Integrating Costing and Budgeting

A White Paper

Prepared by Armstrong Laing Group

Phone: +44 (0) 1565 687010

+1 888 374 4321

http://www.algsoftware.com

Integrating Costing

with Budgeting

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Executive summary

ALG Software provides a single solution for budgeting and activity-based costing

(ABC). This solution is based on business drivers, which unite the operational and

financial management of an organization and provide users with:

sophisticated analysis of the profitability of customers, products and

channels;

The ability to transform the annual planning and budgeting process by

adopting more sophisticated approaches such as driver-based budgeting;

more accurate approach to shared service costing, making it part of the

budgeting process.

Delivering this functionality seamlessly in a single solution both reduces the

administrative overhead in the finance function and improves the utility and

timeliness of information provided to managers, enabling them to make more

informed decisions, more quickly.

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Introduction

The financial performance of commercial enterprises seems to follow

a normal distribution. At one end of this bell curve are organizations

that deliver such awful results that they either fail or are acquired by

predators who feel able to deliver a better return on their assets. In

the middle of the curve we find the majority, companies whose stock

price follows the general index of their market. The few at the top

end of the curve seem to have the Midas touch, performing well at

everything they do. They are quick to detect and respond to subtle

changes in their markets, absorbing external pressures without undue

disruption and consistently delivering superior results for their

investors.

Some of these high performing organizations have charismatic

leaders and cultures of continual innovation; others have patented

technologies that give them a competitive advantage and the ability

to earn above average returns. In addi tion, there is increasing

recognition that high performing organizations rely on unified

Corporate Performance Management (CPM)

solutions to measure,

manage and monitor their financial and non-financial performance.

CPM is a catch-all term to describe the processes, methodologies,

metrics and technologi es used to manage performance. As such, it is

not new. Most organizations have many of the key components of

CPM in place; they produce plans and budgets and routinely measure

their progress towards their objectives. What is new to the debate

over the last few years is the drive to bring these key performance

management methodologies together.

There is broad agreement that the core methodologies are budgeting,

ABC, financial reporting and score-carding. Although the finance

function typically owns and manages these methodologies, CPM goes

far beyond the financial domain and unites key non-financial data and

traditional financial data. This key non-financial data is typically the

type of data that would drive line item expenses in a budget, cost

assignments in an ABC model or populate a score-card; sales

volumes, resource consumption rates and capacity utilization are all

good examples.

Also call ed Business Performance Management (BPM) and Enterprise Performance

Management (EPM).

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Another key aspect of CPM is that it is no longer simply concerned

with historical reporting and variance analysis. To add value, the

finance function needs to provide managers with information that

helps managers make better decisions that will improve tomorrow’s

financial performance. Simpl y providing variance reports of historic

financial performance clearly does not do this as it only shows the

financial outcome of some underlying issue. What is needed is insight

into the non-financial drivers of revenues and costs and enterprise-

wide models where all the data and the cause and effect relationships

are brought together. This way, managers can test out their

assumptions about the future and arrive at decisions that optimize

future profitability.

This is no longer just a vision. It’s a reality that ALG Software has

delivered numerous times.

The increasing adoption of activity-based costing

Many companies are still unable to report on product, customer and

channel profitability with the frequency they desire, even though this

information is critical for decision-making at both strategic and

operational levels. Activity-based costing (ABC) is into its third

decade and has been reported to help users deliver cost savings of

between 3% and 5% of their cost base and revenue growth of

between 5% and 15%

. It is only now that companies are seeking to

embed ABC across their entire organization. Prior to web-based ABC

applications, collecting and collating non-system driver data – such as

time-splits – was both time-consuming and laborious. But today

these issues have gone away, and analysts Gartner are predicting

that ABC will become much more widely adopted. The advocates of

ABC, who for many years perhaps thought themselves to be in the

wilderness, will be vindicated as thi s comes to pass.

There are a number of clear links between ABC and budgeting:

Forward looking ABC

Many organizations with ABC models have used their “what-if?”

functionality to test assumptions for their long range plans. However,

such modeling tends to be ad hoc and done by a single power user

rather than as a collaborative effort involving managers from across

the organization. Other than this, in most organizations ABC and

budgeting are totally separate.

Dave Boulanger, CFO Report, October 2002

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To maximize the value of their investment in ABC, companies should

not limit the scope of their projects to reporting on the historic costs

and profitability of products and customers. They should extend the

scope of their projects and run cost and profitabili ty reports on

forecast revenues and expenses, bri nging ABC and budgeting much

closer together. If compani es ran forecast expenses through their

models before their budget was signed off and before the spending

was committed to, most likely they would find numerous instances

where departments were planning initiatives that had an unforeseen

and detrimental impact on the profitability of customers, products

and channels. Providing a closed l oop between costing and budgeting

is one of the compelling arguments behind the whole CPM

propositi on.

Shared services costing

ABC is already being adopted to provide more reliable costing for the

cross charging of shared services. In organizations with shared

services units, costing and cross charging business units is an

essential step in preparing any budget or re-forecast. But it is

typically done as a separate exercise right at the end of the budgeting

process, leaving little time for further iterations. Ideall y, shared

services costing and enterprise budgeting should be part of a single

process so that responsibili ty managers can develop their plans and

expense budgets with visibility of their li kely cross charges, rather

than being hit with a large (and often crude) apportionment, when it

is too late to make any changes.

The deadlock with planning and budgeting

In most organizations, budgeting is limited to collection and

consolidation of line-item expenses. Typically, there is limited

integration with operational planning, so the resulting budget is not

based on any of the known relationships between demand, resource

consumption and expenses. Because bottom-up re-forecasting is

usually time-consuming, it is typically infrequent, so departmental

capacities can quickly become misaligned and visibility into future

performance is compromised.

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Furthermore, the growing adoption of packaged appli cations appears

to be delivering small incremental improvements rather than the

transformational benefits they promised. In an independent study

amongst the UK’s top 1,000 companies

, those using packaged

budgeting applications fared little better than the majority who were

still using spreadsheets. The table below shows comparisons on the

key measures:

Table 1: Comparative difference in budgeting and re-forecasting between

companies using packaged budgeting applications and companies using

spreadsheets

Companies using

packaged

budgeting

applications

Companies

using

spreadsheets

Time taken to complete the annual

budgeting cycle

12.4 weeks

13.3 weeks

Time taken to complete a mid-term

re-forecast

12.6 working days 12.3 working

days

Given the operational logic and causality the organization is well

equipped to move from ‘traditional budgeting’ – the collection and

consolidation of line item expenses – to a driver-based model that

integrates bottom-up operati onal plans with financial forecasts.

Today, most operational modeling is done outside of the enterprise

budgeting application. When operational managers are asked to

budget or re-forecast, they will first model the demands facing their

own departments, so that they can identify their resource

requirements and calculate the cost of these resources. So,

whenever a mid-year re-forecast is asked for, these model s have to

be updated and recalculated before a new set of line item expenses

can be generated and re-submitted. If the level of demand in a

department depends on the level of acti vity in a department up-

stream of them, the manager finds it difficult to begin their planning

and forecasting until they receive a reliable forecast from the up-

stream department. Waiting for this delays the whole process and it

is not surprising that so few organizations manage to re-forecast as

frequently as they would like.

The Re-forecasting Survey 2005 commissioned by ALG Software and sponsored by

the Chartered Institute of Chartered Accountants (UK). Available at

www.algsoftware.com

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Incorporating off-line modeli ng, and joining all the pieces together

with rules that span departments and time-periods, transforms

planning and budgeting. Managers simply review and update non-

financial data such as sales conversion rates, loss ratios, staff

productivity ratios and unit resource costs. The model then predicts

their line item expenses and they can either accept them or amend

them. This way of planning and budgeting is called ‘driver-based

budgeting’, ‘consumption-based budgeting’ or ‘predictive planning’.

With driver-based budgeting, the time taken to produce an annual

budget or a re-forecast is dramatically reduced. Organizations can

complete bottom up re-forecasts every month within approximately

three working days. Each manager spends a matter of minutes

reviewing and re-forecasting the key operational drivers that

determine their line items expenses. Indeed, many would argue that

using driver-based models is the only way to deliver enterprise-wide,

bottom-up, rolling re-forecasts every month.

More frequent re-forecasts bring significant benefits. At a time when

cost management is critical, more frequent re-forecasts force

managers to review their resource requirements and keep them

better aligned with demand. What’s more, as the model includes all

the planning assumptions previously modeled off-line, there are f ewer

tendencies for managers to game or over-resource. Over time,

everyone should be working towards optimal capacity management –

smoothing the peaks and troughs to close the gap between resource

demand and supply and to improve organizational efficiency.

The other main benefit of more frequent re-forecasting is better

visibility into future performance. If all the drivers of financial

performance including expenses, loss ratios, market share and

market growth are updated on a regular basis, the organization is

better able to sense and respond to issues. Rather than stumble

upon an issue in a future period, by which time it may easily have

become a major problem, the organization has given itself time to

assess and respond. It has gained agility.

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A single solution based on drivers: the way forward

Although they are fundamentally inter-related, ABC and budgeting

are typically carried out in separate systems. In an ideal world, it

should be possible to update any one of them and rapidl y assess the

impact that changes have on the other models. For instance, it

should be possibl e to predict how an updated expense forecast would

impact the future profitability of products and customers.

Similarly, working with silo-ed applications involves much

unnecessary work in transferring data between models. This typically

results in multiple versions of the truth.

The issues outlined above are often indicators that no single aspect of

performance management is fully exploited. In many organizations,

budgeting remains a costly and onerous chore, re-forecasts are

infrequent and most cost and profitability reporting is limited to

historic performance and is rapidly out of date. This lack of

integration compromises the timeliness and credibility of the

management information provided to executives and business

managers, so their visibility of the future and their individual

understanding of performance issues facing them is lacking.

ALG Software provides both in a single solution

There is no other vendor of corporate performance management

systems that can provide planning and budgeting functionality with

fully integrated cost and profitability analytics. Some other vendors

do provide both applications, but their cost analytics solution remains

a stand-alone, silo-ed application gained through the historic

acquisition of a niche vendor.

ALG’s approach is different. Our core capability is in understanding

what drives costs inside organizations and how to model it to deliver

insight. Starting with this as a foundation, and building other

functionalities around it, ALG provides organizations with a single

system for planning, budgeting & forecasting and ABC. This solution

– Predictive Planning – allows users to develop linked models that

cover different functionality across different parts of the organization,

but can easil y be consolidated for enterprise-wi de reporting.

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Implementation

It is frequently said that implementing multiple methodologies -

planning, budgeting & forecasting and ABC – simultaneously leads to

problems. Whil st this is undoubtedly the case when multiple

applications are involved, it is not the case when the methodologies

are delivered in a single solution, such as ALG’s Predi ctive Planning.

All the data is in a single database and much of it is common across

all the methodologi es. For instance, the number of active customers

might be a driver for resource planning in a driver-based budget, and

a driver for cost assignments in ABC. The same piece of data is used

in both methodologies, and is also likely to be a key performance

indicator reported in any score-card. As long as this data has been

identified and is available, numerous users of Predictive Planning

have successfully built models that deliver both budgeti ng and

costing.

Migrating existing ABC models

Where organizations have already invested in ABC, it makes sense to

migrate existing ABC models from ALG’s Metify ABM or other

applications into the EPO Suite. This will immediately enable the

organization to take advantage of the web-based environment for

both collecting non-system driver data and reporting. Utilizing

administrative tools such as Work Manager further eases the burden

on the ABC team by automating these tasks. In our experience, this

has enabled users to refresh their ABC models much more frequently

and deploy reports to a larger and more diverse community of users.

Flexible model structures and multiple alternative, attribute-based,

hierarchies mean users can rapidly update model designs to reflect

changing organizational roles and responsibilities. It is also possible

to compare multiple versions. This means that models can be easily

kept up to date and relevant to all areas of the business, thereby

improving the integrity and credibility of the outputs.

The assignment methodology in ALG’s CPM solutions offers powerful

and efficient functionality that allows users to enhance the design of

their models. This is especially important for account and activity

reallocati ons and cost object assignments, where users will be able to

reduce the number of allocation methods and drivers required, to

sharpen the focus on true causality.

Reviewing the current activity-based costing model will also bring it

up to date with current organizational structures, and therefore

improve the validity of the results. Simplifying the model whilst

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preserving the business logic will make the results easier to interpret

and analyze.

Implementing driver-based budgeting

As mentioned above, many of the drivers used in ABC will form the

bases of cause-and-effect relationships used to forecast revenues and

line item expenses in a driver-based budget. Implementing this

involves confirming the relationships and rules of thumb that

responsibility managers use in developing their plans and budgets

and building these into the model, ultimately leading to the P&L

statement, cash flow and balance sheet, generated as the outputs of

any budgeti ng process.

Conclusion

Many organizations recognize the importance of having a detailed

understanding of costs and profitability and this can only be provided

through ABC, which many predict will become an indispensable

component of the CPM strategy. Yet the same drivers used for cost

assignments in ABC provide the basis for driver-based budgeting,

something that transforms the annual budgeting process and allows

for much more frequent re-forecasts.

Having built its vision of CPM around uniting operational management

with financial management, ALG Software is a unique position of

being able to deliver budgeting and costing in a single solution.

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About the Author

Richard Barrett, MBA, FCIM

Richard Barrett is Vice President of Global Marketing at ALG Software.

He started his career wi thin the pharmaceutical industry and gained an

MBA in 1981. He has a wealth of experi ence in consultancy and holding

national and international positions in consumer marketing, insurance

and as well as business-to-business marketing with DHL Worldwi de

Express. Richard first became involved in product and customer

profitability whilst with DHL during the late ‘80’s and conti nued his

interest in the topic in the insurance market, where he claims there are

to many actuaries looking at loss ratios and not enough people looking

at profitability.

About ALG Software

Founded in 1990, ALG Software (ALG) is a global provider of Enterprise

Performance Optimization applications, which can be implemented

across an entire enterprise and across a broad spectrum of industries.

ALG software applications and service solutions help organizations

develop insight into their costs and profitability, formulate and execute

strategy and increase their operational agility to optimize performance

and shareholder value. In short ALG provides the foundation of

profitable strategic and operational decision-making. ALG Software

operates across Europe, North and South America, Australia, New

Zealand, the Middle East, the Far East and South Africa.

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