By Dr. Albert D. Bates
It is not that budgeting itself is wrong. It is simply that budgeting alone does not seem to improve profitability. Budgeting must be augmented with a Managerial Profit Plan. Fully implemented, this plan has the potential to help firms dramatically alter their financial results.
This article will examine the nature of traditional budgeting versus using a Managerial Profit Plan. It will do so by looking at two different issues.
• The Problems with Traditional Budgeting – An explanation of how the budgeting process too often leaves the firm in virtually the same financial position as before.
• Developing a Managerial Profit Plan – An examination of how the firm can develop an improved process to actually improve profitability.
The Problem with Traditional Budgeting
The problem with traditional budgeting is two-fold. First, it is top down in nature; second, it involves a lot of trees and not much forest.
Top Down Approach – Typically a budget is prepared by starting with sales and working down through the line items in the income statement. Nothing could be more logical. The firm plans sales, then cost of goods sold. Subtraction produces gross margin. Next, expenses are planned. Finally, profit is whatever is left over when expenses are subtracted from gross margin.
The problem is that profit becomes a residual factor. It is, in fact, whatever number is produced after all of the subtractions are completed. There is no real focus on improving profitability.
Trees, Not Forest – Budgets tend to be extremely detail oriented. Almost every budget has at least 20 expense categories. Budgets with 50 items are not all that unusual.
At some point such detail is essential; however, in the real planning part of the financial improvement process such detail gets in the way. It is essential to understand the nature of the forest before reviewing the individual trees.
Developing a Managerial Profit Plan
The function of a Managerial Profit Plan (MPP) is to determine where the company is going regarding profitability and how it will get there. Within that structure there are two elements. The first is to plan profit. The second is to focus on the Critical Profit Variables to the near exclusion of everything else.
Exhibit 1 reviews the process by looking at the performance of a typical MHEDA member based upon the DiSC report. The exhibit presents the income statement for this firm along with total assets and return on assets.
The firm has sales of $20,000,000 on which it generates a profit of $400,000, or 2.0 percent of sales. To generate this level of sales and profit, the firm invested $8,750,000 in total assets. This result is a pre tax return on assets (profit before taxes divided by total assets) of 4.6 percent.
The remainder of the exhibit demonstrates the structure of the financial portion of a Managerial Profit Plan. Each financial action needs to be supported by an action plan as well.
Plan Profit First – The left side of the exhibit presents a suggested sequencing of actions in the plan. The very first step that needs to be taken is to determine a profit requirement. This is a decision for top management. It cannot be off loaded to the accounting staff.
Profit First Planning overcomes the problem of profit as a residual. It forces the entire organization to focus on how much profit must be generated. It is absolutely essential to success.
For the typical MHEDA member in Exhibit 1, the firm is planning to increase its ROA from the current 4.6 percent to 7.0 percent. This reflects a philosophy of slow, but steady improvements. Assuming that the asset base does not change, dollar profit increases from $400,000 to $612,500 ($8,750,000 times 7.0 percent).
The Critical Profit Variables – At this point, a very logical and real question emerges: “How are we going to get to that profit level?” The answer is not by developing a 50-line budget; that will come later. The real answer is to focus intently on three critical items, what are commonly referred to as the Critical Profit Variables. There are the three that matter most.
The first of the CPVs is sales growth. The one requirement to planning this item is to develop a conservative sales forecast. That means a sales increase that the firm is close to certain it can achieve.
In Exhibit 1 the firm is planning on 5.0 percent sales growth. This figure includes inflation, growth in the overall market and any gain in market share the firm may enjoy.
It is important to note while the firm may well think a higher growth rate is possible, it is essential to temper such expectations in the financial plan.
As with every one of the CPVs the financial plan must be supported by a corresponding managerial plan. There must be an explicit statement of how the sales goal is going to be achieved. Again, this is a top management issue.
The second of the CPVs is the change in the gross margin percentage. In virtually every industry the gross margin percentage is the key driver of financial performance. MHEDA is no exception. In planning gross margin, the same philosophy as was used for sales growth applies. The firm should plan on only a modest increase. Luckily, a small increase produces large results. The exhibit shows an increase from 31.0% of sales to 31.2%. Once again a supporting plan for getting there is required.
The final CPV is the control of payroll. Here an almost universal improvement factor: Sales needs to increase about two percentage points faster than payroll expenses. This forces the firm to leverage payroll expense effectively. Since sales increase by 5.0 percent in the example, payroll can only increase by 3.0 percent.
The rest of the plan, pardon the phraseology, is simply plug and chug. Total expenses must equal gross margin minus profit. Non-payroll expenses must equal total expenses minus payroll.
At this point the plan can be turned into a 30-line budget, a 50-line budget or even a 200 line one. What is essential is that before the final budget is set, management must put together a comprehensive plan that emphasizes profit improvement and control of the Critical Profit Variables.
For the overwhelming majority of firms, budgeting as practiced has not resulted in significant improvements in profitability. A Managerial Profit Plan must be constructed well before the detailed budget is developed. If the plan is properly thought out and supported with an appropriate set of action steps, almost every firm can generate greater profits.
Albert D. Bates, Ph.D., is president of Profit Planning Group, located in Boulder, Colorado, and on the web at www.profitplanninggroup.com.