ACTIVITY/PROCESS

BUDGETS

A TOOL FOR CHANGE MANAGEMENT

The essential reason we prepare organizational budgets
and track results is to influence people to do different things and to do things differently.
To succeed in this, we need to identify risks and opportunities
before they happen. The key is a much tighter integration of operational and
non-financial measures with our financial measurement systems.

by Paul Sharman

That differentiates management accountants from financial accountants is, indeed, their focus on managing, and this focus is both forward-looking and operational. Of particular importance in managing are planning, budgeting, and monitoring of performance. This is true for management accountants in all organizations and industries. The management process engages us in a series of activities that include establishing financial and non-financial goals, developing operational plans to meet the goals, and preparing budgets to reflect the operational plans. We then execute the plans, record performance and, finally, adjust operations to respond to actual circumstances.

Planning and budgeting has been a fairly specialized field within the finance function of most organizations. It is often combined with analysis of business cases for new products, or acquisition of capital equipment. Planning and budgeting groups are sometimes described as financial planning and analysis departments (FP&A). In most cases, the FP&A department works with operational functions, which are responsible for developing non-financial goals, such as sales, transaction volumes, customer and employee satisfaction targets, and interpreting their impact on functional budgets. In most cases, the finance department's role is to organize the planning and budget timetable, develop assumptions, receive budget data from the operational departments, roll up the numbers, check them, analyse them, and schedule review meetings. Analysis tends to be quite sophisticated and is designed to validate the data and explain significant trends and variations.

This approach to budgeting has left the actual interpretation of goals and non-financial information in the hands of operational functions. Unfortunately, this forces the finance analysts into the role of messengers. Accountability for performance resides with the operations folks themselves. The problem is that this forces the financial measurement system to report on plans based on assumptions made by others, and to report on results with explanations provided by the operations functions. Thus, management accounting budgeting and reporting mechanisms are perceived to be trailing indicators. Little wonder that groups such as the Conference Board have criticized accounting measurements for being too financial and rearward-facing .

The primary purpose of budget preparation and results tracking, as with any measurement system, must be to influence people in the organization to do different things and to do things differently. After the results come in is too late to take corrective action. What is required is a better way to identify risks and opportunities before they have happened. This involves a much tighter integration of operational or non-financial measures with financial measurement systems, in both the planning and budgeting mode. In addition, the integration of non-financial measures enables operational measures to provide a predictive or leading indicator of financial consequences.

It is now well accepted that activity/process-based performance measurement systems exist to provide the desired level of integration. Most applications have been developed as modelling applications of historical performance, where "what if" applications have been developed to support decision-making processes. More advanced users of activity-based costing have turned a historical, or a trailing, perspective into broader activity-based management application. This has been accomplished by understanding the links between activities and cross-functional processes, and then establishing complete operational and financial management plans and budgets for each process.

Figure 1: Integrated ABC and performance measurement equals information for performance management

An activity-based approach to budgeting requires a substantially different logic from that of the past. In an activity or process-management organization, the person who is assigned accountability for all aspects of a particular process's performance (financial, quality, time and quantity of throughput) is highly influential in managing the business. These people are called process owners. Process owners represent the cross-functional servicing of customers and other stakeholders of the organization. They must have as great an influence on managing the operations of the organization as functional managers. Therefore, management and employees have a different attitude to setting budgets. It involves a combination of top-down goal setting with bottom-up activity analysis by function. Negotiations between functional managers and process owners, over activity assignment to processes, create the reconciliation between the organization's strategy and the work of its employees. Of particular importance is the impact on the organization's political structure as functional managers become subcontractors to process owners, and are accountable to them as well as to senior executives.

Activity/process analysis

In order to prepare an activity/process-based budget, the organization must have already completed activity-based costing and process analysis of all major processes. Information from these analyses will greatly influence the goals set by management. Combined, the two provide the raw material for budgets based on prior-period performance which management will modify accordingly to meet new goals.

The steps are applicable to any organization, whether manufacturing or service,
revenue generating or public service.

Activity-based costing has two major components. The first is activity analysis, resource assignment, and activity costing. The second is activity-driver analysis and cost-object costing. It is important to distinguish between the two components because the first facilitates the costing, budgeting and managing processes. The second focuses on the economic performance of outputs (product/service/customer profitability) of the organization, which provides strategic and goal-orienting input to the planning process.

Process analysis also has two major components. The first is a high-level identification of definitions of the processes themselves. It includes determination of process measures and goals. The second involves the assignment of activities to processes, process costing, and the creation of current state process maps (see figure 1).

Steps in activity/process-based budgeting

The steps described are applicable to any organization, whether manufacturing or service, revenue-generating or public service. Fundamentally, the mechanisms are the same. However, goals will vary according to the operational objectives. For instance, a government organization that is program-funded will not have a sales forecast. Instead, there will be a series of program objectives and policies to be addressed.

Organization goal setting

Goal setting is often based on strategic or operating plan assumptions. These assumptions include information about the market size, market share, competition, environment, quality expectations and technology, as well as priorities set by stakeholders of the organization. For example, the market served by an organization may be expected to grow by 25 per cent in the coming year. To compete effectively, management has decided it needs to increase market share by 10 per cent. This creates a goal for sales to increase in excess of 30 per cent from the current period. In addition, owners or influential shareholders may have established a return on investment goal for management. In government, targets for service improvement and cost reduction may have been set, while productivity improvement is expected to be sufficient to maintain the current volume of work.

Figure 2: The process-managed organization

Existing ABC information is critical to organization goal setting. It is used strategically to identify which product/service, and customer/market segments, make or lose money. Not-for-profit and government organizations identify inefficient use of resources relative to perceived customer value, thus providing insight to process improvements or potential privatization targets. Management uses this information to focus marketing and organizational energy into the most profitable channels, or to create strategies to turn around strategic but inefficient uses of resources.

Process goal setting

This information provides management with a set of criteria to establish high-level organization goals. These, in turn, are decomposed to establish the implications for each of the major processes. For example, banks have a process to sign up new customers. It involves application processing, credit checking, risk assessment, opening accounts, obtaining signature specimens, and printing cheque books. The banks have other processes for actually handling cheque transactions, and so on. Overall organization goals for banks will have a substantial impact on process goals, because growth plans will define how many new accounts will have to be set up and how many cheques will be cleared. In addition, there will be goals set for level of accuracy (quality), and the amount of time it takes to open an account or process a cheque.

One aspect of process management is identifying critical business issues. These include issues such as the need to introduce new products more rapidly to secure future revenues, or to process orders more quickly to increase customer satisfaction and retention. Strategic ABC information influences which processes to prioritize for re-engineering, or potential elimination. Finally, management will establish financial/cost goals for the process, based on its perception of the degree to which the process is strategically important to the future performance of the organization. For critically important processes, management may choose to increase the amount of resources consumed by the process, thereby permitting an increase in the budget.

Activity analysis

Activity analysis is a comprehensive evaluation of all significant activities performed by people in the organization. It is prepared for each function or budget cost centre to reflect changes to the organization structure or work performed by the people. This will include changes which have either already occurred, or are planned to occur, during the budget period.

Additional effort is required to analyse other operating expenses by function to assign them, where appropriate, to activities. This will evaluate depreciation and operating costs of running, setting up, and idle or downtime for equipment, as well as other functional expenses, such as building, travel, consultant's fees and other anticipated items.

To help function managers prepare their function activity budgets, it is necessary for them to know what is required of them in order to serve the processes to which their function activities contribute. This will include information on numbers of transactions or new initiatives. Responsibility to define activity requirements rests with process owners. In forecasting total process throughput, process owners also derive activity-driver quantity information (see figure 2).

Budget negotiations

Each process consists of a number of activities that have a common purpose, even though they are performed in a variety of functions. Process definitions are established during the initial process analysis project. In their role as agent for customers and other stakeholders, process owners buy only what is needed from function owners to ensure that their needs are met for the right quantity of quality products and services, and that they are delivered exactly when needed at the lowest possible cost.

Budget negotiations begin in earnest as process owners debate with function managers to agree on what activities the process owner wishes to acquire from the function. Agreement is reached on what driver quantities and resources that the function will supply, and that process owners are prepared to fund. These negotiations establish the budget foundation for both the function and the process. Each function owner meets with the owners of all processes that their function supplies and creates a series of service agreements. It is these service agreements that form the basis of both the function and process budgets.

Function budgets are determined by adding up the value of all of the contracts they have negotiated. As each contract specifies which activities and resources are funded, managers match budgeted funds against existing resources employed in the function. From this, they determine what action is required to increase or decrease them. In the event that there is a significant shortfall in funding, function management must develop appropriate plans with senior managers in the organization, either to redeploy resources or to receive funding from other sources. If senior management permits the function to utilize resources that are not funded by processes, the cost should not be allocated to funded processes, but rather, treated as an allowed budget overrun, classified as business sustaining expense, funded by executive management.

Process budgets are determined by adding up the value of all of the contracts negotiated by their owners.

Integration with non-financial measures

Non-financial measures of performance within an organization are effectively measured by examining process characteristics. By understanding which activities are used by each process, and assigning resources consumed to the activities, management accountants are able to calculate its cost. Process costs are calculated in total and by individual activity. In addition, the activity driver quantities are used to determine the cost of each transaction, as well as the cost of things such as idle capacity. Both financial and non-financial measures can be calculated in aggregate for the process, or decomposed to sub-processes and even to individual activities. The individual activity is the lowest building block within an organization that can be managed. It can be measured in terms of all attributes -- resources consumed (cost), timeliness and cycle time, quality and quantity of throughput.

With clear information on activities and process relationships, both function and process owners are able to compare and evaluate how effective the performance is in the area of responsibility. This is often accomplished through benchmarking, or comparing their performance against that of organizations which perform similar activities. It is used to determine what innovations exist in order to process similar throughput more efficiently.

Productivity improvement

Productivity improvement is a clear objective for both function managers and process owners. Both are required to improve the productivity of activities that fall within their joint realm of interest. Simple activity and process-value analysis and benchmarking may identify opportunities. Function managers are able to prioritize spending decisions between activities that are critical to the effective operation of the business, and those that are only nice to have. In the event that process cost exceeds the perceived value or goals established during target setting, its owner has the ability to create a process re-engineering team to examine ways in which to reduce cost. This option may be pursued in order to improve performance in other ways such as timeliness, accuracy, reliability, or volume of throughput.

Tracking performance

As the new budget year progresses, operational data is tracked by function managers and process owners who monitor actual results in comparison to budget. Resource utilization is monitored and management accountants are involved in updating activity-based costing results with sufficient frequency to provide insight to process owners on their performance. Management accountants produce reports wherein the overwhelming requirement is to clearly and understandably depict what the organization is spending money on, and where it makes or loses money in comparison to plan. This is necessary so that managers can make decisions on how to react. Operations managers and process owners may also receive new versions of profit and loss statements. These would include statements where costs are organized by process , product/service and customer.

Even with a process-based approach, the management accounting information is still prior-period and rearward facing, unless the information actually drives strategy on an ongoing basis -- not just at budget time.

Management accountants have to work (play) with the activity drivers and quantities based on future activities or changes to technology which may drastically alter the cost of the drivers or of the activities themselves. This involves a great deal of interaction with the functional departments and also suggests that the functional management and process owners be very familiar and comfortable with ABC and ABM and activity-driver analysis.

In summary, the only reason to measure performance is to influence behavior. For too long financial accounting requirements have been disconnected from operational and non-financial measurement systems. Somehow, management accountants were distracted from their most important role in serving their organizations in the pursuit of strategy. And so, the information provided by accountants appears to have been out of synch with the needs of our organizations. As most organizations operate predominantly as economic entities (even in government departments where budgets dictate functionality), it would seem obvious that we should be addressing this disconnect. Yet, the biggest impediment to doing so is our willingness to change the mechanisms accountants employ. Activity/process-based budgeting offers a most powerful device to our organizations in driving change and human behavior. It is one that directly aligns strategy implementation with the day-to-day activities of individuals. This is the device that will secure management accountants, correctly, in the role of organization performance knowledge integrator. cma

Paul Sharman, features editor for CMA magazine, is president of Focused Management Information Inc. The company helps businesses to implement new cost management techniques.

Reprinted from the CMA magazine with permission from The Society of Management Accountants of Canada.