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  • Laresa McIntyre, CMA, MBA
    Senior Finance Executive ~
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Pay it Right

I’m currently reading “Discovery-Driven Growth” by Rita McGrath & Ian McMillan and came across this quote which I thought was so appropriate for today’s post:  “Whenever you see someone doing something really stupid in business, there’s a good chance that he thinks he’s being rewarded for it.”  We all know this scenario and it doesn’t usually turn out well for businesses.  We want people to go left but they go right.  And sometimes it’s because we set the cheese at the end of the maze on the right, not the left.  Our fault.  How do we fix the problem?  We need to look at the way our pay and incentive programs are set so we encourage the behavior necessary to make the business successful.

Incentive programs at many companies are still tied to the static budget.  You may recall in one of my earlier posts I said the budget represents a best guess about where the business will be, given the set of assumptions made at the time the budget was created.  Tying the budget and bonuses together makes the budget even more suspect as to its value.  This is because it inevitably leads to the back-and-forth negotiating that is such a frustrating exercise during the budgeting process.  Because employee bonuses are tied to achieving a static number, employees are motivated to get the number as low as possible to make the task involved in getting the bonus easy.  Management, on the other hand, has business growth in mind and wants to set the target as high as possible to gain the most.  What we end up with is a compromise of something in between that doesn’t reflect employee capabilities, company capabilities or economic conditions.

What if, instead, we structured the incentive program so it was based on the attainment of short-term goals actually related to the strategic plan of the business or on relative measures of growth year-over-year?  This type of setup keeps employees focused on the things that are important to the company and would eliminate the frustration employees often feel when they know getting to the static budget number is not possible.  For example, if the company wants to grow sales year-over-year, the bonus program could be set so for every 2% in sales growth achieved, the employee receives 5% of their salary as a bonus.  What if we also said there was no cap to the potential bonus a person could achieve?  Do you think the employee would be more motivated to do the things needed to grow the business if they know they will benefit from their efforts?

Now, I know there are pundits out there who will say money isn’t a good motivator and things like promotional opportunities and a good working environment are equally, if not more important, in keeping a work force happy.  I will not disagree these are important.  But for those of you familiar with Maslow’s Hierarchy of Needs, you know getting to the higher levels of the pyramid (love, belonging, self-esteem & self-actualization)  is not possible until you take care of the base needs like food and shelter.  The only way this happens is if you have money to pay for those base needs so they are no longer a concern.

One note about structuring an incentive program around relative measures like year-over-year growth — it is essential the business evaluate the current economic conditions to determine if an adjustment to the base figure is necessary.  This is especially true in situations of large economic downturns or upswings.  If you don’t adjust the base you are working from, you can create the same situation for employees as if they were measured against a static budget.  The number may just be unattainable and the same frustration levels and lack of motivation will return.

Being Flexible: Using a flex budget

As mentioned in last week’s post on budgeting, the issue with the static budget is that it is out of date before the first month-end makes its appearance.  When this happens, a tremendous of amount of energy is spent month after month “explaining the numbers” when they may not need to be explained or can be explained in much simpler terms.  The solution is flex budgeting.  A flex budget is a budget where costs are adjusted based on changes in activity levels of the business like sales volumes or production output.

Flex budgeting actually helps on two fronts.  First, it will reduce the amount of time to prepare the budget once the model has been created.  Second, once the new budget year starts, it will ensure that more meaningful discussions are the focus of variance analysis instead of arbitrary line-by-line comparisons to a static budget that bears no resemblance to reality.

Preparing a flex budget model does require some upfront work but the end result is well worth the extra effort.  You will need to determine the nature of the various costs within your business.  Are they fixed, variable or step costs?   You will also need to determine what drives each of the variable and step costs.  Is it sales, headcount, machine hours or some other driver?  Once all of these determinations are made, the budget model can be built so it’s only necessary to update the assumptions about the values of the drivers and then many costs will be automatically calculated.  An examination of historical trends will help in verifying the relationships between drivers and costs.

Once the fiscal year starts, actual results are compared against the flex budget which is calculated using the budgeted assumptions and the actual value of the activity level (usually sales volume).  By doing this, there is no variance between actual and budget for sales, and the focus of any analysis work can center around costs.  Yes, it is important to understand why sales differed from what we budgeted but with a flex budget that discussion can stand on its own.  There is no cross-contamination between sales and costs to muddy the analysis waters.  And without complicated analysis work, everyone can get to the root cause of cost issues and how to improve the bottom line much quicker.

A word of caution here — DO NOT take the easy way out and build your budget model so everything is calculated off of a single driver like sales volume. The predictive and analytical value of the flex budget goes into a nosedive when you do this. Take, for example, benefits which are directly related to the number of employees on staff. Yes, there may be an indirect correlation between the cost of benefits and sales volume since a certain number of people are needed to support sales.  But since the number of people needed will probably stay constant over a certain range of sales, the cost of benefits is not a 1:1 ratio when compared to sales.  Therefore, calculating benefits as a percentage of sales will not give you a meaningful number to compare against actual spend.  You are far better off spending the time to have the model first determine the number of employees for the sales volume and then calculating the benefits cost based on the number of employees.

If you are interested in seeing how this all comes together, I’ve created a spreadsheet example that you can access here: How the Flex Budget Works

This is a simple introduction to the concept.  A good flex budgeting model is very robust and requires everyone in the business to determine how revenues, costs and other drivers come together.  This deeper understanding ensures that the focus of each person is on how to improve the bottom line.

Up next:  The Balanced Scorecard

New Year, New Budget … but is it the right tool?

There is always something exciting about starting a new year.  It’s like having a clean slate so to speak.  Oh, it doesn’t mean that what has happened to you in the past disappears but it’s a point from which to start measuring new challenges and new initiatives.  This is true whether you are an individual or a business.  Individuals use resolutions to set up these challenges and initiatives, many of which will fall by the wayside before the end of January.  For a business, it often means the beginning of a new budget and that too can fall by the wayside quickly.

A budget can be a dangerous business tool when its weaknesses are not well understood and too much faith is put in it.  The budget that was created last year, after many months of work, represents a best guess about where the business will be this year given the set of assumptions made at the time the budget was created.  But we all know that the assumptions can become skewed or change as the economy ebbs and flows.  And as a result, measurement against a static budget isn’t always going to lead you in the right direction.  So what do you do to avoid the budget becoming a wasted effort and the nemesis of everyone in your company?

I recently read “Beyond Budgeting”, a book addressing the weaknesses of the traditional budgeting process and how to combat it.  The authors promoted the idea that the budget can be done away with and gave a number of case studies attesting to the success of this method.  However, the budgeting process is so deeply ingrained in the American business psyche that only a handful of companies will ever be able to achieve this nirvana.  Instead, there are a number of tools that I have worked with in the past that can help make the budget more valuable and supplement it to drive growth.

  • Flex budgeting
  • Balanced scorecard
  • Benchmarking
  • Incentivizing the right way

I will be discussing each of these tools in posts throughout the coming week starting with flex budgeting.

Wishing everyone a Happy and Prosperous New Year!