Are budgets inherently backward-looking? On the face, this seems like a preposterous question. After all, it seems obvious that budgets are full of new ways to grow your accounts, operate more efficiently, and improve your company.
The budget process is central to a CFO's effectiveness. It is the top financial manager's primary method for ensuring that his or her company is moving forward, that the company's managers are well-coordinated, and that sound financial discipline prevails throughout the firm.
A good budget process enables a CFO to set the company's operating game plan and guard rails as the company moves forward in its market over time. If the CFO's budget process is sound, the company will set a sound course. But if the budget process is flawed, the best efforts of the management team will fail to achieve the company's potential.
The Big Question
Here's the really big question: if the budget process is a central determinant of a company's performance, why do so many companies have so much embedded unprofitability?
In virtually every company today, 30-40 percent of the business is unprofitable by any measure, 20-30 percent of the business is so profitable it provides all the reported earnings and subsidizes the losses, and no one is responsible for managing profitability (i.e. managing the interaction of costs and revenues customer-by-customer and product-by-product). The upside? Over 30 percent profit improvement within a year, and every year after.
That is what I have found even in leading companies, large and small, in over a dozen industries as diverse as distribution, manufacturing, financial services, high tech, steel, and telecom. I've written about this for the past decade, and no one has disagreed with my findings.
Why do so many companies have a budget process that not only fails to reverse this problem, but fails even to recognize it?
Two Big Problems
Traditional budget processes have two big inherent problems that lead companies to systematically underperform their potential – even if every manager in the company beats his or her budget goal.
Lack of granular profitability information. Virtually all companies have accurate financial reporting information, but poor micro-level profitability information. Think about this: if I selected five of your accounts at random, and in each account I selected five products, could you tell me how profitable each was? Could you explain exactly how to increase the profitability of each? If I asked your sales and operations managers, would they know? Would they agree?
The problem is that most financial managers simply assume that they should use their existing financial information – developed for financial reporting – to do granular profitability analysis. This is a big mistake. It doesn't work because virtually all companies compile revenues and costs in categories that are much too aggregated for effective micro-level profitability maximization, which requires accurate information on every product in every account.
Instead, you need to develop new information using a technique I call "profit mapping." Essentially you develop an "income statement" for every transaction (customer order line). This is not especially hard to do: one or two capable managers can develop a profit map in a matter of weeks using standard desktop tools. But it is completely different from the information developed for financial reporting. I explain how to do it in my new book, Islands of Profit in a Sea of Red Ink.
Lack of granular coordination. Because most companies lack the granular profitability information that profit mapping provides, managers throughout each company are not able to identify the exact ways in which they must coordinate with each other in order to maximize their company's profitability. Importantly, these measures will vary from account to account, and product to product.
This causes a big problem. When a company's managers cannot coordinate to optimize the profitability of individual accounts and products, they are forced, without realizing it, to focus on creating incremental improvements in their respective areas of responsibility. Most often these take the form of relatively broad initiatives: sales managers develop ways to increase overall revenues, while operations managers create new programs for efficiency.
These initiatives may generate incremental gains. But the company's managers lose the opportunity to create the huge gains that come from transforming the business by reversing the company's embedded unprofitability.
In most companies, this amounts to tuning up yesterday's business.
Instead, the prime objective of the budget process should be to identify the company's islands of profit – the 20-30 percent of the business that generates all the reported earnings and more – and to really focus resources on securing and growing it through precisely coordinated initiatives. Once this process under way and producing results, your managers can turn to the task of making each marginal account and product more profitable, again through sharply targeted measures.
Both of these critical aspects of profitability management require precise interdepartmental coordination for success. And successful interdepartmental coordination must be rooted in the detailed, granular profitability information that profit mapping provides.
Importantly, the process of reversing embedded unprofitability almost always generates cash as order patterns are stabilized, pricing is rationalized, orders are consolidated, inventories are reduced, and other efficiencies are developed.
Investing in Tomorrow
Armed with the powerful financial information that profit mapping provides, the effective CFO can identify the company's true profit picture, reverse the company's huge embedded unprofitability, and develop a well-grounded roadmap to rapidly move the company into the future.
By embodying this transformational roadmap into an action-budget (actions, timetables, upside, and resources), the effective CFO can create strong sustainable profitability and growth in a matter of weeks and months, all self-funded by the new cash flow generated by the process.
After all, budgeting for a 5-10 percent improvement to a 30-40 percent unprofitable business is simply investing in yesterday.
Why not invest in tomorrow?
Jonathan Byrnes, a consultant and senior lecturer at MIT. His latest book is Islands of Profit in a Sea of Red Ink.