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Value-Based BudgetingA Value Driven Alternative to Traditional Budgeting

Traditional Budgeting Issues

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A traditional approach to budgeting does not ensure spend is focused on the activities most critical to achieving enterprise strategy and objectives.

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Budgeting is viewed by many as one of the least effective management practices.

• Requires significant time and effort for limited/uncertain benefit

• Premises are often obsolete before the budget is finalized

• Static – built off of history; difficult to adapt to rapid changes in business conditions and competitive requirements

• Often drives counter-productive management behavior (spend to budget; poor collaboration; internal competition)

• Bottom-up budgets are often inconsistent with top-down plans

• Can result in sub-optimal resource allocation

Kill the Budget?

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A better question, “Is there a different approach to budgeting that will provide even more benefit?”


Budgets and the process of creating them are core to effective business management.

• Key control in managing costs

• Structured process for reviewing priorities, evaluating cost structures, considering tactical options and allocating resources

• Important element in managerial development and performance evaluation

So, budgeting is important but should you expect better results simply by working harder following the same approach?

Alternative Budgeting Approaches

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There are merits to each approach, however we believe VBB strikes the right balance between effort and results for many organizations.

• Rolling 12 month budget – budget is continually updated as each budget period (month/quarter) is completed

• Zero-based budgeting (ZBB) – start at zero across the enterprise

• Selective ZBB – only some departments use ZBB (often G&A focused)

• Rotating ZBB – departments rotate between ZBB and traditional budgeting on annual basis

• Value-based budgeting (VBB) – establish threshold budget level and add budget increments based on relative value generation


Leading companies have embraced alternative budgeting approaches to drive more effective business management.

VBB – Budgeting for High Performance

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• Value Optimization – the overall budget reflects the best combination of options as measured by net value generation (enterprise first)

• Strategic Connection – incremental activities are aligned with strategic priorities

• Leadership Alignment – shared understanding of cost and value of optional activities as well as regrets for activities that didn’t make the cut

• Innovation – new thinking about how to achieve objectives at lower cost

• Improved Decision Making – value-centric, enterprise-wide

• Collaboration – working across organizational boundaries to build the optimized budget

• Cost management – enables more effective cost visibility, understanding, governance and accountability

• Effort – less effort than full ZBB

VBB is designed to deliver much more than basic budgeting

VBB Process Overview (1)


1. Develop a threshold budget by department of 50 to 60% of the current budgeted spend and headcount. This is generally a good starting point for the core activities reflecting the minimum acceptable level of service and performance.1

2. Define the activities2 that can’t be performed within the threshold budget at current cost levels and calculate the expected net value of those activities.

3. Consider alternative approaches to performing those activities - outsourcing, consolidating, automating, process simplification, etc. -comparing cost to benchmarks where available.

Objective: a budget prioritized basis relative value generation

Best Practice Tip

Cost categories such as T&E, advertising and IT projects are often looked to as prime areas for discretionary cost reduction. However, some of those expenditures may generate much greater value than others in cost categories considered non-discretionary.

If you aren’t clear on the activities that are core to the business’ success it is crucial that you work through that first to avoid making cuts to activities that might prove to have significant unexpected consequences.

1) Threshold budgets could be set basis benchmark standards where available

2) Combination of ongoing activities and project-type activities

VBB Process Overview (2)


4. Define increments (cost and headcount) of optional activities (notionally 10-15% of original budget per increment) up to the current budget level.

5. Rank order incremental activities by value to build to the targeted overall budget limit.

6. Increase departmental budgets to fund the most valuable composite set of incremental activities.

7. Establish reporting and management processes to achieve budget compliance and to modify budgets as business conditions change.

Best Practice Tips

Sound estimates of the cost and value of each activity are required for proper comparison. The rationale behind cost and value must be robust enough to withstand challenge.

However, while the estimates should be fact based to the maximum extent possible, some estimates will be necessary to avoid investing excessive time in the VBB process.

The Finance organization should provide guidelines and standard factors for use in estimating cost and value.

Beware of bias in the selection and evaluation of activities. Many activities may be viewed as critical and/or highly valuable simply because they have been performed for a long time.

Case Study


Caseco revenue is expected to decline in the next fiscal year as they respond to aggressive competitor pricing. The Caseco CFO has determined fixed cost must be reduced by 10% to met target profitability.

Approach A – Cut and CopeEach department reduces their current budget by 10% without consideration of potential impact on sales, quality and workforce.

Approach B - Modified Zero Base BudgetingThe organization builds their 90% budget to fund the best combination of activities based on enterprise value.

Start with a threshold level (minimum acceptable spend) at ~50% of total budget and then build up to 90% with increments of 10% to 15%.

The CFO believes VBB will allow Caseco to meet the target without destroying value.

Threshold Budgets


OriginalBudget

Threshold Budget

Threshold as % of Original

Finance $1,250 $ 700 56.0%

Logistics 1,850 1,100 59.5

Sales 2,175 1,300 59.8

HR 1,750 1,000 57.1

Manufacturing 975 525 53.8

Total 8,000 4,625 57.8

Caseco establishes departmental threshold budgets to cover critical, core activities (generally 50-60% of current budget/spend.)

Each department then defines the set of activities that can’t be performed at the threshold budget level and calculates the cost and benefits for each of those activities.

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Building Out the VBB BudgetSelecting Incremental Activities with Greatest Net Value

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Activities ranked from

highest to lowest value

Add activities with positive value up to budget limit

Org and

Increment

Proposed Activity Cost Net Value Cumulative

Budget

Total Threshold Budget 4,625.0

Finance 1 Maintain billing and collection staffing to maintain/improve DSO 100.0 400.0 4,725.0

Mfg. 1 Upgrade vibration sensors 100.0 375.0 4,825.0

Finance 2 Maintain staff for business performance reporting 150.0 350.0 4,975.0

Logistics 1 Maintain overtime level to maintain on-time delivery rate 250.0 350.0 5,225.0

HR 1 Retain staff required to support performance management process 175.0 325.0 5,400.0

Sales 1 Maintain full sales staffing levels 200.0 325.0 5,600.0

Sales 2 Upgrade portal for customer self-serve 100.0 300.0 5,700.0

HR 2 Upgrade portal for employee self-serve 300.0 250.0 6,000.0

Finance 3 Upgrade invoice scanning software to reduce contract invoice processing 200.0 200.0 6,200.0

Logistics 2 Maintain plant and equipment at current level of spend 300.0 250.0 6,500.0

Mfg. 2 Maintain rotating equipment at current level of spend 100.0 175.0 6,600.0

Logistics 3 Upgrade routing software 200.0 150.0 6,800.0

Mfg. 3 Maintain tanks at current level of spend 100.0 150.0 6,900.0

Sales 3 Add sales support staff 200.0 100.0 7,100.0

Finance 4 Retain staff required to maintain account reconciliation 100.0 70.0 7,200.0

Sales 4 Continue in-store promotions for low-growth products 200.0 55.0 7,400.0

Sales 5 Maintain annual sales recognition program 175.0 50.0 7,575.0

Mfg. 4 Retain contract electrical inspector 50.0 25.0 7,625.0

Mfg. 5 Upgrade blend analyzer 50.0 20.0 7,675.0

Mfg. 6 Continue use of roaming operator during off hours 50.0 -10.0 7,725.0

HR 3 Retain in-house physician for on-site medical services 275.0 -25.0 8,000.0

Comparing the Resulting Budgets


Cut and Cope Budget VBB Budget

InitialBudget

10% Cut

Revised Budget

Initial Budget

VBB Cut

Revised Budget

% Change

Change vs C&C

Finance 1,250 125 1,125 1,250 - 1,250 - 125

Logistics 1,850 185 1,665 1,850 - 1,850 - 185

Sales 2,175 218 1,957 2,175 375 1,800 17% -157

HR 1,750 175 1,575 1,750 275 1,475 16% -100

MFG 975 97 878 975 150 825 15% -53

Total 8,000 800 7,200 8,000 800 7,200 10% -

Value Reduction 1,158* 115

* Cut and cope value reduction reflects best case scenario with some partial activity reductions. Worse case scenario would result in nearly 1,600 in value reduction.

The two approaches result in dramatically different budget allocations

Key Considerations in Implementing VBB


• Don’t wait until you need to cut the budget to implement VBB. Start well in advance of the next budget cycle to build an understanding of cost and value drivers.

Consider a pilot involving one or two departments to build understanding and validate the benefits. Finance is often a good starting point as the pilot helps them develop expertise to support others in a broader implementation.

• Management reporting should be modified to periodically update the cost and value of the incremental activities. This may require some form of activity based costing however we don’t recommend ABC without activity based management.

• Finance should ensure cost and value are calculated correctly and consistently so options can be properly compared. This may mean Finance must be more involved in working with the business in building the budget.

• Reward and recognition systems may need to be updated to drive behavior consistent with optimizing enterprise value.

VBB Concerns


There are several potential issues that must be considered and addressed as appropriate before launching into VBB

• VBB may require significantly more managerial effort than the current budgeting approach, particularly in defining incremental spend alternatives and determining their associated value

• It may be difficult to assign economic value to “intangible” activities such as R&D, advertising and community relations

• Strong leadership is required to deal with significant reallocations of funding and staffing and to prevent gaming

• Requires additional support from Finance for valuation of alternative activities and budget integration

If done well, improvements in enterprise performance and organizational alignment more than justify the additional effort involved in VBB.

For More Information

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Steve FinkelsteinSenior [email protected]

Doug GrovesFinance Practice [email protected]

To learn more about Modified Zero-Based Budgeting please contact:

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