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The Limitations of Isolated Management Methods

Minti — Mon, 02 Aug 2010 17:25:37 +0000

Historically it has been common to implement management methods as standalone initiatives. For example, Activity-based costing (ABC) is often implemented as a financial tool for identifying sources of profitability. Budgeting is the tool for financial planning in this same company, but may not benefit from the insights derived from a parallel but separate ABC initiative. Analytics may focus on predicting future revenues, but fail to predict future profits. Efforts to cut costs using six sigma or similar techniques may be guided by measures of quality rather than cost.

I would argue that the real value of a management method is derived by integrating it with other methods where the values compound. For example, a financial services company may have a risk department that assesses the likelihood of default on loans. The finance department in the same company may have a profit analytics system (based on ABC) that assesses the profitability of individual loans and customers. This system may show that risky customers are more profitable. But are they sufficiently more profitable to offset this extra risk? And does this profitability cover the risk over the lifetime of the loan? These profit versus risk assessments can only be made accurately if the risk and profit analytics systems are combined into a single solution.

Budgeting is another management method that benefits from integration. In isolation, budgeting often falls short of the ideal of an accurate analytic planning tool to support management decisions. For example, forecasting of revenues and expenses are often just exercises in extrapolation of the past. Developing resources plans (e.g. headcount for a critical operational process) is often a simplistic exercise in adding or subtracting a percentage of the previous year’s spending. However, the accuracy of forecast revenues and expenses can be substantially improved using statistical forecasting. The accuracy of resource plans can be improved using predictive models combining activity-based models and analytics. Scenario analysis is also more powerful with resource models and analytics.

Six Sigma is a widely used method to improve the quality of process outputs by discovering and eliminating the causes of defects in the process and minimizing process variability. Six Sigma is used to improve quantifiable targets such as customer service, safety, and cost. In the case of cost, why not combine Six Sigma with ABC to provide these measurements to support prioritization of Six Sigma projects and action plans, and to allow tracking of the removal of cost?

Does one plus one really equal more than two? What is your experience? Can you share with us examples from your company that illustrate this? What other methods work well together? What difficulties have you encountered, or do you envision, combining methods? How did you, or how should you, overcome these difficulties?

The State of Budgeting

Minti — Mon, 15 Mar 2010 01:29:29 +0000

I recently talked to a controller about the state of budgeting. He said that budgeting is a dysfunctional process and little has occurred over his long career to change that view. He has seen many methods come and go including programming planning budgeting systems (PPBS), zero-based budgeting (ZBB), activity-based budgeting ABB) and performance-based budgeting (PBB). He commented that each one of these methods over-promised and under-performed. None are widely used as replacements to traditional budgeting.

Maybe this is not surprising, but it is certainly disappointing. Many budgeting systems are dysfunctional and create plans that are inaccurate and out-of-date before the ink is dry. They are strategically irrelevant, inflexible, and disconnected from operational reality. To say that managers do not enjoy or value the budget process is an understatement.

For those of us who are committed to the benefits of performance management, this is tough medicine to swallow. If budgeting is dysfunctional and so many people recognize it to be so, why is it so difficult to fix?

Let me take a stab at answering this question. Most of the methods referenced above focus on the effectiveness of the budgeting process. Are budgeted costs an accurate reflection of strategy, sales volume and mix, and process performance? Does the planned level of each type of resource reflect the likely demands on these resources? If you make a change to the efficiency of the process, is it easy to estimate the impact on budgeted costs?

These are important analytic questions, but it is difficult to answer them until a more fundamental question is answered. Is the current budgeting process reasonably efficient? Our experience suggests that budgeting processes are often highly inefficient and not susceptible to improvement in effectiveness until the inefficiencies have been addressed.

Take the case of the parts manufacturer. This company prepared a quarterly rolling forecast that projected operational requirements and financial results. The planning process was labor intensive involving as many as 60 people working more than 90 days to complete. Given the need to do manual data entry, maintenance and consolidation of over 4,000 spreadsheets, it was not surprising that the new quarterly forecast started before the forecast for the previous quarter was complete. The process was poorly controlled, error prone and inaccurate.

What was the impact of this forecasting system on the business? There were significant costs associated with the manual process. Forecasts were late and unreliable. Importantly, the analysts who were buried in data and spreadsheets had no time for analysis. Management could not fine tune their plans to better accommodate known changes and improve earnings. They blamed the forecasting system on their inability to adapt quickly to changes in run rates and product mix from key customers resulting in lower than expected quarterly earnings and reductions in the stock price.

I would argue that this experience prohibited any improvement in the underlying method until the inefficiencies and the high cost of planning were addressed. Importantly, fixing the inefficiencies of the system would free up the time of analysts to focus on cost and performance management rather than data churn and spreadsheet manipulation.

Does your experience support this view? Does your budgeting process lack discipline, accuracy, relevance and responsiveness? Is the inefficiency of the budgeting process the biggest barrier to improvement? If the process were fixed, could you successfully address the issues of relevance and operational responsiveness?

The Return on Investment from ABC

Peter — Fri, 05 Feb 2010 17:09:33 +0000

There are three reasons you implement ABC—a compelling business need, recognition that ABC is superior to whatever you currently have or don’t have, and a positive return on the required investment. We could focus on any of these three, but let’s start with the return on investment (ROI). If you can’t demonstrate a positive ROI, it is unlikely management will support the initiative, and highly unlikely they will pull out the check book and fund it.

A real plus is that ABC is a natural for computing an ROI. The benefits are derived from eliminating the profit destruction associated with unprofitable products, services and customers, eliminating costs that don’t add value and other tangible and intangible factors. It is a compelling way to show that ABM is not the typical systems project that has no measurable ROI and often seems to go on forever. I can think of a customer that spent $500 million on an Enterprise Resource Planning (ERP) system. Once it was complete (after many years and the inevitable cost overruns) it was impossible to compute an ROI and no-one was using the system. Yes, the data was in good shape, but managers were still using spreadsheets and ad hoc analyses to make decisions. I am sure many of you have horror stories like this to share with us.

Each organization will have different business needs, and benefits from ABC that will vary with these needs. For example, a credit union might need to know the cost of acquiring and maintaining customers, so they could make optimal marketing decisions around profitability. If ABC reported product and customer profitability (ideally risk adjusted customer lifetime value) it would support this business need. We could develop a model of how this decision process would work, factor in the size of the marketing budget, and then make a reasonable estimate of the ROI. A government agency might want to replace equipment at the time that minimizes the total cost of ownership (maintenance plus ownership costs) over the expected lifetime of the equipment. Alternatively the agency might want to pinpoint areas of inefficiencies so resources could be migrated to fit budgetary needs. In both cases the financial impact of these decisions could be estimated and factored into an ROI computation.

I encourage you to share your thoughts on this important topic. In particular, it will be helpful to identify where you believe ABC can provide a positive ROI. It will be invaluable if any of you have specific sources of ROI you can identify from your own experience. Thoughts on overcoming difficulties computing ROI will also be very helpful. I look forward to your comments.