Two easy ways for executive teams to attempt to raise profits is to lay off employees to cut costs or to lower prices to take away market share from their competitors. But these are merely short-term fixes. An organization cannot reduce its costs and prices to achieve long-term sustained prosperity.
Entrepreneurs know the age-old adage, "you need to spend money to make money." However, belt-tightening an organization's spending can be haphazard. Rather than evaluating where the company can cut costs, it is more prudent to switch views and ask where and how the organization should spend money to increase long-term sustained value. This involves budgeting for future expenses, but the budgeting process has deficiencies.1
A Problem with Budgeting
Companies cannot succeed by standing still. If you are not improving, then others will soon catch up to you. This is one reason why Professor Michael E. Porter, author of the seminal 1970 book on competitive edge strategies, Competitive Strategy: Techniques for Analyzing Industries and Competitors , asserted that an important strategic approach is continuous differentiation of products and services to enable premium pricing. However, some organizations believed so firmly in their past successes that they went bankrupt because they had become risk-adverse to changing what they perceived to be effective strategies.Strategy execution is considered one of the major failures of executive teams. At a recent conference, Dr. David Norton, co-author of The Balanced Scorecard: Translating Strategy into Action, reported, "Nine out of 10 organizations fail to successfully implement their strategy. ... The problem is not that organizations don't manage their strategy well; it is they do not formally manage their strategy."2
Empirical evidence confirms that companies execute strategy poorly. Involuntary turnover of North American CEOs in 2006 will beat the record high set just the previous year.3
In defense of executives, they often formulate good strategies - their problem is failure to execute them.
One of the obstacles preventing successful strategy achievement is the annual budgeting process. In the worst situations, the budgeting process is limited to a fiscal exercise administered by the accountants, who are typically disconnected from the executive team's strategic intentions. A less poor situation, but still not a solution, is one in which the accountants do consider the executive team's strategic objectives, but the initiatives required to achieve the strategy are not adequately funded in the budget. Remember, you have to spend money to make money.
Value is Created from Projects and Initiatives, not the Strategic Objectives
A popular solution to failed strategy execution is the evolving methodology of a strategy map with its companion balanced scorecard. Their combined purpose is to link operations to strategy. By using these methodologies, alignment of the work and priorities of employees can be attained without any disruption from restructuring the organizational chart. The balanced scorecard directly connects to individuals regardless of their departments or matrix management arrangements .
Although many organizations claim to use dashboards and scorecards, there is little consensus on how to design or apply these tools. At best, the balanced scorecard has achieved a brand status but without prescribed rules on how to construct or use it. For example, many companies claim to have a balanced scorecard, but it may have been developed in the absence of a strategy map from executives. The strategy map is arguably many orders of magnitude more important than the balanced scorecard. Therefore, when organizations simply display their so-called scorecard of actual versus planned or targeted metrics on a dashboard, how do the users know that those measures displayed in the dials, commonly called key performance indicators (KPIs), reflect the strategic intent of their executives? They may not! At a basic level, the balanced scorecard is simply a feedback mechanism to inform users how they are performing on preselected measures that are ideally causally linked. To improve, much more information than just reporting your score is needed.
One source of confusion in the strategy management process involves misunderstandings of the role of projects and initiatives. For the minority of companies that realize the importance of first developing their strategy maps before jumping ahead to designing their balanced scorecards, there is another methodology challenge. Should organizations first select and set the targets for the scorecard KPIs and subsequently determine the specific projects and initiatives that will help reach those targets? Or should the sequence be reversed? Should organizations first propose the projects and initiatives based on the strategy map's various theme objectives and then derive the KPIs with their target measures afterward?
We could debate the proper order, but what matters more is that the projects and initiatives be financially funded regardless of how they are identified. Value creation does not directly come from defining mission, vision and strategy maps. It is the alignment of employees' priorities, work, projects and initiatives with the executive team's objectives that directly creates value. Strategy is executed from the bottom to the top. Dr. Norton uses a fishermen's analogy to explain this: Strategy management tells you where the fish are, but it is the projects, initiatives and core business processes that catch the fish.
Three Types of Budget Spending: Operational, Capital and Strategic
Figure 1 illustrates a broad framework that begins with strategy formulation in the upper left and ends with financial budgeting and rolling forecasts in the bottom right. The elements involving accounting are shaded in green. Some budgets and rolling financial forecasts may distinguish the capital budget spending (#2 in the figure) from operational budget spending (#1), but rarely do organizations segregate the important strategic budget spending (#3).
The main purpose of the figure is to illustrate that the budget depends on and is derived from two separate sources: 1) a future demand-driven source (operational) and 2) a project-based source (capital and strategic).
Ideally, the strategy creation in the upper left uses meaningful managerial accounting information, such as understanding which products and customers are more or less profitable today and are potentially more valuable in the future. With this additional knowledge, the executives can determine which strategic objectives to focus on.
Note that the operational budget (#1), those expenses required to continue with day-to-day repeatable processes, is calculated based on forecasted volume and mix of "drivers" of processes, such as the sales forecast, multiplied by planned consumption rates that are calibrated from past time periods (and ideally with rates reflecting planned productivity gains). This demand-driven method contrasts with the too-often primitive budgeting method of simply increasing the prior year's spending level by a few percentage points to allow for inflation. The operational budget spending level is a dependent variable based on demand, so it should be calculated that way.
Regardless of whether an organization defines the strategic initiatives before or after setting the balanced scorecard's KPI targets, it is important to set aside strategy spending (#3) not much differently than budgeting for capital expenditures (#2). Too often, the strategy funding is not cleanly segregated anywhere in the budget or rolling financial forecasts. It is typically buried in an accounting ledger expense account. As a result, when financial performance inevitably falls short of expectations, it is the strategy projects' "seed money" that gets deferred or eliminated. The priority must be reversed. Organizations must protect strategy spending and allow it to go forward as it is the key to competitive differentiation and successfully accomplishing the strategy.
Put your money where your strategy is!
Managing Strategy is Learnable
Organizations with a formal strategy execution process dramatically outperform organizations without formal processes. Building a core competency in strategy execution creates a competitive advantage for commercial organizations and increases value for constituents of public sector organizations. Managing strategy is learnable. It is important to include and protect planned spending for strategic projects and initiatives in budgets and rolling financial forecasts. Those projects lead to long-term sustainable value creation.
1. See Gary Cokins' article "What's Broken about Budgeting?" at http://www.dmreview.com/article_sub.cfm?articleID=1056684.
2. Dr. David Norton. Balanced Scorecard Collaborative Summit. November 7, 2006. San Diego, California.
3. Jones, Del. "Turnover for CEOs is on record pace." USA Today. July 12, 2006. p. 2B.