the revenue and costs from the general ledger that are specifically appropriate for each transaction.
These transactions can be combined and recombined to form a comprehensive, integrated view of any segment of the company—from customer to business segment to specific product in a particular customer. Once the CFO sets this process, assigning objectives and priorities to the segments, the EPM-based budget process can disaggregate the revenues and costs for each segment or subsegment into the company’s organizational units, and can track each organizational unit’s performance on its segment-specific objectives.
Importantly, these organizational unit objectives can be disaggregated so that Profit Peak customers get better, more expensive service (with the company charging higher prices for the premier service)—while the Profit Drain and Profit Desert customers get service that is appropriate and compensatory. All of these elements can be specified in the budget for each organizational unit, and each can be tracked, analyzed and managed closely.
Manage the transition
The transition can be managed in two years. The objectives are: (1) to steadily move toward a more effective profit-driven budget process; (2) to create significant, needed benefits quickly; and (3) to allow time for the organization to see the advantages of the new process and to accommodate the change.
In the first year, the CFO uses EPM, which can be configured in a few weeks, to accomplish Step 1: granular budget variance analysis. This is an urgent need, and will quickly produce very strong, visible benefits that will engage the whole organization—especially the C-Suite and board of directors.
During this first year, the CFO should prepare the following year’s budget using blended budgeting. This will give the organization a deep understanding of the importance of basing budgeting on the completely different needs of its key profit segments, while retaining the familiar process of structuring the budget using aggregate categories and organizational units.
In the second year, the CFO can interpret the budget variances using both the more granular view of actual performance that EPM provides, and the more powerful profit-segment based view that profit-driven budgeting adds. This will allow the organization to understand the crucial new value that the profit-segment view creates, while gaining a comfort level with the new process.
During the second year, the CFO can transition the budgeting process to Step 3: profit-driven budgeting. Once the organization has gained a deep understanding of the critical importance of its profit segments and how they differ from each other, and its managers have become accustomed to working with the new blended process, the CFO will be able to introduce a full profit-driven budget process to create the third-year company budget.
Accelerate profitable growth
The budget cycle is the heart of every company. It converts the company’s strategic and operational goals into concrete financial needs and results, and provides the basis for the management reviews that charge the company’s managers with purpose and direction.
The company’s profit segments are the key to achieving profitable growth. The company’s prime objective is to grow its Profit Peaks, while reversing its Profit Drains and reducing the cost to serve its Profit Deserts. This is the basic game plan for success.
Profit-driven budgeting is rooted firmly in this core company game plan. It translates these very different profit-segment objectives into effective company actions, creating a direct pathway to accelerated profit growth. This is the fastest and surest way for an effective CFO to ensure a company’s success.