In many organizations, there exists a disconnect between strategy and execution with the missing piece being the lack of an effective budgeting and planning processes. The budgeting and planning process is the gear that converts the potential energy held with the strategy to the kinetic energy of execution within operations. However, the traditional budgeting and planning process is not well suited for the modern day resource allocation that successful enterprises now require. Most budgeting and planning processes are long, painful and distracting and take time and attention away from the business of serving customers and meeting with prospects. Adding insult to injury, they become quickly outdated and are pushed aside for rolling forecasts or periodic projections until the next budget and planning cycle.
Most organizations do not explicitly tie their operating plan to their strategic plan. For example, a company that has a strategic goal of entering two new markets within twenty-four months and achieving at least $50 million in sales may not tie that directly to goals within the operating plan. There also may be a disconnected between the strategic plan and the operating and financial plan. The financial plan, which is the output of the strategic and operating plan, may look a lot different than originally anticipated after everything is rolled together, causing significant confusion.
In defense of the traditional budgeting and planning process in general, the needs of the modern enterprise far extend beyond what the budgeting and planning process was ever intended to do. The original idea of a budgeting and planning process was intended to provide a rational way in which to allocate scarce resources and ensure their effective use over a period, a function that it performs quite well. The budgeting and planning process was never initially designed to be used as a basis for forecasting or variance explanations but grew naturally from its genesis. More importantly, it was never meant to convey or manage the business strategy and used to set targets. Instead of cursing it and looking to eliminate the budgeting and planning process as some do today, we should look to accept it for what it is, a tool for the allocation of financial resources, and look to other systems to solve the disconnect.
One of those systems is driver-based budgeting and planning process. Moving to a driver-based budgeting planning process will help to minimize these disconnects between the strategic, operating and financial plans, minimize frustration and enhance transparency throughout the organization. Although driver-based budgeting is no panacea for all budgeting woes it will go long way in moving an organization toward a point of consensus and enhance a business’s execution of its executive’s strategy.
What is Driver-Based Budgeting?
Driver-based budgeting and planning is a relatively new approach to the resource allocation process. Driver-based budgeting and planning uses casual models constructed from key operational activity drivers that are then linked to the operating plan in order to plan for future financial results.
Each model is a unique equation that represents a mathematical relationship between an operational driver and a financial outcome. Models are created by analyzing the cause and effect relationship between:
- Business activities
- Resource requirements and
- Financial outcomes
These relationships have always been the basis for any budgeting and planning process, but they were organized starting by general ledger line item and worked backwards. Driver-based budgeting and planning represents the equation by starting with the operational driver and ending with the financial outcome in a way that is more transparent to those throughout an organization.
With the continued refinement of the equations based on cause and effect relationships and their linkages to the strategic, operational and financial plan driver-based budgeting and planning can continue to evolve and enhance the overall performance of the enterprise.
Driver-Based Variance Analysis
Traditional budgeting and planning variance analysis reporting focuses on reporting variances to past results, budget and forecast. Management reports focus on what happened not why is happening. This provides little help to senior management in helping them to avoid future missteps or repeat past successes. A greater focus may be given to minimizing variance to the budget and not on understanding the cause of the variances or seeking ways to boost overall performance and meet strategic objectives.
When a driver-based budgeting and planning process is implemented, management can look at the “why” behind performance variances to the casual models that incorporate the key operational drivers that support the financial plan.
Using driver-based, casual models for variance analysis enhances the performance management process by focusing on the operational drivers that influence the financial results. This will inevitably shift the dialogue from a pure financial discussion to a discussion about the internal and external factors that are impacting the business and what changes and decisions needs to be made to adapt.
For example, in Figure 2 below, there are three tables that sum to the budget variance in the traditional variance analysis in Figure 1, above. Because price, volume and mix were all identified as drivers of sales (a financial outcome) within the casual model in the driver-based budgeting and planning process a variance analysis to actuals can be performed that quickly shows that although the actuals came in 9% above budget, Widget A’s higher price was able to offset the discounts offered for Widgets A and B. Looking deeper I, can also identify that for only a small decrease in price Widget B, nearly doubled its volume and although there were significant changes in price and volume, overall sales produce mix remained relatively steady. Through budgeting and planning for drivers you are able to change the conversation for variance explanations and make better decisions for the future, saving time by not accumulating reams of untargeted variance explanations from business units and departments.
Benefits and Drawbacks to Driver-Based Budgeting and Planning
Driver-based budgeting and planning is neither complicated nor new. In many cases, most organizations are already doing some form of driver-based budgeting and planning as part of their regular business planning process, but once it is incorporated into an enterprise process the solution can magnify the benefits and provide increased transparency, but it is not without cost.
- Increased Financial Agility – Changes to external factors and market reactions such as input costs, demand, product/service prices, cycle times, and productivity can be quickly modified within the driver-based equations with their outputs flowing throw the budgeting and planning process to a general ledger line item showing the financial impact at various levels. This allows for more frequent sensitivity analysis and scenario iterations. In addition, the use of drivers more easily allows for statistically based forecasting and probabilistic-based output that may not have been possible with the traditional budgeting.
- Tighter Operational Alignment – Instead of focusing on an annual budget number, each area works to develop their own driver-based equation that is tied back to general ledger line item. Without a focus on a dollar amount, management can focus on the operational metrics, better aligning headcount and resources to match demand. For example, if you were responsible for budgeting and planning at a mortgage company and the Federal Reserve lowers interest rates mid-year causing a home refinancing boom, the head of operations may realign headcount capacity to prevent a bottleneck and customer frustrations, without the constraint of a fixed limited dollar amount that an annual budget may cause.
- Quicker Root Cause Analysis – With traditional budgeting variance analysis, significant Financial Planning and Analysis (FP&A)resources is outlaid in contacting responsible parties to ascertain explanation of variances to budget and uncover additional operational detail including any insight into potentially future variances that may be expected. Because most of the heavy lifting of analyzing the operations has already been done in the beginning with driver-based budgeting and planning, causes to financial variances are apparent, leading to quicker responses and easier reporting. For example, using the mortgage company example above, if labor expenses exceeded budget for a period a further investigation of the driver-based equation would determine that increased underwriting headcount was the cause of the variance due to a refinance boom, caused by actions taken by the Federal Reserve.
- Less Sandbagging and Gaming – In driver-based budgeting and planning the input metrics that drive the equations tend to be more objective and are therefore subject to less contributor interpretation. This makes people more accountable for their submissions and the submissions themselves more accurate.
- Increased Productivity – With a focus on business operations and not budget creation, the entire process shifts to increasing productivity and enhancing organization profitability. The time that was to create complex budget and planning modelscan now be used to create business process analysis and projects that lead to measurable ROI.
- Model Complexity – The time, level of expertise and resources needed to initially identify the key drivers and build the operating equations that tie back to the individual general ledger line items can be very intensive. Business rules need to be created and maintained over long periods of time and as the business changes so do the equations and supporting documentation. The work that was performed on a condescend time frame is now spread out over the year and performed on an on-going basis to maintain the driver-based models and their relevancy and accuracy.
- Spreadsheet Capacity – Spreadsheets may have difficulty coping with the large amounts of data required to consolidate and analyze driver-based budgeting and planning information. With traditional budgeting, a series of spreadsheets can be consolidated to produce an integrated corporate budget, but when you add an additional layer of 60 to 70 complex equations that support each spreadsheet and are fed data from external source systems, you come up against a systems constraint which makes the use of a Corporate Performance Management System or another enterprise type software solution package a better solution, but these packages may cost a significant amount of money.
Best Practices to Implementing Driver-Based Budgeting and Planning
Driver-based budgeting and planning establishes the link between the tactical day-to day operational decisions and the long-term strategic analysis that drive business performance and supports continuous learning and adaption throughout the organization.
In implementation of a driver-based budgeting and planning process you may come up against some resistance as the casual modeling process provides a greater depth of transparency which no longer allows people to pad their budgets, game the system or conceal as much information. In addition, it requires managers to cross organizational boundaries to gather information and work together to a common goal, which is not always easy. Following these best practices will help to minimize implementation frustrations.
Commit to it!
Driver-based budgeting and planning must be a senior management responsibility. They must understand the drivers used and the levers they can pull to move the business forward, slow it down or pivot.
A key output of the strategic planning process should be top-down targets of key drivers to ensure that goals are cascaded throughout the organization, tied backed to the operating plan and reflected in the financial plan. Having senior management setting a percentage of sales increase to last year and calling it strategic planning is not commitment!
BEST PRACTICE: HAVE EACH BUSINESS UNIT COMPLETE 1-PAGE ANSWERS TO 5-STRATEGIC QUESTIONS, DELIVERED 1-WEEK PRIOR TO THE STRATEGIC PLANNING MEETING AND CIRCULATE IT WITHIN THE PLANNING BINDER.
Keep It Simple
For each driver-based equations it is important to keep them as simple as possible. Equation complexity does not necessarily equate to budget or plan accuracy. A driver-based equation that is easily understood and can be managed to will be much more effective than a more accurate, complex equation that no one understands.
Limit The Number of Key Drivers
There is no optimal number of total drivers an organization should strive to have and there is a constant tradeoff between efficiency and accuracy. Initially, the number of total drivers used could easily reach several hundred, but applying the Pareto Principle, only about 10 or 20 will represent 80% of the business (See Keep it Simple).
What is a Key driver? A Key driver is ones that has a major impact on the performance of the organization. The only way to truly find that out is to test through sensitivity analysis, prioritizing the drivers that have the greatest impact. The key drivers must:
- Be measurable and accurately obtainable
- Can be linked from strategy to operations
- Can be tied to performance measures that reflect the organizations strategic objectives
- Ideally, can be benchmarked against competitors
The rate of refresh should also be considered. How often will these key drivers be re-evaluated, annually, quarterly, etc…
Key drivers are not typically used for budgeting but for planning purposes. The objective of financial budgeting is control (expense minimization), not to maximize enterprise value. Budgeting is internally focused, where all other income statement line items are some functions of revenue and which a multitude of business drivers is typically derived.
Planning on the other hand, is dynamic, externally focused, and plans contingencies based on external threats and opportunities. Planning’s objective is to steer the organization’s performance and optimize corporate investment.
When you blend them together in a driver-based budgeting and planning process, not all of your budgeting line items may be used within your planning model as they are not impactful to the organizations financial outcomes.
For example, a driver-based budgeting equation for accounting may be a function of fixed salaries times a variable transaction driver based on volume bands and a headcount variable. This equation is important for budgeting and variance analysis and ties back to general ledger line item for labor costs, but for planning purposes, the use of this equation may not be impactful over a 9 to 12-month horizon. Therefore, it may make sense to use this driver-based equation for variance analysis but not for planning as a key driver.
Use of a Corporate Performance Management System
Implementation of a driver-based budgeting process is possible using spreadsheets but it is going to be hard. Due to the volume of data that is required and the documentation of the various equations and their assumptions, it is going to get difficult to make sure there are no errors in the final product. The three major shortfalls in deploying a driver based budgeting process with spreadsheets are errors within the spreadsheets, versioning control and security. If you can manage those three major risks, then it possible. Implementing a driver-based planning process is absolutely doable because it requires fewer variables and less precision.
The use of a Corporate Performance Management System will allow for the integration with external databases and greatly enhance the organization’s ability to manage such a complex task. The system must be able to integrate with financial systems such as the general ledger and sub ledgers as well as the human resource system, sales and marketing, and as many other production systems as possible so it can pull in the data with as few manual inputs as possible.
Dashboards and other reporting features will be helpful but not required as the major consolidation and control function is most critical. The ability to store notes and other non-numeric supporting documentation will also be important as many equations will require explanation as to why they were chosen as the best drivers for a particular area or department.
Shorten the Planning Cycle
With the pace of business continuing to accelerate, organizations can’t take months to get the budgeting and planning process complete. Plan for the whole process to take less than 30 days including all iterations to final sign-off. A shorter cycle puts an emphasis on speed, coordination and flexibility. Will lead to less frustration and less redundancies. In addition, it allows you to use the most recent information to plan for the future.
To do everything in less than 30 days, you will need months of planning and preparation, strong central leadership, the use of planning tools and process discipline.
Rethink the Incentive System
After implementing a driver-based budgeting and planning process, the use of previously used measures of individual performance may not be as relevant. With the identification of business drivers now being tied to general ledger line items identification of what drives profit will be more clear. Changing employee incentives to motivate their actions to optimize those drivers may improve company performance and lead enhanced enterprise value.
Effectively Balance Financial Control, Ambition and Risk/Opportunity Management
Think about the objective of each part of the budgeting and planning process and how it can best be used to balance the objectives of the company.
A budget is used as a control mechanism. A driver-based budget is great for explaining variable cost deviations when demand fluctuates. It can also be used to hold shared service units accountable for key costs based on drivers that have nothing to do with demand as opposed to a percentage of revenue allocation.
Corporate planning, on the other hand, sets targets. It may start with the budget but frequent forecasting, adjusting and re-aligning will allow the company to stretch to improve performance, re-deploy capital to take advantage of a new opportunity so sell off an underperforming asset. Planning is less precise by nature and an agreed upon desired level of precision needs to be documented.
Finally, forecasting for risk and opportunity management. This will be done as part of the planning process, but forecasting involves the use of external micro and macro factors that impact the business regardless of whatever the plan may set forth.
The key is to focus the annual planning process more on strategy and setting major business objectives while the periodic and mid-year planning process is used for target setting and control. These periodic planning sessions are supported by scenario analysis and forecasting.