If you have kids, you will understand the anxiety most parents get when the kids are constantly asking for money. And usually it is for all sorts of justifiable things that come up out of the blue. When the semester begins, when school excursions get scheduled, for extra pocket money and so on it goes. Yet somehow you manage to get through it.
For companies, like kids, we run a budget. But unlike kids, companies assign responsibility to managers to plan resources to deliver services demanded to meet the business plan. This money allocation process is called Budgeting and takes a serious amount of time in many organizations as they sort out the priorities.
Looking into how good ones do it, we find once business plans are set , budgeting is about figuring out what resources you need meet it.
This process is completed as a bottom up exercise by functional areas. Transfer pricing and second level allocations enable sharing of upstream services to the operational business who generate the income. Internal services like IT and Finance are no different to buying external services and must be based on equitable and manageable consumption drivers for the services activity performed. For example, if unit cost is struck for receivables management then this can be built into the cost of a product.
This means it can be quasi arms length so bottom line measurement of all business channels can then be done. This in turn ensures accountable and definable income segments are managed and profitable.
So budgeting in the end is really all about how you allocate cost of resources among business units/lines in an effective way.
A company I have been advising recently had some complex allocations. They had been using simple drivers based algorithms. The had four levels being Group, support and operational services added to the direct costs of their 3 key business channels. Headcount percentage of time writing drivers were used for cost sharing.
When I examined the logic behind this, it seemed the base was quasi equitable but it was hard to understand the driver percentages. Transparency was therefore clouded and arms length visibility to negotiate internally was difficult. This of course opens doors to dangerous cross subsidization and misunderstanding on hidden costs.
My client who is a successful mid sized bundled product services business understood their allocation rules had to change to be more equitable. Of critical importance to them was understanding the real cost of components in order to make marketing decisions on products
In the prior year, operating costs regardless of nature were spread just on head counts. This year’s they added a combination of time writing drivers for cross functional services sharing. They plan adding more drivers based on percentage of expense and so on.
This change has meant their allocation rules had changed to be more equitable but was it good enough?
When I discussed with them the logic behind this it seemed that although the base was quasi equitable is was too complex to understand the real money flow and its value. Transparency was quite clouded as using percentages of other metrics had slippery flaws when it came to corrective action on a decline in performance.
Like business itself, it is critical that the internal supply chain is well defined so costs can be attributed to full value of all services. The rigors of Activity Based Costing or similar in some organizations goes quite a long way to solving this issue , but in many others it is overkill when simple driver based rules can be a applied at more macro levels.
The principal is that allocated money from different Support Units to the Core Business Products should be no different to going outside to an outsource provider. In the latter case it is easy to see how the money is used as it has to be billed and booked directly.
As mentioned it may be easy and straight forward, even in Excel. to make calculations. However, things get a little tougher when assumptions must be changed.
Some practical things to consider for allocation rules is they will be refined and changed over budget cycles, as business relationships and management organizations grow.
Taking shortcuts such as using using top down percentages may work for a while but in the end bottom up supply and demand based driver work and believe me, it’s time consuming to set up but once done its a breeze. Making changes with anything less is a nightmare .
Consider also that budgets are not things that people own but agreements to fund resources that will deliver results aligned to business strategy.
I looked at some of the anecdotal feedback. For fun I thought I would just add this to my post
Our main role is to provide IT services to departments inside the company, They are accountable for these service costs aren’t they we are just the providers and it costs what it costs?
Also, who should account for travel expenses related to our regional IT upgrade project? Is it the project management team, the home department or the personnel who travels on behalf of the project?”
In a commercial world we expect the vendor to be fully inclusive.
From: Group Business Director
In your product costing , does this include the direct costs of the service provider, and indirect business costs (as allocated overhead from other service and functional department?) If so, how do you manage these?
I notice a high spend allocated from IT in the Sales Department. What’s going on there? Also, our Oman Project needs more funds. I need to cut someone so I can give more to it. Who is stockpiling excess budget?
The allocation process may seems straight forward, but there’s more to it than just rules, It has a life of its own like any supply chain and must be respected similarly.
And thinking about how you manage the allocation in your family, parents need to be the BEST CFO’s in the world!!