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The Key To Successful Zero-Based Budgeting

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To do it right, let go of your company's "evolutionary past" and take a granular look at where your profitability comes from today—it might surprise you.

Have you ever wondered why we hiccup?

In a fascinating book, Your Inner Fish, University of Chicago anatomy professor Neil Shubin describes how we humans carry the very real vestiges of our evolutionary past—hidden right in front of our eyes—in the way our bodies work every day.

For example, hiccups. Shubin writes, “If the odd course of our nerves is a product of our fishy past, the hiccup itself is likely the product of our history as amphibians…It turns out that the pattern generator [the nerve controller] responsible for hiccups is virtually identical to one in amphibians. And not in just any amphibians—in tadpoles, which use both lungs and gills to breathe.”

Shubin continues, “Tadpoles use this pattern generator when they breathe with gills. In this circumstance, they want to pump water into their mouth and throat and across the gills, but they do not want it to enter their lungs. To prevent it from doing so, they close the glottis, the flap that closes off the breathing tube…They can breathe with their gills thanks to an extended form of hiccup.”

In short, our hiccups are a vestige of our evolutionary past, when we shared an ancestor with tadpoles.

Your company’s evolutionary past

If you really want to understand why a company does what it does, look at its business challenges and situation five to 10, or more, years ago. Chances are that most of what the company does simply grew out of the way it met past needs, and that these business practices were passed along as part of the company’s culture—“the way we do business”—over the years, without being reviewed and reconstructed.

I teach a very powerful case about this in my graduate course at MIT. This case presents a very complex optimization problem. Typically the students work hard on the optimization and come to class prepared to discuss their quantitative approaches. I surprise them by starting the class discussion by asking, “What is the problem we need to solve?”

After a lengthy discussion, it turns out that in fact the company no longer needed the process that was being optimized. Not only that, but the process actually was harming the company much more than it was helping it—and the more complex the optimization, the less likely the students would be to think about whether the underlying process was actually needed.

The prime lesson is that the most important things a company does are determined tacitly, and are never seen, never questioned and never examined. Within this tacit, historically determined framework, a lot of tuning up takes place, but the framework itself—“the way we do business”—is almost never examined.

What’s most important is that the really big money lies in changing the tacit framework, not in tuning it up. But almost no one operates at this more fundamental level.

What Margaret Mead said

To emphasize the point about the pervasive unseen influence of the past, I tell the class a story about an anthropology course that I took with the famous anthropologist, Margaret Mead. The course was about how culture was tacitly transmitted through the generations.

Toward the end of the course, a student raised his hand and asked whether Americans had any traditions that were passed unseen through the generations. When Professor Mead asked the class, she heard responses like “hot dogs” and “baseball.”

She then gazed out at the lecture hall with about 500 students in attendance. She asked everyone who was born and brought up in New England to raise his or her hand. I was brought up in Western Massachusetts and Connecticut, and my parents and grandparents were from Providence and Hartford, so I raised my hand. I looked around and saw that the New Englanders were ringed around the sides and back of the room like a horseshoe.

She explained that in the early days of town meeting government in small New England towns, the selectmen asked for volunteers to do the town’s work. If there weren’t enough volunteers, the people who sat in the front and middle were called upon to help.

So over the years, New Englanders started to sit on the sides and back of the room—and this tacit behavior was passed down through the generations without anyone realizing why, even long after people stopped going to town meetings. My wife, who is from New York City and likes to sit in the front of the room, finds this both frustrating and amusing.

The problem with zero-based budgeting

Zero-based budgeting is a very important management process. Its logic, on its face, is very sensible: all expenditures should be evaluated as if there were no pre-existing practices. I think of this as the “if I could only wave a magic wand” approach to business.

The problem with this seemingly obvious approach is that it is almost impossible for managers to penetrate below the surface business procedures to examine and question the more fundamental “way we do business.” Managers almost always get so stuck in their traditional way of doing things that they are unable to carry out the objectives of zero-based budgeting. Hence, they fall back on tuning up existing practices for small incremental gains.

Breaking the mold

Enterprise Profit Management (EPM) is the key to seeing clearly your company’s tacit set of business practices in order to take a real zero-based look at your company. EPM creates a full, all-in P&L for every transaction (every product bought by every customer every time) and uses a sophisticated data structure to combine and recombine these transactions to show the actual all-in profitability of every nook and cranny of a company.

Over years of experience with EPM, 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.

EPM gives a crystal-clear picture of your company at a very granular level. It identifies where re-thinking and resetting a company’s “way of doing business” is most needed. This enables you to analyze exactly where your company is making money, where it is experiencing Profit Drains, why this is happening and what to do to accelerate the Profit Peaks, reduce or reverse the Profit Drains and increase the profitability of your Profit Deserts.

Every company is an “accidental company” in the sense that it is built to a surprising extent from old business practices. In our research and work with Profit Isle clients, we’ve found in industry after industry that even in leading companies Enterprise Profit Management’s zero-based look enables managers to increase their profitability by 10-30% per year sustainably.

Why does this occur in so many companies?

This situation occurs in company after company because in our prior Age of Mass Markets, profitability was a function primarily of sales volume, which created economies of scale in everything from production to distribution to advertising. Prices were set by manufacturers, and distribution costs were very homogeneous because products were simply delivered to the customers’ receiving docks.

In the past 30 years, we have moved into what I call the Age of Diverse Markets, in which everything changed. Prices are negotiated, and often vary by account and product. Costs also vary widely, as suppliers form very different relationships—ranging from arm’s length to highly integrated—with their customers. Industry boundaries are blurring, and capable new competitors are seizing market share.

In this new environment, markets are segmenting rapidly, and success or failure rides on a manager’s ability to deeply understand where his or her company is making all its profits, to assess whether this segment is adequately differentiated and protected, and to channel the company’s resources into the market segments with high sustainable profits. In short, the company must cut loose from the sea anchor of its history and build its future with a real zero-based process. Enterprise Profit Management is the only way to accomplish this life-or-death objective.

Today, the traditional broad accounting categories of revenues and costs, which worked so well in the prior era and which still work well for financial reporting, are completely inadequate for understanding granular profitability. Yet we continue to manage as if we still live in the prior era.

What you get is the familiar pattern of “islands of profit in a sea of red ink” that is the vestige of doing business in a way that worked years ago, but no longer fits—just like hiccups and sitting on the sides of an auditorium.

Where the real money’s at

The power of Enterprise Profit Management is that it yields an extremely powerful view of the company as it really is today—where it is working, where it is not and why.

When you see this very granular picture of your company’s profit landscape, you will immediately realize where your company’s activities—its “way of doing business”—fit today’s business needs, and where they are deficient because they are essentially continuing to apply old ways of doing business that are vestiges of the past and no longer appropriate.

With this detailed profit picture, you can’t help but take a real zero-based look at your company. You will be able to develop a sound step-by-step plan to bring your “way of doing business” into alignment with today’s business needs. This is where the really big money is.

Enterprise Profit Management SaaS systems can be configured in a few weeks. They are extremely timely and accurate because the information is drawn directly from a company’s general ledger. Because the zero-based actions they enable are rooted in an intuitively clear, granular profit picture, you can be confident that they will be accepted and work.

Without a hiccup.


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