Dynamic budgeting takes center stage

Driver-based budgeting is having a moment. A growing percentage of CFOs are using the method, maybe 20%, according to The Hackett Group, but many more are exploring it, putting it next to zero-based budgeting, among other approaches, as something that might improve their process. As it’s understood broadly, driver-based budgeting is a way to allocate resources to achieve goals by tying the budget to what drives an organization forward, although how that's done in practice can vary. To understand how DBB looks from one perspective, we talked with Tom Seegmiller, vice president of financial planning and analysis (FP&A) at Vena.

Ramona Dzinkowski: Can you explain what we mean by driver-based budgeting and how it differs from traditional budgeting?

Tom Seegmiller: Driver-based budgeting links real resources and activities to your budget, and most FP&A organizations are striving to achieve that. From my perspective, it really acknowledges that the budget is the articulation of a series of operational items or activities. It's different from traditional budgeting in that it shifts the focus to outcomes, and that's ultimately how you drive your annual budget. It also shifts the focus of ownership from finance to operations and ultimately [to] all parts of the organization, versus traditional budgeting, which tends to be a more finance-heavy activity. 

Dzinkowski: What are the steps in implementing this type of budgeting?

Seegmiller: It's going back to a whiteboard, to be entirely honest with you. But chances are, if you're sitting in the FP&A world, you already probably have a pretty good understanding of what drives the business. It starts with what we think the activities and resources are that push the business forward. Whiteboard out what you think those drivers happen to be. Then you're going to have to build a model that yields a financial output. The first time can be very challenging for organizations. So, I think it's really important to acknowledge that you're not going to necessarily have measured all of these metrics historically and you won't necessarily have a database to draw on. These metrics will need to be built up based on monthly operational reviews; you’ll have the opportunity to refine your inputs during future iterations of your forecasts. 

Dzinkowski: What are some of the other challenges involved in DBB? 

Seegmiller: The biggest challenge is that getting all the data and factors to consider can be time-consuming. However, one of the greatest outcomes to expending all of that time and effort from an FP&A perspective is that you get an intimate understanding of the internal operations of the business. This allows you to spot many more opportunities and risks, and helps to either mitigate those risks or capitalize on those opportunities. It ultimately acts as a catalyst for budget owners to be calling on the FP&A team for their insightful, value-added insights. 

Dzinkowski: How can DBB impact working capital efficiency? 

Seegmiller: If you think of a quote-to-cash process in a business-to-business (b2b) environment, for example, you need to understand the drivers that will ultimately lead up to a sale. For example, how many leads need to be generated? What activities need to be undertaken by sales? What is your typical time to close a sale? Those sorts of things are going to drive your timing of sales. So, if you understand how an opportunity ultimately moves through your sales funnel, it should give you a really good indication of when your finance team can start to begin their collection process. Then you're going to layer on driver-based activities like time-to-collect against accounts receivable (AR) balances to ultimately forecast your cash flow.  

Dzinkowski: What are some of the less tangible benefits resulting from the DBB process?

Seegmiller: Creating these drivers forces a great deal of collaboration within the business and also forces you to formulate better plans as to how to improve those metrics in the future.  Constantly measuring these metrics, or drivers, that you're loading into your plan, and understanding what the business is doing day in and day out, will improve your assumptions and get a tighter plan that more accurately represents reality.

Dzinkowski: How can this help CFOs manage costs at a time when this is top of mind for them? 

Seegmiller: What it can do in terms of rationalizing dollars is help make sure you're placing your investments in the areas that yield the greatest return for the organization. Instead of deploying cash broadly and hoping it yields, CFOs can place more targeted investments through having a more intimate understanding of how their investments will materialize. Through targeting specific drivers, it’s easier to run multiple scenarios to ultimately determine what creates the best outcome and permits a CFO to more easily navigate a cash constrained environment. 

Dzinkowski: What are the top four things CFOs need to understand about DBB? 

Seegmiller: First, I think CFOs need to realize that DBB massively increases predictability in your business and that’s a huge factor. Second, they’re going to shift the ownership of the budget from a finance-owned activity to a business-owned activity and this increases buy-in within the business. Third, it's going to elevate your finance organization, because you’ll have a much deeper understanding into actual operations. Finally, it's going to be much easier to complete your analysis on a regular basis. Traditional budgeting feels like you just happen to have a number in a period, and that's the budget. In driver-based budgeting, when you've thoroughly documented your assumptions and how you created that budget, it's way easier when you get six months into the year to explain any variances. You're looking at those underlying details and it’s thorough enough that you can say, “Here's what's diverged from plan, and here’s the exact impact on the business.”

As enterprises search for ways to cut spending and forecast demand in unpredictable times, zero-based budgeting, and its subset, category management, are back in style.

Together, they mean a company takes every line item in every category and justifies its existence. It's "building from the bottom up, the true category demand and specifications as opposed to relying on historical patterns," McKinsey partner Samir Khushalani said.

This is especially relevant now, when historical metrics don't necessarily apply. The pandemic is "causing us to totally rethink our category strategies both in terms of what we are buying and how much of it do we need," Khushalani said. "Everything's changed."

Enterprise can go beyond cutting just discretionary spending, if they put in the work to completely rethink how they spend money.

Old tactics work today — if done right

Zero-based category management isn't new, Tradeshift chief procurement officer Roy Anderson, who has worked in procurement for more than 40 years, said. Early in his career, Anderson worked at defense contractor Raytheon, when the U.S. government cut military spending through zero-based budgeting.

"You go into an area and say, 'You have no budget. Prove to me you need one.' For every item, you have to build up as if you were starting the company from scratch," he said. "It's horribly painful and amazingly impactful."

The "horribly painful" part is why it's not practical to do every year, or even every other year.

Starting from zero and proving every cost in every category takes an enormous amount of time, effort and energy, said Kent Mahoney, senior vice president of Proxima and commercial leader for the North America division.

The process also must have buy-in from management. And it must include training on how to zero-base, along with dedication to stick to the process, even when cutting corners — such as using historical forecasts to determine costs — might be tempting.

"There's an ongoing investment of time to ensure people don't lose the mindset of zero-based budgeting as they go," Mahoney said. Otherwise, costs will start creeping back in and employees will "revert to using last year's budget as a zero baseline."

Most enterprises are doing some form of zero-based budgeting if they are cutting discretionary spending, Mahoney said. "With COVID, it's like everyone's become a zero-based budget organization overnight whether they know it or not," he said. "A lot of organizations have organically found their way to their minimum operating cost right now. They've done so not necessarily with the rigor and level of process that actually implementing zero-based budgeting would entail."

Too little, too much or just the right spend

Just as it's easy to cut too little, it's also easy to cut too much, or not take the full picture into view.

When the Jimmy Carter administration did zero-based category management, it went too far in some cases, Anderson said. A 10-year program was cut halfway in, so the federal government still had to pay for some of those costs, "and get nothing for it," he said.

For private enterprises today, it means seeing how all costs hook together. It also entails "strategic spending so you don't miss out on growth opportunities once we emerge from the crisis," Mahoney said.

Consolidating or cutting spend too quickly can lead to hiccups. If companies consolidate their IT implementation with one firm, they may eliminate smaller, niche providers needed to keep things rolling, Mahoney said.

Consider all pieces of the spend puzzle

Applying zero-based category management can also help firms map out their costs, even if that means additional spend in some areas.

Companies that have consolidated their real estate portfolios during the pandemic may assume they're saving costs in workspace overall, Khushalani gave as an example. However, their facilities management needs don't also scale down.

Instead, costs for cleaning and personal protective equipment have risen. Also, if the enterprise is providing things like printers, desks, VPN connections and better Wi-Fi for workers at home, and has a bigger software and cloud spend to keep operations going, real estate lease savings may be much smaller than initially imagined.

Zero-base category management also means rethinking vendors, Khushalani said, especially if the nature of the company's business has changed at the hands of the pandemic. "When it comes to something like marketing, if you're not using the right agency, it could be an existential threat," he said. Every piece of the puzzle needs to be considered.

When asked about risks of doing zero-based category management and zero-based budget right now, Khushalani said, "I see a financial risk in not doing it," adding, "If you don't, what you come up with is an inaccurate estimate of demand and an inaccurate estimate of your requirements. It creates a lot of havoc down the road. This is time well spent."

If you're not using zero-based budgeting in your accounting function, it may be worth considering; the method forces business leaders to look at their spending with fresh eyes, budgeting experts say.

Under zero-based budgeting, instead of using last year's budget as a baseline and adding money for initiatives on top of that, you build your budget from scratch. That way, you review existing expenses before moving them to next year's budget.

"It forces people to really justify their spending on a year-to-year basis," Gregory Panik, vice president of FP&A at International CTDI, a communications engineering company, said in a CFO.com webinar.

Panik said the budgeting approach could lead to a more reasonable IT spend by giving a tech executive a more nuanced view of what the business needs.

"Many times, our IT services will say, 'I need 99% on-time and I need it 24 hours a day, every day of the week,'" Panik said. "When you take a hard look at what it costs to provide that level of support, people start to step back and say, 'Oh, wow, I didn't realize it cost that much,' and it forces you to think about why that expense is on board."

Major undertaking

Moving from traditional to zero-based budgeting is neither easy nor cheap, so company leadership must initiate the change, the budgeting pros said.

"It's going to take about three years, on average, to really refine and hone it," said Chris Vanacore, controller of Ithaka, a nonprofit technology platform for academics. "It's going to change the culture of your organization."

That's because it requires buy-in from all operational heads of an organization: HR, IT, product, sales and so on. These department heads have to look at their existing programs and come prepared to defend them and anything new they want to get, so the process requires more effort and time.

"You will get push-back from each of the operation [heads] who still want to go with that traditional budget approach," Panik said. "You ask them to cut back to their original budget, you fight for a little bit, and then you move on. This [by contrast] is much more business-centric, much more tied to the P&L for understanding what is the benefit to the organization for every dollar of spend."

The benefit, though, is better alignment between what the organization is spending and its goals.

"Managers are hesitant at first," Vanacore said. "I think they view this as a way to just come in and cut expense. Well, that's not really the priority; the priority is to better understand all of our expenses in terms of the value they bring in. ... If we were to cut project XYZ, what would be the impact? That helps bridge the gap. It could be, 'Well, we can live with that,' and that's how you can begin to break down some silos."

Easier with cloud system

Because the method relies on operational leaders digging into their annual spend, zero-based budgeting works best when it's built on a cloud-based system, which gives executives the ability to access, share and analyze their numbers at any time.

You can switch to the new system even if you're still using Excel spreadsheets, but you'll have to devise a way to give operational leaders what they need in a format they can use.

"The real difference is the data itself," said Panik, who transitioned to a zero-based system while he was a finance executive at Campbell Soup Co. and used the system at Deutsche Bank and at CTDI. "We used a hybrid approach, and we had strong enterprise resource planning (ERP), and reporting modules sat on top of it."

Beyond transition

To benefit from the system after putting it in place, help operational leaders use and review their numbers. 

Vanacore suggested operational leaders look at their spend in terms of ranking. Line up all the programs the division spends money on and rank them in order of importance. Once a decision is made on what organization-wide spend will be for the year, the operational leader will know what to eliminate if cuts are needed.

"Go down to the bottom of the rankings — that particular expense that ranks 28th out of your list of programs and that returns very little or even has a negative value,"  Vanacore said​. "Instead of giving everyone an unfair across-the-board 5% cut, why don't you just cut that 28th project? If the dollars still don't add up, cut the 27th project, too."

Panik suggested trying an incentive system, which would give operational leaders a concrete reason to stay on top of their spending and be prepared to make tough choices each year.

"I don't know if you have alignment of the budget tied to your incentives, but that is always a wonderful way for people to get in the spirit of being accountable for their budgets," he said. "If people don't have skin in the game, they will continue to ignore it and just expect someone to come yell and scream at them or pull them into a meeting [but without any penalty]. People are willing to take that risk in some cases."

Access "Beyond the Baseline: Best Practices in Zero-Based Budgeting."

If you don't already use a rolling budgeting process, implement one gradually and allow your finance team time to adapt, consultants said in a CFO.com webinar.

A rolling process covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated monthly. It's used in place of a static, annual process; some companies have even eliminated their formal annual budgeting process after putting one in place.

As you update your budget with the latest monthly data, the data from the earliest month of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

That ensures you're always looking at the most current information, the consultants said. That gets you as close to real time as possible, and it's going to give you more accurate and informed decisions than if you were just simply to look at a static, months-old annual budget.

Best practices

Rolling forecasts are considered a best practice, and today, about 60% of world-class companies use them, said Miles Buntin, director of enterprise performance management ​(EPM) transformation at consulting firm The Hackett Group.

Despite its popularity, the process is not yet commonplace. A Planful survey found 75% of companies still use an offline annual budget process, typically based on Excel spreadsheets, but a survey conducted among the webinar attendees found that most of them wanted to make the transition in the next year or two.

Once the transition is made, rolling budgeting should save a company's financial planning and analysis (FP&A) team considerable time; the traditional annual process is notoriously time-consuming, involves most staff in an "all hands on deck" exercise, and leaves executives with data that quickly becomes outdated, the consultants said.

The rolling forecast can also help companies grab savings mid-cycle if expenses or revenues change, said Maria Cherry, a Planful senior financial analyst.

"If something comes in a little higher, you can adjust for that in real time," Cherry said. “If something comes in lower, you can reprogram [your savings] to something you need."

Start small

To maximize efficiency, focus on big value-added areas of the budget cycle, the consultants said.

Unlike traditional annual forecasting, which typically uses Excel, rolling forecasts are principally based on third-party online platforms that provide analytical tools already built in.

Transitioning to rolling process is part of a broader move by companies to use cloud-based EPM platforms to improve their operational efficiency, Buntin said.

"Improved predictability is one of the strongest use cases for the deployment," Buntin said. "A lot of these new tools use algorithms to identify patterns, pull in data from outside sources, as well as internal financial and operational systems and — here's the key point — take out potential bias. These can vastly improve the accuracy and objectivity of your forecast."

Brian Kalish began working this year with a spirits company whose products were so popular it periodically underestimated demand and lost sales from a lack of inventory.

"They had no stranded inventory," Kalish, a financial planning and analysis (FP&A) consultant, told CFO Dive. "They sold everything they could make."

Kalish said the company was on the classic Dec. 31 calendar-year close. "They were forecasting to the wall," he said. "They went into the budgeting process in late September, early October, to put together the budget, plan and forecast, but they weren't really getting a lot out of it. It was just more variance as they went through the year."

Absent accurate forecasts, the company could never be sure it would have enough product available to meet demand, he said.

"They were basically looking over what had happened the last 12 months, [made] a best-guess growth estimate, and assumed that’s how they were going to do it," Kalish said. “And it wasn’t bad. But the problem was stock-out. All of a sudden, orders were coming in and they just couldn't fill them as efficiently.”

His prescription: Replace their static, 12-month forecast with a rolling 12-month forecast, updated quarterly.

Longer shelf life

A rolling forecast covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated at regular intervals. As you update your forecast with the latest monthly or quarterly data, the data from the earliest month or quarter of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

"By going to a rolling forecast, it gave them a much better idea, not only because they could see their internal information but because we structured it so they could start bringing third-party information in there," Kalish said. "All of a sudden, you can start seeing ramp-up."

The transition has been easier than it might have been, he said, because the company was ready to make a big move. "To make any of this work, you have to have four pillars: culture, process, people and technology," he said. "They wanted to go from having pretty immature to world-class analytics, so that's a beautiful situation to walk into. It's not a question of convincing someone."

The company is 25 years old, sells globally, and its finance function used Excel and an enterprise resource planning (ERP) platform. After conducting an audit to identify the tools and processes the finance operation was using, Kalish changed the company's architecture on the data analytics side and brought in a cloud-based tool for forecast planning and budgeting.

"What you don't want to do is what we call a lift and shift, which would be taking the [Excel] process and doing it in [a cloud] environment, because then you're missing 95% of the advantage of bringing on the new technology," he said.

Go for small wins

Kalish said it's unnecessary for a company to transition its entire forecasting process to a rolling system at once, especially if you're a larger company with multiple lines of business. In such cases, it can make better sense to pick a discrete line of business and forecast just that part on a rolling basis.

"It's always a challenge if you try to do something enterprise-wide, so I always argue, make little bets and wins and let them build, so there's nothing stopping you from doing it in parallel," he said.

Once you have a pilot underway, you can compare the rolling forecast to the old, static forecast to see whether you're getting more accurate numbers. "You can go back and model it," Kalish said. "These were the numbers we had the previous 12 months, say three years ago. What would the model have been that we constructed going forward?"

The spirits company is small enough that it made sense for it to transition its forecast as a whole. "They had no problem going all in," he said.

You also don't have to include in the forecast all of the data you're watching; you only need to include metrics that are actually driving your business. "You don't need to include things that aren't going to impact the company, aren't going to cause a decision to be made," he said. "You don't have to forecast them as frequently as something that has a much greater impact."

People focus   

In addition to transitioning the process and tools, you have to transition the people and, in some cases, that can mean rethinking whether the people who are most adept at using Excel are best positioned to manage the forecast under the new system.

Kalish said he worked with a long-established insurance company that saw the transition as a way to cut its finance staff. The new system required fewer people because so much of the work was automated, but the company erred by keeping its most experienced Excel staff.

"They found out shortly after these weren't the right people because they didn't have the skill set," he said.

The company ended up letting the Excel specialists go and hiring back some of the people originally laid off. "Some had moved on, of course, and they basically had to go out and find new talent," he said.

At the spirits company, the CFO will hire a director to oversee forecasting under the new system. It will either be an existing finance manager or a new hire, depending on internal personnel matters, but having someone who can oversee the system is key, particularly during the transition. The first year tends to be labor intensive, because you're asking your finance team to update the forecast every quarter, when in the past, they only had to do so once a year. 

"If someone tells you it's not going to hurt, they're lying," he said. "It's painful. At first, people are going, 'You're asking us to do four times as much work if we do this on a quarterly basis.' But the point is, you have to look at the whole year, because what happens is, when you get to September, you've already done it. You're just going to push yourself out 12 months.

"The beauty is," he added, "you build it once and you get better and better at it, get better information in it. When you're looking at your forecast, your next 90 days should be more accurate than your second quarter, your third quarter, your fourth quarter. And that's always rolling forward. And if you have not just the proper processes but the proper culture, you get your forecasts in a more timely, efficient and, arguably, smarter way."

Putting together your annual budget and forecast are among the most time-consuming exercises your finance and accounting teams undertake, and yet these planning tools tend to become outdated quickly when they're put together using a traditional, snapshot-in-time approach.

That's why financial planning and analysis (FP&A) consultant Carl Seidman recommends you transition to a more dynamic process by producing a rolling forecast.

"These dynamic forecasts are not replacements for annual budgets — they are complements to them," Seidman has said. "Static budgets are generally inflexible and reactive. They are time consuming to build and update and quickly become outdated after only a short time. They often aren't utilized effectively, thus causing employees to lose faith and not take the budgeting process seriously."

A rolling forecast covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated monthly. As you update your forecast with the latest monthly data, the data from the earliest month of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

Seidman, an adjunct faculty member of the American Management Association and a longtime FP&A specialist, points to research showing that organizations are better at leveraging the financial and operational data they collect to predict trends when they use a rolling, instead of a static, forecast.

"With the advent of big data, more companies are able to utilize their information to perform analytics, identify drivers of performance, and make better business decisions in real time," he said.

8-step process

You take a risk any time you transition from a long-held practice, so Seidman recommends you give yourself sufficient time to implement the changes. "It should be done in a sequential order to avoid missteps and rework," he said.

Here are the transition steps he outlines:

• Objectives. Start with your goal in mind. "The individuals tasked with building and managing the rolling forecast should be clear about its objective," Seidman said. To identify your goal, try to answer questions such as, Who will be relying on the forecast? What business decisions will be made using the forecast?
• Time horizon. Determine how far into the future you want the forecast to go. "The further out into the future, the more insightful the forecast may be, but the less accurate," he said. In addition to the time horizon, you need to set what Seidman calls forecasted increments. "Will the forecast look into the future one week, one month, one quarter, or one year at a time?" he said. The longer the increments, the less detailed they will be, but the less frequently they will need to be updated, he said.
• Level of detail. Seidman calls for setting the level of detail based on the importance of the decisions being made using the forecast. "If the consequences of a bad decision are large, more time and effort must be spent to improve accuracy," he said.
• Contributors. Limit who takes part in the forecasting process to people who can contribute insightful, unbiased intelligence. "Participants should be empowered to contribute and held accountable to achieving or failing to achieve targeted performance," he said.
• Elements of value creation. Seidman recommends limiting the elements that get updated each increment to quantitative and qualitative indicators you've identified as value-drivers. "Assess what dimensions of the business are most important to its success rather than focus on every line item in the chart of accounts," he said.
• Vetting. Before you include a data source, be comfortable with its quality.
• Scenarios. Moving to a rolling forecast lets you test scenarios by asking what-if questions and then running the data, so Seidman suggests you make this part of your practice. "As new information becomes available or as assumptions change, the flexible rolling forecast can be easily updated and new scenarios can be run," he said.
• Tracking. As you would with a static forecast, you can assess variances between actual and expected performance, although with rolling forecasts, it's recommended you do this on an ongoing basis.

Ultimately, moving to a rolling forecast is about using the technology available today to better understand what's affecting your business. "It is no longer enough to install basic financial systems and employ someone to maintain them," Seidman said. "In a constantly changing world, companies must aspire to change with it."