Read The Mobile MBA: 112 Skills to Take You Further, Faster (Richard Stout's Library) Online
Authors: Jo Owen
If you are in a position to make decisions about the required rate of return, you will need to do what most firms do: use some simple rules of thumb. These rules of thumb come with plenty of health warnings from finance professors. But in the world of management simplicity rules over sophistication. These rules of thumb will be targets that typically come in one of three flavors:
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ROI (return on investment):
the higher the risk, the higher the expected return becomes.
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NPV (net present value):
this is the discounted sum of all the cash flows associated with an investment. The riskier the investment, the higher is the required discount rate.
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Payback period:
this looks at how many months or years it takes before the investment generates enough cash to pay back the initial investment. The higher the risk, the shorter the payback period required.
The simplest way of doing things is to sort all proposals into three piles: high, medium or low risk. High risk requires high returns, low risk requires lower returns, as follows:
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High risk:
new products, new markets and new ventures.
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Medium risk:
such as investment in new machinery and product extensions.
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Low risk:
such projects may be dominated by cost savings (changing suppliers, cutting staff, changing the product mix).
This simple approach has the flaws of most approaches: it is open to game playing (what is high or medium risk?); it does not work for all sorts of spending (IT business cases are notoriously hard to connect to business and financial
outcomes); and it only addresses the financial, not the business, case for a project. At the margin, some good projects will be missed and poor projects may slip through. But for the most part, business does not require making fine judgements about whether a project will make 10.1% ROI (accept it) or 9.95% (reject it).
To make a sensible investment decision, managers need to ask themselves four basic questions:
• Is the project financially attractive?
• Are the assumptions behind the proposal sound?
• Does the project fit with our strategy and direction?
• How credible are the people behind the proposal?
Ask these four questions and you are much more likely to make a good decision about a project than if you rely on CAPM.
Budgets are one of the must-fight and must-win battles of the management year. You have a choice:
• You can be an alpha manager and accept the challenging targets that your boss has dared you to rise to. That is a guarantee of 12 months of hard grind and frustration, with possibly no bonus at the end of the year as you struggle to hit an impossible target.
• Alternatively, you play hard ball and negotiate a sane budget that enables you to have a sane working year. You can then beat the modest budget and enjoy a bonus that your alpha colleagues will miss. Your choice.
Here is how to play budget hard ball.
How to play budget hard ball
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Manage this year’s performance
. If you overperform this year, you simply set a higher baseline for next year. Being a good manager, you should aim to beat the budget, but not too much. If you have slack this year, then delay recognition of revenues and bring forward recognition of costs where you can. This gives you the added bonus of a windfall start to next year: lower costs and quick sales against a modest target.
•
Set expectations low
. Find all the reasons why next year will be far tougher than this year: the market will be harder and the workload will be greater than ever. You know your unit better than anyone else, so you have the advantage here.
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Strike early
. The later you leave it, the less room for negotiation you have. Starting early means starting before the formal planning or budget process has started. As soon as the first set of planning guidelines have been issued, expectations have been set and you have lost negotiating room.
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Talk to the right people
. The right people are the decision makers and influencers: your boss, the CEO, and any planning group.
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Be relentless
. Keep on hammering away with your analysis and your carefully selected facts. Eventually the planners will go away and search for easier victims.
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Stay positive.
You need to be seen as the positive manager who will heroically overcome the daunting challenges which your unit faces. If there is any gloom, it is about external factors only. The outside world is the problem, you are the solution.
Of course, if you are setting budgets, then the rules are largely reversed. You have the advantage that you have seen all the game playing before and you have probably played the games before. You should also be reasonably familiar with the budgets, economics, and personalities behind each budget. As a budget setter, you need to apply five tests to each budget.
The five budget tests
1. What are the key assumptions?
Numbers are simply reflections of assumptions, so test the assumptions not the numbers. This is routinely missed by managers who like to argue that the budget is too high or too low. That is an emotional debate that can only be defused by testing the key assumptions.
2. How does this compare with last year?
This is where game playing becomes a real problem. But you should know the history of the unit and all its special circumstances, which you have had to adjust to. Newly appointed managers do not know this history and are most vulnerable to the game playing.
3. What is happening in the market?
Budgets are by definition internal documents. Part of your job is to connect internal perceptions to external market reality. If sales and share are declining, then even HR and IT should take their share of the pain.
4. Is productivity rising or falling?
Productivity measures the amount of work done for the amount of resource used. Even support functions such as HR and IT should be able to offer some measure of productivity. Inevitably, this will involve a degree of management judgement, but managers are paid to have and to use judgement.
5. What is happening to unit costs?
Check the cost per unit: the cost per employee or the cost per tonne of raw material. Fight the inevitable inflationary assumptions which are built in.
This is where prudence and practice part company, even though they share the same destination: you must make budget. Failure to do so is a career limiting move. Prudence and practice are two different routes to the same destination.
Prudence says you manage your budget conservatively. A simple rule is the 48/52 rule: aim to spend 48% of your budget and achieve 52% of your sales (or tasks) in the first half of the year. Once you have worked out what this means for the first half of the year, then apply the 48/52 rule again to the first two quarters of the year.
a simple rule is the 48/52 rule
The prudent approach means you give yourself a chance of beating budget. Just as important, it enables you to deal with any crises and unexpected events which may occur later in the year. You build in a safety margin into your operating performance.
The problem with the prudent approach is that it makes you a prime target for the year end squeeze, which comes around as regularly as Christmas but rarely brings any presents. The squeeze occurs because there are always some units that overspend or underdeliver: everyone has to be squeezed to make up the shortfall. By the time the year end looms, it is too late to make up ground in the marketplace, so the only realistic response to the squeeze is to cut costs. As ever, short-term savings can lead to long-term costs, so you need a way of insuring yourself against this.
The practical approach to managing budgets looks something like 51/53. You still want to get ahead on sales and outputs if possible. If you can achieve
53% of your goal in the first half, that is a good start. But you also need to find a way of protecting your spending. Since you know your budget will be squeezed in the last quarter, it makes sense to have no discretionary spending items left in the last quarter. In practice that means you have to spend ahead of the curve, selectively. That is not prudent, but within reason, it is practical. For instance:
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Make essential investments early in the year.
These might be test markets, technology spend, market research and the like. Remove them from the coming squeeze.
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Spend discretionary items which are dear to your heart early.
If you want a conference for all your units and team members, do not schedule it for the last quarter.
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Commit budget where you can.
If you have advertising planned, make sure the media spend is committed. Advertising is a soft target for bosses who do not understand that cutting advertising kills your brand and your sales.
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Build a slush fund.
Since you know there will be a squeeze, identify in advance where there is some fat to be cut. Simple acts such as delaying the start of new hires by a few months will allow you to build up reserves which can be released when necessary.
once the budget is set you have entered into a contract with your bosses
Finally, remember that once the budget is set you have entered into a contract with your bosses. You have to deliver on your commitment. Budget blues are the driver of much management angst, pressure and grief. Manage your budget tightly from day one and you have a chance of minimizing the grief at year end. If you are falling behind on budget, act swiftly. Cut fast to get your running rate of costs down: the longer you leave it, the greater the cumulative gap becomes and the less time you have to recover. The earlier you deal with your budget crisis, the smaller it is.
You will find very little written about how to control and oversee budgets which you have delegated down to managers beneath you. This is a vital art: if you cannot control the delegated budget, you will quickly find yourself in severe trouble. Here are six hard won lessons from the front line.
Six hard won lessons from the front line
1. Be unreasonable
. There are always reasons why costs overshoot and revenue falls short. But if you accept excuses, you accept failure. If you see that budget might be missed, you simply have to focus on one question: “So what will you do differently to make budget?” These are uncomfortable but necessary discussions.
2. The budget is the budget is the budget
. You will be asked to make budget revisions, which normally means reducing the budget. Don’t. A budget is like a contract: your managers have promised to deliver certain results for certain resources: keep them to that promise.
3. Cash versus accruals
. Cash is easy to spot: you have either spent the money or not. Accruals are the hidden iceberg that sinks many a budget. When reviewing a budget, make sure that you have identified every forward commitment, even if the purchase order has not been signed, and that it is reflected in the budget. You want to know about all the bad news as soon as possible, so that you can do something about it if required.
4. Game playing
. As budget holders we are all used to playing games: hiding and deferring expenses (accruals) and bringing forward revenue recognition where we can. Perhaps we slip the start of a new promotion from the end of this year to the start of next year. Or we hire someone six months later than originally budgeted, which gives us a miraculous but unrepeatable cost saving in this year’s budget. You are the poacher turned gamekeeper: you know the tricks, so stop them.
5. Steal any cost savings
. If one of your departments makes a cost saving they will do their very best to spend the saving before you can do anything about it. Cost savings belong to you: they are your safety net for making up the inevitable shortfalls elsewhere. You will, of course, recognize and reward anyone who produces cost savings and you may even let them reinvest some of the savings in their area. But the decision is yours to make, not theirs.
6. Work with your finance department, book keeper, or controller
. These people are your impartial financial ears and eyes. A good finance person knows the tricks, knows what to look for, and will spot problems before you do.
Financial and management accounts only give a partial view of the health of the firm. You need a more balanced view of performance that looks at how the firm is performing in the marketplace (share, sales); how it is doing organizationally (staff turnover, morale, etc.); and how well it is innovating. From this simple insight, Norton and Kaplan developed the idea of the balanced scorecard. As its name implies, it is an attempt to give managers a balanced view of the performance of their firm.
The balanced scorecard, however, is one of those good ideas whose time has come and gone. In the hands of the consultants, it just became too complicated and too expensive. Strip away the hype of balanced scorecards, and you can find a very simple and practical way of monitoring the progress of your business or department. Here is how:
Start with a blank piece of paper. On it, write down all the items of information you want about your business on a weekly and monthly basis. In practice, you will probably find that the information you want falls into five categories:
1. Financial information.
You probably already have this, so this should be easy to fill in. But financial information is a lagging indicator of performance. It is best not to drive ahead by watching the rear view mirror. So you need some other sorts of information on your one piece of paper.