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© 2024 N. Dean Meyer and Associates Inc.
Excerpt from www.NDMA.COM, © 2024 N. Dean Meyer and Associates Inc.

Frequently Asked Questions (FAQs): The Internal Economy

market-based financial/resource-governance, including budgeting, service catalogs, cost modeling, project intake and priority setting (demand management), and chargebacks

Book: Internal Market Economics

  1. Can a department implement investment-based budgeting despite an existing corporate budget system?

  2. Our budget process has a base plus capital projects; isn't that good enough?

  3. Why should business planning and budgeting be integrated in a single process?

  4. What's the difference between investment-based budgeting and the budget modules in some accounting/cost-aggregation systems?

  5. Don't we need to get our historical data in shape before working on the planning process?

  6. Why should a service cost model be part of the planning process rather than reporting actual spending?

  7. Why should budgeting and rate setting be an integrated process?

  8. We have a governance committee that sets priorities; isn't that good enough?

  9. What does "portfolio management" mean?

  10. How is investment-based budgeting related to portfolio management and demand management?

  11. Don't you have to implement chargebacks to actually change behaviors?

  12. Some vendors advocate "show-backs" (mock invoices); what are the risks?

  13. Shouldn't benchmarks look at actual spending rather than the plan?

  14. Shouldn't cost transparency look at actual spending rather than the plan?

Suggest another question and get a personal response....

  1. Can a department implement investment-based budgeting despite an existing corporate budget system?
  2. Investment-based budgeting does not overlap enterprise budget systems. It feeds them.

    Enterprise budget systems roll up each department's proposed budget; and then once budget decisions are made, they document the decision and track actual spending.

    Investment-based budgeting comes earlier in the process. It's the way you develop your business plan and budget, and then submit the resulting budget proposal into the enterprise budget system.

    If anything, an investment-based budgeting tool replaces the spreadsheets you use to prepare your budget submission.

    It also helps you during budget negotiations, explaining what you can deliver for various levels of funding. If you're pressed for savings, you can clarify which products and services you won't deliver. And on the up-side, you can propose specific new investments based on business needs.

    Once the budget is decided, the output of your investment-based budgeting tool can be fed directly into the enterprise budget system.

  3. Our budget process has a base plus capital projects; isn't that good enough?
  4. Many organizations format their budget as a base (which is usually last year's spending plus/minus a percentage) plus the cost of a few large projects.

    This is not as good as investment-based budgeting for two important reasons:

    • The base is opaque; people don't know what it pays for. The consequences are:

      • Executives don't appreciate the value delivered in that base, and may accuse you of costing too much.

      • The lack of transparency may breed mistrust.

      • There may be items in that base which are of low value, and should be discontinued. But these cannot be seen.

      • The base may need to grow due to increased business volume, the costs of supporting assets produced by last year's projects, changes in vendors' pricing, new services, deferred maintenance, and other legitimate reasons -- grow at a rate faster than the percentage applied to last year's spending. But it's difficult for you to defend such an increase.

    • Those few major project may not be priced at full cost. Typically, the costs just represent capital and direct labor, but not a fair share of all the indirect costs such as support services. This, too, creates problems:

      • When costs are under-estimated, projects may appear to have a favorable ROI when in truth they don't; so poor investments may be approved.

      • As more projects are approved, indirect support services don't grow in proportion. These support services become a bottleneck that threaten project delivery.

    A far better answer is an investment-based budgeting process that treats all products and services (not just major projects) as distinct deliverables, each with its fully burdened costs.

    Of course, the deliverables in an investment-based budget can be sorted into categories, such as base versus discretionary projects, for review. Nonetheless, the deliverables in the base should be visible and priced.

  5. Why should business planning and budgeting be integrated in a single process?
  6. A business plan and a budget should be developed together in a seamless process.

    Business planning defines what your managers will deliver in the year ahead, how they'll produce it.

    A budget forecasts what resources managers will need in the coming year.

    Managers cannot forecast costs if they don't know what business will be conducted in the year ahead, and how it will be executed. In simple terms, you have to know how much you are going to "sell" before you know what resources you'll need.

    Anecdote: Operational Planning
    why operational planning, budgeting, and rate setting must be a single, integrated process

    Without a linkage to a business plan, the budget can be nothing more than a trend based on past years or a wish-list of things the organization wants to buy without justification. Such unfounded budget proposals -- not based on the investment opportunities at hand -- cannot support a fiscally sound budget decision process.

    An effective planning process begins with an operational (tactical) plan that defines what the organization will deliver in the year ahead. Based on this business forecast, it plans how it will produce those products and services, and what resources staff will need to do so. This is the basis for a cost model which produces both an investment-based budget and a service catalog with rates.

  7. What's the difference between investment-based budgeting and the budget modules in some accounting/cost-aggregation systems?
  8. Many financial accounting systems have a "budget module" which vendors claim can be used for budget planning. These systems provide trends in costs, and some provide trends in service volumes.

    These systems support the old paradigm, where the budget for next year is based on prior year's spending (plus or minus a percentage), regardless of the changing needs of the business.

    There's a lot more to budget planning than trends. Managers have to consider discontinuities such as:

    • Increased business volume
    • The costs of supporting assets produced by last year's projects
    • Changes in vendors' pricing
    • New staffing and sourcing strategies
    • New projects and services, including speculative
    • Internal investments like new infrastructure, deferred maintenance, and process improvements

    But most budget modules presume that a budget is a spending forecast, not a business proposal for the coming year.

    Furthermore, those systems generally aggregate costs into high-level categories (like major product lines, applications, service portfolios); but they aren't designed to forecast the costs of specific deliverables -- at the level of granularity of purchase decisions.

    Thus, they don't support the kind of budget dialog where clients defend their needs, and executives understand exactly what they'll get for various levels of funding.

    Trends in costs and sales coming from accounting and invoicing systems are valuable inputs to investment-based budgeting (helpful, but not sufficient). But they're not a substitute for real investment-based budgeting.

    Independent research report: IT as a "Business Within a Business"
    Vision, Financial Processes, and Systems
    (the difference between planning tools and actuals accounting systems, and analysis of planning software products)

  9. Don't we need to get our historical data in shape before working on the planning process?
  10. In practice, this has not been necessary. Here's why:

    With investment-based budgeting, you develop a plan (and budget) for the future. Planning uses historic data, but it also involves management judgments about the future. Historic data should season management judgment, not substitute for it.

    Sure, the better your historic data, the better your estimates of the future. But we've found that managers who run your business already know most of what they need in order to develop an investment-based budget.

    The investment-based budgeting process structures what managers know along with their judgments about the future. So it will significantly improve the quality of their forecasts, with or without better historical data.

    In fact, it's better to install a business and budget planning process before you implement product/service accounting and invoicing systems. There are a number of reasons:

    • Planning is prerequisite: You need a plan before accounting data has analytic value (to compare actuals to a plan).

    • Tracking is not prerequisite: You don't need historic data to develop a plan; historic data will fine-tune management judgment, but a plan isn't a simple projection of the past. And managers already know enough to develop a budget.

    • Quicker win: Implementing a planning process is relatively inexpensive and quick, with huge benefits. Implementing accounting systems is very expensive (costly software, time to implement it, and behavioral changes like time-cards), and has fewer benefits.

    • Save money sooner: Planning takes costs out before they happen. Accounting identifies cost-savings opportunities after the money has already been spent.

    • Have to do much of it anyway: You'll have to do much of the planning process anyway in the course of implementing accounting systems that track costs of services, including decisions like lines of business, catalog and rate structure, cost model which associates all costs with products/services, project codes, and definitions of unbillable time.

    • Motivation versus resistance: Until people understand that they're funded based on the deliverables they sell (which they learn in the planning process), they won't be interested in utilizing the accounting data and they'll resist the administrative burden (e.g., time-cards).

    • Need rates to invoice: Even if you charge back (fee-for-service), you don't need to get your accounting systems perfect. Invoices can be based on the plan until accounting systems evolve to improve their quality. But accurate rates are needed before invoices have validity; and rates (published at the beginning of the year) come from the Planning process.

    Whether or not you have good historical data, you have to plan your budget based on what you know today. Structuring your existing knowledge into an investment-based budget is the best place to start.

  11. Why should a service cost model be part of the planning tool rather than the system used for invoicing and reporting actual spending?
  12. A service cost model assigns all your costs to your products and services, portraying the full cost of each.

    Within your financial systems, there are two possible places to build a service cost model:

    1. In your planning tool, where it's the basis for an investment-based budget and rates.

    2. In your accounting systems, where it is used to compare published rates with actual costs, or (inappropriately) for invoicing.

    There are two reasons why you need a service cost model in your planning tool:

    • To produce an investment-based budget, you must associate all your costs with your planned deliverables.

    • Rates, which are based on the cost model, are published in advance of the year, and should be stable throughout the year.

    So no matter what, a service cost model has to be part of your planning process.

    A service cost model in the accounting systems calculates actual costs of services:

    • You don't need a service cost model to produce invoices. Invoices multiply actual volumes times published rates. (If you were use a service cost model for invoicing, your rates would vary month-to-month depending on what vendor bills you paid!)

    • It's only real use is to compare actual service costs with revenues, to continually monitor service profitability.

    The benefits of building a service cost model in your accounting system are minor. But if you do so, it must exactly replicate the cost model in the planning tool to ensure consistency.

  13. Why should budgeting and rate setting be an integrated process?
  14. Budgets and rates should be two outcomes of an integrated annual planning process.

    A service catalog with rates should be published before a new fiscal year begins. And barring a major change in the business, those rates should be stable throughout the coming year.

    Rates are the fully burdened unit-costs (like staff's cost per hour) of the products and services in the catalog. Rates are used for chargebacks, show-backs, governance (portfolio management) processes, project estimation, and benchmarking.

    Budgeting is also done before the fiscal year begins.

    Investment-based budgeting associates all planned costs with the products and services you plan to deliver. Inherent in that process is a service cost model that apportions indirect costs to those deliverables.

    That same cost model can be used to calculate rates.

    Mathematically, this is easy to do. If you add up the cost of all the deliverables in the plan which are sold by a given unit (e.g., all for a given product or service), and then divide by the forecasted volume, you get a rate (the per-unit cost).

    There is one difference: Reimbursables (pass-throughs, like the "materials" in a time-and-materials contract) are in the budget, but are not in rates.

    Thus, budget and rates are mathematically related as follows:



    Once you have an investment-based budget (with its service cost model), you can easily extract rates. That's just another view of the same data cube.

    Using the same cost model to calculate both an investment-based budget and rates has two major advantages:

    First, developing a separate cost model is a lot of unnecessary work. There's no advantage to doing all of this twice.

    Second, it's important to charge rates during the year that add up to the total costs promised in the budget. If rates don't match the budget, clients may get budget approved to spend on your organization, and later find that their budget won't buy what they thought it would.

    Meanwhile, staff may find themselves collecting insufficient revenues to pay their costs (running at a loss), or making a profit and exposing themselves to criticism for overcharging customers.

    By using the same full-cost data, an organization can be confident that its rates are fair, defensible, directly comparable to benchmarks like outsourcing, and consistent with the costs described in the budget.

    The right tool makes this as easy as running two different reports from the same data.

  15. We have a governance committee that sets priorities for major projects; isn't that good enough?
  16. Priority-setting is part of the demand-management (governance) process. Its goal is to dedicate scarce resources to the purposes that most need them (alignment), and to limit expectations to available resources (balance supply and demand).

    Simply setting priorities among major projects doesn't accomplish that goal for two important reasons:

    • It doesn't consider reducing consumption of services (or pools of hours for minor projects) to fund additional projects (or vice versa). So it doesn't optimize returns on the entire portfolio.

    • It doesn't limit demand (expectations) to what's affordable. Simply a list of projects that are rank-ordered doesn't explain "where the line is drawn." So clients may go on expecting it all, in that sequence.

    To be effective, that governance committee should treat the priority-setting process as investment portfolio management -- much like the way you manage your personal stock portfolio. They should move resources out of lower-payoff investments to fund higher-payoff projects and services. And, of course, they can't spend more than they have.

    To do investment portfolio management, that governance committee needs to know two things:

    1. How much is in their checkbook, and what of that is encumbered by their past purchase decisions

    2. What people are requesting, and what those projects and services cost

    Both depend on investment-based budgeting. The budget explains how much to put into each client's checkbook. And it explains what things cost -- the full cost of deliverables in the plan, and rates to estimate the costs of new projects/services that arise during the year.

    This is why the Planning subsystem (investment-based budgeting) should come before any further work on your governance processes.

  17. What does "portfolio management" mean?
  18. There are at least three common uses of the term "portfolio management" within organizations:

    • Project portfolio management is a way to track many projects, and all the organization's resources (time and money) that they share. It helps you avoid double-booking your staff, and tells you when you can schedule the next project.

    • Product (application) portfolio management analyzes the installed base of your products, and looks for opportunities to save money by investing in the consolidation of similar assets. These opportunities are put in the hopper alongside other proposed project and service requests, awaiting funding through your demand-management process.

    • Investment portfolio management is the demand management (aka governance) process that decides "what checks to write" -- which projects and services to approve within the bounds of available resources (your budget).

    While all are valuable, investment portfolio management is generally the most pressing. It brings expectations in line with resources, and ensures that the organization is working on the right things.

    Without an effective investment portfolio management process, project portfolio management can only help you do a good job of what might be the wrong list of projects. And product portfolio management will only suggest more investment opportunities that will make the imbalance between supply and demand worse.

  19. How is investment-based budgeting related to portfolio management and demand management?
  20. Internal portfolio management means managing investments in service providers (such as IT) as one would manage a portfolio of financial investments. Another term for this is "demand management."

    Clients use their finite budget to "buy" products (projects) and services from internal staff based on returns on investments (ROI). This is the essence of market-based governance.

    Portfolio management is key to managing expectations and to aligning internal service providers with enterprise strategies and clients' business needs. It also helps clients understand where their money is going.

    Typically portfolio management is based on a steering committee comprising client executives who set priorities.

    True portfolio management requires knowledge of how much money is in the "checkbook" and the costs of various investment opportunities. Without that information, a steering committee can do little more than rank-order major projects.

    FullCost tells you how much of your budget is in that "checkbook" managed by clients (versus the portion of the budget that's yours to manage).

    FullCost also defines the costs of all your products and services.

    Although there's more to internal portfolio management than just knowing the organization's products and services and their costs, FullCost is an essential and practical first step.

  21. Don't you have to implement chargebacks to actually change behaviors?
  22. No. You can get virtually all the benefits of chargebacks (including impacting buying behaviors) without actually moving money among departments.

    The goal is to give clients control of what they buy, and to require them to live within their means. This aligns your organization with their needs, and ensures that you have the resources to satisfy all their (funded) demands.

    Giving clients your budget and then requiring them to pay for your services (chargebacks) is one way to do this.

    But you can accomplish the same without chargebacks using concepts of internal market economics.

    Consider your budget as pre-paid revenues -- money put on deposit with you by clients, and then used to buy your products and services during the year.

    This "checkbook" (essentially a claim on your resources) is given to clients in a demand-management process. They can write checks for whatever they most need; but they can't expect more than they can afford. In other words, demand is limited to your budgeted resources.

    Through these processes, you have virtually all the benefits of chargebacks without money changing hands.

    The only thing that internal market economics does not do (and chargebacks does) is allow clients to take your budget and spend it elsewhere -- on decentralization, outsourcing, or other services entirely.

    Theoretically, that freedom would ensure that they're getting the very best returns on their money. But if you're not already their vendor of choice, or if you can't prove that you're a better deal than decentralization and outsourcing, then handing over your budget could cause a downsizing for all the wrong reasons.

  23. Some vendors advocate "show-backs" (mock invoices); what are the risks?
  24. Show-backs are mock invoices, produced after products and services are delivered.

    The reason vendors give for recommending mock invoices (beyond just selling their invoicing software) is "financial transparency." They say they build an understanding of the value delivered by an organization.

    But from a political point of view, show-backs can be dangerous.

    There are better (and less expensive) ways to be transparent, the foremost being investment-based budgeting. Being clear up front about what your services cost -- before the year begins and before purchase decisions are made -- is far more meaningful than after-the-fact reports.

    Meanwhile, an invoice implies that clients have some degree of control over those costs. The alternative -- billing them (even on paper) for things they cannot control -- is not palatable.

    So when you hand them invoices, you can expect clients to try to take control.

    But if you haven't implemented a demand-management process that gives them meaningful control over their purchase decisions, you're building expectations of empowerment before you're ready to grant it.

    That can lead to power struggles, micro-managing your costs, and strained relations.

    On the other hand, once you've implemented internal market economics, invoices are real (not mock). They may decrement the pre-paid revenues (clients' checkbooks) rather than actually transfer money (chargebacks). But they reduce clients' spending power nonetheless.

    It's wise to wait until invoices really impact clients' spending power (with or without chargebacks) and processes are in place to give clients control over what they buy before producing them. Thus, an optimal strategy starts with investment-based budgeting, then demand management, and only later implements invoicing.

  25. Shouldn't benchmarks look at actual spending rather than the plan?
  26. There are two different kinds of benchmarks.

    Benchmarks of total spending (percent of revenues, towers) can be very misleading. Your costs may be higher than your peers for many legitimate reasons.

    For example, you may be investing in strategic opportunities that your competitors haven't yet discovered.

    Or your company may have adopted a business strategy that rests on greater utilization of your services; for example, a strategy of local presence requires more spending on telecommunications.

    The more meaningful kind of benchmarks is rates. These answer the question, "Can I buy this service for less elsewhere?"

    The Plan produces a service catalog with rates. These rates may be compared with external sources of the same services (benchmarks).

    Alternatively, the Actuals subsystem tracks actual spending. If costs are associated with services (a big, expensive "if"), these too may be compared with benchmarks.

    The problem with using Actuals is that it mixes together two different questions:

    1. Is our cost structure in line?

    2. Did we execute the plan well?

    You already have other metrics for question #2, such as variance tracking or managerial profit/loss statements. And if you use Actuals for benchmarks, you are taking on the extra step of diagnosing whether a discrepancy is due to #1 or #2.

    This is why it's better to benchmark the plan to address question #1, and rely on other existing metrics to monitor question #2.

  27. Shouldn't cost transparency look at actual spending rather than the plan?
  28. The concept of "cost transparency" means making clear where the organization's funding goes. Transparency builds trust, and it gives the enterprise the data it needs to make fact-based decisions.

    Generally, the term is used to mean more than conventional accounting which tracks spending. Clients want to know what they got for their money, i.e., what your products and services cost. Cost transparency generally refers to service costing -- assigning all costs to your products and services.

    Transparency can be provided at two points in time:

    1. In the Planning process, in the form of an investment-based budget and rates.

    2. In the Actuals accounting, associating spending with deliverables as on invoices.

    Generally, it's best to be transparent about the costs of your products and services before you ask the enterprise to make any purchase decisions. Cost transparency in the Planning subsystem has much more value than detailed after-the-fact accounting.

    Investment-based budgeting is the basis for making informed decisions about the budget.

    And rates are the basis for making informed decisions about project/service approvals.

    Of course, if you execute the plan badly and over-spend, that needs to be tracked in the accounting systems. But that's done with budget variance tracking or managers' profit/loss statements, not service costing. And that should be managed internally, not by clients; it's not what transparency is about.

    Clients want to know where their money is going. If you invoice at published rates (planned, not actual), as you should, they'll want to understand your cost structure as built into the plan (your budget and rates).


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