One has to put up front-end money if one wishes to grow a business. That money is invested in tomorrow's profit makers, so those front-end investments will only be costs with no returns, and sometimes for a long time. How does one manage those to maintain cost control? The first thing is to budget these growth activities separately. Peter Drucker calls this the, "Opportunities Budget." The second rule, therefore, is to think through what results we expect from these investments in the future and within what time period.
In his book, "The Daily Drucker: 366 Days of Insight and Motivation for Getting the Right Things Done," Peter Drucker refers to Citibank's rise to become the world's only successful transnational bank through the 1970s and 1980s as an effective example of this.
Citi first thought through how much front-end investment could be justified in a new branch and it thought through what the minimum results in the new territory could and should be. Citibank asked: "How much business can we expect in this new area if we are successful and become a market leader? And how much front-end investment is then justified assuming that the front-end investment must not exceed a certain percentage of the potential results?"
And then Citi knew from its own experience how long it should take before this new branch should reach break-even, that is, before it should begin to produce profits.
The lesson to take from Drucker, in my estimation, is to budget development projects separately. Develop most likely estimates of expected results and monitor results and adjust expectations accordingly.
Adjusting Expectations
One of the easiest methods of tracking performance is to compare actual results with your budgeted expectations. Depending on the start and end of your fiscal year, you probably went through some budget planning process, analyzing the effectiveness and efficiency of the previous year, and planning performance levels, projects, and revenue targets for this year.
As the year progresses you're sure to notice how things differed from your original budgeted expectations. This is where making adjustments comes in. Keep your original master budget, and make no changes to it. At the end of the year it's useful to look back at your original expectations and analyze the differences. Instead, make a copy of the original budget and make modifications to it at each reporting period. With this flexible budget, you will have a snapshot of your current expectations as the year progresses. At the end of the fiscal year, with both the original budget and the flexible budget, you'll be able to compare how your performance levels changed throughout the year and also how your expectations changed throughout the year.
The Importance of Flexible Budgeting
As variable costs change with levels of production, your budgeted expectations could be way off from your actual performance levels. With the flexible budget, you have the freedom to make the changes you need. Comparing the actual performance with a static budget isn't very useful because costs are expected to differ from the budget if actual production is different from the production level indicated in the static budget.
Likewise, if your organization is presented with new opportunities, such as entering new markets or expanding production in existing markets, your production levels will definitely increase. This has characterized the new home construction industry in the west for many years. As existing markets fill up, new developments in new markets take their place, and sometimes changing from one market to another can be a very rapid process. Being able to adjust the budget in the middle of the year when these factors are taken into account can be invaluable to your future planning and continued success.
Effective Budget Management
Managing the budget is the real challenge. The easiest way to begin this process is by setting up periodic budget meetings among your management teams. How often you schedule these meetings is up to you, but I do know of some companies who track their performance against the budget as often as once a week.
As you have these budget meetings and go through the process, you will have an opportunity for continuous improvement; always comparing actual results with expected results. In this way you will be constantly benchmarking performance against your best levels of expectation.
There is one caution, however; when you create the budget, in order for this all to work, your expectations must be as accurate as possible. The fact that budgets are used for both planning and performance evaluation presents a difficulty in that managers who participate in the development of their own budgets may tend to understate budgeted revenues and overstate budgeted expenses. The result is budgets that are easy to achieve and contain slack. Just be aware that this can happen, and know that over time this problem will correct itself as you change the flexible budget.
Cutting Costs
As you track performance against the budget, cutting costs will become necessary, especially as operations grow. No matter how well a business prevents cost inflation, it will still have to cut costs. That's because businesses are like people, and people often get sick no matter how carefully they exercise, control their diet, and avoid substance abuse.
To start cost cutting, management usually asks: "How can we make this operation more efficient?" It is the wrong question. The question should be: "Would the roof cave in if we stopped doing this work altogether?" And if the answer is "probably not," one eliminates the operation. It is always amazing how many of the things we do will never be missed. But businesses that actually succeed in cutting costs don't wait until they have to cut costs. They build cost cutting into normal operations. They build into their routine operations what Peter Drucker calls, "organized abandonment." Drucker recommends setting up a systematic process of reviewing all products, processes, and services. Abandon those that no longer contribute to customer value.
