Annual planning produces business (operating) plans and budgets. Internal market economics suggests a very different, entrepreneurial approach to both.

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 focus exclusively on deciding what value each organization will be funded to deliver, channeling scarce resources to the best investment opportunities based on business needs.

This is not the appropriate forum to coach you on cost efficiency. Conversations about your management of your costs should happy separately, and continually, with your boss, not your customers.

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 yet another 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.

Note: Investment-based budgeting subsumes the concept of zero-based budgeting since all products and services are rows in the budget, and are subject to scrutiny. There is no "base" budget, a fixed sum for unknown ongoing services.

The Differences between Investment-based Budgeting and Cost Accounting

Investment-based budgeting has, at its core, a cost model that associates all costs with an organization's products and services. But it's quite different from cost accounting:

• Investment-based budgeting is forward looking (planning), not after-the-fact accounting. For example, it looks at scenarios telling you what different levels of funding will "buy" from each support organization in the year ahead, so as to decide funding based on business needs and investment opportunities (not last year +/- a percentage).

• Investment-based budgeting costs the organization's entire product line, including internal services of support functions, not just a few external products/services. Everybody is an internal entrepreneur.

• Investment-based budgeting apportions all indirect costs, not just those related to a specific product. It's more accurate and comprehensive.

• Investment-based budgeting is a tool for aligning everybody with your strategies. Cost accounting is after the fact, and doesn't affect alignment (it's too late).

When the costs of the rows are visible 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.

Specific benefits include:

• Trust is earned through transparency.

• Budget requests are far more defensible.

  In fact, internal customers can (and will) defend your budget by explaining their needs and the business value of your products/services. This is appropriate, since customers are the ones who suffer when your budget is cut -- they're constrained to buy less in the year ahead. And they're the ones who benefit from giving you a larger budget. Note that customers are more convincing since they're in the best position to know the value to the business of the supplier's work.

• 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 can't link (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 projects and 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 expectations. You won't have to overwork your people to attempt to satisfy unconstrained demands.
  More on managing expectations....

• 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.

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 and innovation).

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

The benefits of sorting out these different types of costs include:

• Budget rows include separate funding for enterprise-good services (which are not "overhead" built into your rates). That way, they don't unfairly inflate your rates (putting you at risk of misguided outsourcing) or the costs of business-driven projects (perhaps turning down what in truth would be good investments).

• 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 internal customers' largess).
  Anecdote illustrating this....

• Costs include both direct costs and a fair share of indirect costs such as overhead. Thus, you can build in necessary expenses for critical sustenance activities like professional development and product research, within the limits of competitive pricing. You won't have to cut corners on maintenance, back off on training and innovation, or stop investing in process improvements.
  Anecdote illustrating this....

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 facts come out of an investment-based budget.

The approved rows in the budget explain which checkbooks get the funding -- checkbooks owned by specific business units, consortia, and the organization itself. They also reveal the full cost of projects and services known at that time.

Additionally, this annual planning process updates the organization's catalog of products and services, and calculates fully burdened rates (unit costs) for each (using the same cost model that produces the budget). For projects that arise mid-year (and weren't costed in the proposed budget), these rates are used to estimate project costs accurately and consistently.

Specific benefits include:

• An investment-based budget tells you how much money flows into each of the various checkbooks.

• Throughout the year, an investment-based budget, or estimates of new projects using the rates calculated in the budget, let pursers know what they're spending so that they can live within their means.

Cost Accounting and Allocations

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

Specific benefits include:

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

Internal Entrepreneurship

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....

"FullCost allowed us to deflate large buckets of general cost and appropriate the costs to those departments that were actually using the services ... initiating some substantial discussions around the value we bring to each of those business units."

David Caldwell Director, Compassion International

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 better-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 customer.

• Executives can better know the full cost of strategic initiatives, not just in the lead business unit (the tip of the iceberg) but across all the relevant 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.

"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

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 bottom line: Investment-based budgeting enhances shareholder value.

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

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