If the budget cycle is so central to every company’s financial management process, why is there so much unprofitability among virtually all companies?
With years of experience with Enterprise Profit Management (EPM)—a transaction-level SaaS profit improvement system that creates a complete P&L on each invoice line—we’ve found that nearly all companies have a distinctive pattern of profit segmentation. Is:
• Profit Peak Customers—typically about 20% of customers generate 150% of the company’s profits;
• Customers who lose profits—typically about 30% of customers lose about 50% of these profits; And
• Profit Desert customers—typically the remaining customers generate minimal profit but consume about 50% of the company’s resources.
The same pattern occurs in company products, suppliers, sales reps, stores, and most other company dimensions.
The basic problem with today’s budgeting is that the main budget categories, such as revenue, gross margin and cost, are aggregate measures that show whether a company is profitable, but not whether it is making and losing money.
Since the budgeting process in most companies is based on these categories, it is doomed to miss the mark, no matter how much time and effort is devoted to it. Simply maximizing revenue and minimizing costs doesn’t maximize net profit — and gross margin doesn’t predict net profit. For example, bringing in more large, money-losing profit drain customers will reduce profits, and cutting service for service-sensitive profit peak customers is the fastest way to reduce profits.
Yet most budgeting processes are based on the old “more revenue, less cost” paradigm, rather than being rooted in a company’s actual profit segments—each of which has completely different profit-generating potential and completely different characteristics. are, and each of which requires a fundamentally different management game plan, metrics and resources.
change the budget cycle
One of the most important but difficult problems facing CFOs is explaining and resolving budget variances. This is extremely important for every C-suite officer, every board of directors and every company’s shareholders. It is also important to determine the correct company direction, management process goals and resource allocation.
Yet in most companies, the core budgeting process is based on revenue maximization and cost minimization by organizational units, and is differentiated neither by profit segment, nor by integrated segment-of-service process. This fundamental flaw is a major drawback and puts pressure on resource productivity and profitability.
An effective, well-structured budgeting process requires a CFO to be able to do four key things:
• State clearly where and why budget differences are occurring, and specifically how to correct them.
• Make operational improvements in near-real time to prevent budget variances, especially for integrated programs (for example, vendor-managed inventory) based on meeting the varying needs of a company’s profit segments.
• Build job clarity across the organization, with clear profit-segment based objectives.
• Identify and prioritize emerging profit opportunities, and ensure they are managed in a fully resourced and integrated manner while minimizing losses to fund new initiatives.
The problem is that the current budgeting process in most companies is so embedded in both the company and the financial community that it is dangerous to flash-cut to a new budgeting system. A three-step process will enable a CFO to transition to a true profit-driven budget (based on the company’s profit segments and subsegments during the budget cycle, which will then be summarized in current total financial reporting metrics such as revenue, gross) . margin and cost).
Step 1: Fine budget variance analysis. In this first phase, the CFO bases the budgeting process on traditional composite categories, but uses the EPM to identify underlying sources and reasons for variances. Because the EPM generates a complete P&L on each transaction, it will show exactly where the variances are occurring.
For example, a beverage distribution company budgets its revenue by brand and geographic branch. It has a budget tracking system which tracks the actual production in these buckets. The problem is to show what is really happening at the ground level.
EPM can easily present an analysis of where revenue differs by customer, by date (for example, the 4th of July holiday), by sales rep, type of account (on-premises or take-out) and so on . Similarly, it can indicate specific operating conditions, such as excessive unbilled uptake, excessive returns, supplier cost issues, that lead to cost variance.
It provides details that the CFO needs to identify and explain the specific causes of the variances, and initiate action to expedite the positive situations and remove or eliminate the negative ones.
Step 2: Mixed Budgeting. In this second phase, the CFO budgets in traditional categories. However, two enhancements make this process more effective.
First, the CFO may create more detailed budget categories, such as tracking beverage sales on July 4 for specific liquor stores, or for specific inns near campus at the start of the university semester. It offers a lot of granularity, and it can add to the accounting and product planning process. Importantly, it offers the possibility of fine-grained budgeting and actual tracking down to the level of detail of a particular brand at a specific location on a particular day or season.
Second, the CFO can enrich this budgeting process with the needs and objectives of specific profit segments. For example, a distributor may want to selectively allow higher costs reflecting higher service needs of significant profit peak customers (eg, running vendor-managed inventory) because it is a great investment. Conversely, the CFO wants the budget to reflect a reduction in uncompressed prompt delivery to large, money-loss profit drain customers, or to reduce excessively frequent ordering by these problematic accounts.
While these initiatives have translated into traditional budget categories, they facilitate the company’s efforts to serve key customer and product advantage segments separately. The CFO can track actuals by these more granular budget categories.
Step 3: Profit-driven budgeting. In this process, the budget cycle starts with the profit segments of the company. Each segment has both opportunities and concerns, and these are the result of the interaction of customer or product revenue and cost. For example, the EPM system can identify excessively frequent orders to be a major issue in a subsection of profit drain customers, and project that if the problem is corrected, the accounts can quickly Profit will turn into peak.
Although this is a highly targeted cost issue, it will have a huge impact on profits. On the other hand, a simple initiative to reduce order frequency across the board will cause serious problems for some profit-peak customers, who base their business on quick response to their customer needs – and this extra fast and consistent service. are willing to pay for .
The key to this highly effective budget-management process is to begin viewing each profit segment, or subdivision, as a “profit river” that generates revenue and costs through the company. The EPM system has been structured to reflect this approach, picking up revenue and costs from the general ledger as appropriate for each transaction.
These transactions can be combined and reconfigured to create a comprehensive, integrated view of any segment of the company – from the customer to the business segment to the specific product in a particular customer. Once the CFO determines the process, assigns objectives and priorities to the segment, the EPM-based budgeting process can separate revenue and costs for each segment or subsegment into the company’s organizational units, and each organizational unit. Can track its performance on its segment-specific basis. purpose
Importantly, these organizational unit objectives can be separated so that Profit Peak customers get better, more expensive service (the company charges a higher price for core service) – while Profit Drain and Profit Desert customers get that service. which is fair and compensatory. All of these elements can be specified in the budget for each organizational unit, and each can be closely tracked, analyzed and managed.
The infection can be managed in two years. The objectives are: (1) to accelerate the transition to a more effective profit-driven budgeting process; (2) making significant, necessary profits quickly; and (3) to give the organization time to see the benefits of the new process and to adjust to the change.
In the first year, the CFO uses the EPM, which can be configured in a few weeks to complete Step 1: Fine budget variance analysis. This is an urgent need, and will quickly generate very strong, visible benefits that will engage the entire organization—particularly the C-suite and the board of directors.
During this first year, the CFO should prepare the next year’s budget using a composite budget. This will give the organization a deeper understanding of the importance of budgeting based on the completely different needs of its key profit segments, while maintaining the familiar process of structuring budgets using aggregate categories and organizational units.
In the second year, the CFO can explain budget variances using both a more nuanced view of actual performance provided by the EPM and a more powerful profit-segment based approach that adds profit-driven budgeting. This will allow the organization to understand the significant new value that the profit-segment view creates, while achieving a level of comfort with the new process.
During the second year, the CFO may transition the budgeting process into Phase 3: Profit-Driven Budgeting. Once the organization has gained a deep understanding of the critical importance of its profit segments and how they differ from one another, and its managers are accustomed to working with the new blended process, the CFO can begin fully profit-driven. will be able to do. Budgeting process for making the company budget for the third year.
accelerate profitable growth
The budget cycle is the heart of every company. It translates the company’s strategic and operational goals into concrete financial needs and results, and provides the basis for management reviews that charge company managers with purpose and direction.
The company’s profit segments are the key to achieving profitable growth. The company’s main objective is to increase its profit peak, while reversing its profit drain and reducing costs for servicing its profit desert. This is the basic game plan of success.
Profit-driven budgeting is firmly rooted in this core company game plan. This translates these very different profit-segment objectives into effective company actions, creating a direct path to accelerated profit growth. This is the fastest and surest way for an effective CFO to ensure the success of the company.