Incorrect or ineffective resource allocation is one of the biggest reasons businesses perform badly. "Executives are not bad at running businesses, but they invest too much in their below-average business lines and too little in their above-average ones," said Greg Milano, the CEO of Fortuna Advisors, a consulting firm in New York City.
A new report by Fortuna Advisors says management teams should appraise and allocate resources between their business lines in the same way that an investor would select stocks.
Nearly all executives understand this, but hardly any do it, the report said. Instead, most spread resources uniformly across business lines without recognising the best opportunities.
Research from McKinsey paints a similar picture. It shows that many companies' resource allocations are highly static, with most allocations across business units staying the same from one year to the next. Those that reallocate more actively tend to perform significantly better, the research said.
Tim Koller, a Connecticut-based McKinsey partner, said that much of this stasis is due to biases such as loss aversion and so-called anchoring, in which companies tend to focus on what they did last year rather than starting from scratch and linking resources directly to strategy.
Resource allocation is rarely easy, as 92% of corporate strategists in a Gartner survey call it the biggest barrier to effective strategy. And the challenges to effective resource allocation aren't going away.
Political infighting and bureaucracy have long been obstacles. But recently an increase in factors causing uncertainty, from trade wars to Brexit and the global slowdown, have exacerbated political infighting, driving resource allocation challenges to new heights, the Gartner report said.
The challenge lies in comparing projects with undefined goals or with results that can't be equally measured. Muhammad Amin, CPA (Canada), ACMA, CGMA, senior finance manager at Core-Mark International, said: "Strategic planning is often wasted because of political infighting over resources. One reason is that sometimes the project outcomes are highly subjective and can't be easily quantified over others — for example, how do we measure the effect of capital expenditure on office renovation and safety expenses versus training and development?
"So, often it poses a challenge for CEOs to identify right priorities, and they spend much of their time assessing projects that could have been pushed back or abandoned because their returns are not aligned with the corporate vision."
Milano agreed that it can be difficult to measure outcomes in some corporate divisions. "It's harder to apply to the HR department, for example, as they don't have a profit line," he said. "So, often the functional heads who can negotiate the best get the resources. IT has also been a problem for a long time. Some IT projects we see are ill-conceived, but they are presented as, 'If we don't do this, the sky will fall,' so they get the money."
John Mobley, CPA, a partner with Fortium Partners in the US, said another reason companies get allocations wrong is they do not have an enterprise-wide methodology to approve project expenditures.
"CFOs are in the best position to set up this methodology, but they often don't have enough time or knowledge to do it," he said. "Many decisions therefore stay with department heads, such as the CIO, or at lower levels in the organisation. Making decisions at lower levels is easier, as it avoids formal approval processes. But the CFO needs to be more involved in project prioritisation."
Solving the problems
To reduce political pressure on decisions, Mobley's company recommends a methodology that has management-level steering committees help with prioritisation by reviewing the business case for project expenditures then monitoring their progress.
"Often, you see steering committees at executive level but not at management level," Mobley said. "But you need them at all levels, so management can see the priorities in the whole company, not just their own divisions. Again, one reason these steering committees don't exist in many companies is that people don't have time for them."
Koller agreed that senior executives need to take on more detailed decisions themselves.
"Executives need to be more granular," he said. "If you have four divisions with 15 units each, many boards will allocate between the four divisions. But they should make decisions about projects in the 60 business units, too, ranking them with a financial metric such as net present value.
"Ranking projects forces you to start with something less political and prioritise correctly for the corporation. Without this granularity, you can end up spreading money all over the company."
Amin suggested a similar approach, saying that executives should ask divisions what they would cut from the existing budget to fund additional spending requests, in the event their budget proposals are not approved. "This will allow them to think on their feet and find better, unconventional ways to achieve the desired results," Amin said.
Milano aims to give people more transparent measures and incentives. "Rather than saying, 'You have to cut X,' incentivise them to cut X," he said. "Then they want to do it — and the transparency means they know it's the right thing to do."
Milano also recommended imposing more accountability on the people who receive resources for delivering the anticipated benefits.
"Most companies do not have enough accountability," he said. "At a minimum, the reward systems need to link to these people's personal outcomes. So if they keep asking for resources they don't need and underdeliver, they will feel that pain personally and will be more careful about asking in the future."
Too many companies' annual bonuses link to profit, even for functional managers, rather than specific objectives tied to the requested resources, Milano said. "We need to ask, 'What measurable things will we get for this budget plan from HR or IT, for example?'" he said. "Then hold them accountable in the same way we would if a business head's profit fell short."
The finance function can play a key role in increasing this accountability and in overcoming people's biases. Koller said companies need an influential financial planning and analysis (FP&A) team to achieve this, however.
"Many companies do not have this, as they have cut back on the number and seniority of people in FP&A, reducing their influence," he said.
Another way to overcome biases is to improve decision-making governance, including instilling a robust debate culture, and having a strong corporate centre that is independent of the many groups competing for resources.
"Our research has also found that it's much more effective to have a small number of executives making resource allocation decisions than a huge group," Koller said.
The timing of meetings is also important, said Marc Kelly, a Gartner vice-president and team manager. "In many cases, executives receive lots of information and have to consume it and make decisions in that same meeting," he said. Kelly advises starting with a session that focuses just on the facts, taking a one-day break, and then coming back and making decisions.
Kelly also advocated an Eastern philosophy called fu pan, which derives from chess but has been adopted successfully in organisations such as Lenovo. In essence, fu pan is a continuous process of analysing what works, what does not, and why.
"The point of fu pan is to get the organisation to have a more objective understanding of the existing challenges and eliminate the blame game that sometimes takes place," he said.
Many companies struggle with resource allocation because the many measures they use are each incomplete and are not good enough to signal value creation, Milano said. One of his clients, a large consumer products company, is completely revamping the way it thinks about such measures, Milano said. Another healthcare client embraced similar measurement changes.
"Every measure tells them a different thing, so too often they give up and smear money across the company without enough regard to where the real opportunities are," he said.
When that happens, bureaucracy and political infighting get to an unhealthy level and become part of the culture, said Milano. The way to address it is to bring the emphasis back to results and how you measure and incentivise people.
Agile resource allocation
Resource allocation should be separated from the two other purposes of the traditional budget — targeting and forecasting. Three purposes fulfilled in one process and in one set of numbers might seem very effective. But herein also lies the problem: The three do not go well together.
How can an ambitious sales target also represent expected revenues? How unbiased is a cost forecast that is also a line manager’s only shot at getting access to resources for the next year?
These conflicting purposes can only be solved by separating the three into different processes, allowing for different numbers. The separation opens up exciting improvement opportunities within each process and allows each to run on rhythms better suited for their purposes.
With that separation, resource allocation should be dynamic. Business teams can always forward projects for approval, at any time. How high up one needs to go is regulated by a mandate structure, which needs to be loose enough to avoid too many decisions going up the chain of command. A yes or no to a project depends on two things:
- How good is the project (strategically, financially, nonfinancially)?
- Do we have the capacity (financially, organisationally — as things look today)?
Dynamic forecasting is used to monitor whether new commitments are within current financial constraints — which is also a dynamic picture.
Managing operating cost without a traditional budget is more challenging, but it is absolutely possible. Here, there are fewer big and distinct decision points, so we need other mechanisms. These include alternatives like:
- “Burn rate” guidance: Operate with full autonomy within this approximate activity level;
- Unit cost targets: You can spend more if you produce more; y Benchmarked targets: For example, unit cost below average of peers;
- Profit targets: Spend so that you maximise your bottom line; or
- No target at all: We’ll monitor cost trends and intervene only if necessary.
What is described above is drawn from the Beyond Budgeting model and its 12 principles. Separating the budget purposes and improving each one must be part of any agile transformation journey.
— This content is adapted from “Want Business Agility? Throw Out the Calendar!” FM magazine, September 2019. The article was written by Bjarte Bogsnes, who is active in the Beyond Budgeting movement and heads the implementation of Beyond Budgeting at Equinor (formerly Statoil), Scandinavia’s largest company. He is the author of Implementing Beyond Budgeting: Unlocking the Performance Potential.
Tim Cooper is a freelance writer based in the UK. To comment on this article or to suggest an idea for another article, contact Neil Amato, an FM magazine senior editor, at Neil.Amato@aicpa-cima.com.