Annual planning processes produce business (operating) plans and budgets.

Internal market economics suggests a very different, entrepreneurial approach to both business and budget planning.

Traditional Planning Processes

In traditional processes, each department submits a budget to get money to pay its costs. The budget is a forecast of spending on expenses such as compensation, travel, training, and vendor services.

This kind of budget just begs for micro-management. "Hey, you don't need all that training!" In truth, top executives really don't know how much training you need to run your business. But what else have you given them to talk about?

Scrutinizing costs and driving efficiencies may be a legitimate discussion with one's boss, but it's inappropriate during budget negotiations.

Budget planning allocates an enterprise's scarce resources among organizations. It should decide what value each organization will be funded to deliver, channeling scarce resources to the best investment opportunities based on business needs. It's not the appropriate forum to coach you on cost efficiency.

The traditional focus on costs has another unfortunate consequence. It induces a perception of costs without a concomitant understanding of value. This gives rise to a vague suspicion that you cost too much (even if you compare well to benchmarks like outsourcing rates).

A back-and-forth on costs has an unfortunate side effect. It encourages managers to build a buffer ("fat") into their budget proposals, knowing they'll be challenged to reduce costs without any reduction in expected results. This doesn't necessarily lead to the right numbers; but it does confirm that your numbers can't be trusted.

Another insidious effect is its damper on innovation. Managers may be reluctant to bring up new ideas, for fear of being expected to deliver more without additional resources.

Perhaps the worst effect is that traditional budgets don't support sensible decision making. Scarce resources (money) should be allocated to the best investment opportunities. But there's no way to analyze ROI on compensation, travel, and training.

Thus, executives are forced to make budget decisions based on factors other than business needs and investment returns, such as last year's spending or current headcount. This does not allocate scarce resources to the best returns.

Once approved, traditional budgets provide no basis for demand management. Clients may say, "You got all that money, so why can't you do everything I want for free!?" And you have no way to explain what is, and what's not, funded by your budget.

Also, traditional budgets don't support cost accounting. There's no way to know what portion of your budget should be allocated to each of the various business units that consume your services.

Investment-based Budgeting

In internal market economics, business and budget planning take a different form.

As a business within a business, you don't get money to pay your costs. You're given money to "buy" your products and services.

That insight leads to a different approach to budgeting.

Key concept: In internal market economics, budgets don't just forecast what an organization would like to spend. Budgets forecast the costs of the products and services an organization might deliver in the coming year.

This is termed "investment-based budgeting."

Picture a spreadsheet where the columns are general-ledger expense codes, and the rows are the projects and services proposed for the coming year.

The key is to total the rows, not just columns.

The differences between investment-based budgeting and cost accounting....

When this additional information is presented in the budget process, there are many benefits....

Changes the Dialog

Investment-based budgeting has dramatic impacts on the budget decision process.

With an understanding of what various levels of funding will (and won't) pay for, budget decisions can be fact-based. Senior executives can decide what they'll "buy" from each organization with scarce enterprise resources, considering business needs, ROI, and enterprise strategies.

Video case study on the impacts of investment-based budgeting on executive-level budget discussions....

Anecdote that illustrates the change in the nature of budget dialog....

Specific benefits include:

• Trust is earned through transparency.

• Budget requests are far more defensible. In fact, clients can defend your budget by explaining their needs and the business value of your products/services.

• The budget dialog builds widespread appreciation of the value delivered by your organization.

• Budget decisions are based on business needs and investment returns, rather than arbitrary benchmarks like prior year's spending.

• Alignment with business strategies results from funding only the most valuable deliverables.

Cost Savings

Investment-based budgeting illuminates three effective ways to cut costs:

• Vendor costs: All indirect costs are linked to deliverables. If you're spending on something that you don't need to produce your products/services, stop buying it!

• Internal support services: Services provided by one group to another within your organization are scrutinized for value. If the internal customer doesn't really need it, stop delivering it!

• Demand management: The process allows clients to manage demand, and stop funding services that are of marginal value.

Demand management is typically the most lucrative source of savings (since most organizations are reasonably well run and have already picked the "low hanging fruit").

"...we actually reduced costs, resulting in our budget for business as usual to come in so far under that it was not even a factor in the overall organizational budget discussion."

David Caldwell Director, Compassion International

If costs must be cut (downsizing), the enterprise has to be selective about the rows it funds.

It fully funds the few things it chooses to do, and removes costs associated with everything else (rather than crippling everything with across-the-board cuts). Thus, expectations are reduced in conjunction with cost reductions.

Reliable Delivery

Another positive effect of investment-based budgeting comes from the clear linkage between funding and specific deliverables (projects and services).

In the budget decision process, executives must decide exactly which of your proposed projects and services they'll fund in the budget.

Even if executives decide your budget based on other factors (such as affordability), you can still determine exactly which deliverables are funded.

"We're going to fully fund what we do; and we're only going to do what we fully fund."

Dr. Curtis Carver CIO, University System of Georgia

The remaining projects either require other sources of funding or they won't be delivered.

Specific benefits include:

• There's no place for the "do more with less" edict, which forces managers to commit to more than they have resources to deliver. This ultimately leads to failures in delivery, not efficiencies.

• There is widespread understanding of what your budget will and won't pay for. This manages clients' expectations. You won't have to overwork your people to attempt to satisfy unconstrained demands.

• By funding the full cost of deliverables, your organization has the resources it needs to deliver reliably. That includes not just the lead group (the "prime contractor"), but also all necessary support groups ("subcontractors").

• Since you're not expected to deliver more than is funded, there's no need to cut corners on quality, safety, or content. You can deliver every (funded) commitment reliably.

Data for Demand Management (Governance)

The data in an investment-based budget provides the basis for a business-driven demand-management (governance) process -- a process that adjusts priorities throughout the year to align your organization with clients' ever-changing business needs and opportunities.

Governance decisions require two kinds of information: what funds are available (what's in the checkbook), and what the various proposed projects and services will cost.

Both of these data sets come out of an investment-based budget.

The approved rows in the budget explain which checkbooks inherit the funding -- checkbooks owned by specific business units, consortia, and the organization itself.

Also, the rows in the budget have fully-burdened costs associated with them. Even for projects that arise mid-year (and weren't costed in the proposed budget), the rates (unit costs) calculated in the investment-based budget can be used to estimate project costs more accurately.

Specific benefits include:

• Throughout the year, an investment-based budget provides the data needed for for a business-driven governance process (demand management). Clients can do more than set priorities (rank-order major projects). They know what's in their "checkbook" of available resources, and the costs of proposed products and services.

Sustainable Business

An investment-based budget sorts out the costs of:

• Services to specific clients and consortia.

• Services to the enterprise as a whole (corporate-good).

• Ventures that benefit the organization itself (e.g., capital for infrastructure).

• "Unbillable" activities that sustain a viable business (such as training, innovation, process improvements, and relationship building). These costs are built into rates for the above three types of deliverables.

Specific benefits include:

• Budget line items include explicit funding for enterprise-good services (which are not "overhead"), so that they don't distort your rates or the costs of business-driven projects.

• Budget line items include explicit funding for capital for infrastructure, deferred maintenance, and major innovation projects -- a reliable source of funding (unlike depending on year-end money or clients' largess).
  
  Anecdote illustrating this....

• Budget line items include their fair share of the costs of critical sustenance activities. You won't have to cut corners on maintenance, back off on training and innovation, or stop investing in process improvements.
  
  Anecdote illustrating this....

Cost Accounting and Allocations

An investment-based budget explains who gets what -- the costs of projects and services delivered to each client business unit. You know what each client business unit is expected to consume.

Specific benefits include:

• The budget provides a basis for fair, consumption-based cost-allocations (if any), and clients know what they're getting for their money.
  
  Anecdote illustrating this....

Cultural Impacts

Generally, managers are engaged in the process of developing an investment-based budget. This experience teaches them to think like entrepreneurs.

Specific benefits include:

• Managers learn how to plan a business, developing the next generation of enterprise leaders.

• When managers understand their deliverables and their customers, the culture shifts from managing resources to accountability for results, customer satisfaction, and innovation.

• Pro-forma profit/loss statements establish performance objectives for managers that encourage frugality and entrepreneurship (unlike traditional budget-variance metrics which discourage growth).

• Teamwork is enhanced through the experience of planning all the components needed for each deliverable -- the internal prime contractor and all needed subcontractors. And teamwork improves when entire project teams and support staff are funded.
  
  Anecdote illustrating this....

The Enterprise Perspective

From an enterprise point of view, there are additional benefits, especially when the practice is adopted enterprisewide:

• Investment-based budgeting makes the annual budget planning process a meaningful dialog that focuses all departments on enterprise priorities.

• The budget process can channel scarce resources to the best purposes, enhancing strategic alignment and shareholder value.

• The process clearly defines the specific deliverables which are expected of each department for a given level of funding, enhancing accountability for results.

• Executives can cut costs surgically by eliminating marginal deliverables, rather than across-the-board cuts that damage the enterprise's ability to do anything well.

• Post-cost-cutting, the process ensures that all remaining resources are in the right place and aligned with the enterprise's more focused strategies.

• You have a realistic basis for profitability analysis when you know total costs (direct and indirect) and have pro forma profit/loss statements by business unit, product line, or client.

• When implemented across an enterprise, executives can better know the full cost of strategic initiatives, not just in the lead business unit but across all support functions.

• Strategy execution improves because resources are aligned with strategies, all departments are clear on their individual accountabilities, and they're all fully funded to deliver their pieces of the strategy.

• Teamwork among departments is enhanced when all are working on the same priorities.

Bottom Line

Investment-based budgeting allows better-informed budget and strategy decisions, explicitly aligns resources with enterprise strategies, defines accountabilities for deliverables, installs a discipline of frugality, enhances cross-boundary teamwork, and gives you a realistic view of product-line profitability.

"The Internal Economy sweeps away old thinking about managing resources. Bringing the tonic of the marketplace to bear, it provides a breakthrough approach for planning and budgeting."

Don Tapscott Author, The Naked Corporation, Paradigm Shift, The Digital Economy

The bottom line: Investment-based budgeting enhances shareholder value.

But investment-based budgeting is more than the numbers.... It's a visionary way to run an organization.

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Other Resources

White paper on investment-based budgeting....

White paper for CFOs and Budget Directors on investment-based budgeting....

FullCost software, method, and consulting to implement investment-based budgeting....