Firms use annual budget cycles. Now, during this COVID19 pandemic, it may be the wrong way to go about budgeting for 2021, because it does not leave you enough flexibility. How can you budget for next year, while keeping maximum flexibility, go after new opportunities when they arise, make the most out of your available budget, and keep maximum control? It may all be possible if you budget the way innovation portfolios are managed.
Benefits of annual budgeting
The benefits of annual budgeting are that it provides clarity and makes that only once a year, you have the conversations about budget allocations. After that, it is settled how much will be spent and what results are expected.
And in stable times, that is absolutely the best way to go about setting budgets.
Downsides of annual budgeting
With so much emphasis being put on the annual budget cycle, it is important to get it right. That means that some firms take as much as 3-4 months to determine the next year's budget. And it can take a lot of bickering between different divisions when money needs to be saved and budgets need to be cut.
Because of that, annual budget cycles make a firm very inflexible. In 2020, sticking to the budgets that were made up in 2019 was insane. Most companies were able to cut costs and reduce spending. However, how many were flexible enough to reallocate scarce funds and invest in new opportunities?
2021 promises to bring more uncertainty
There is little guarantee that 2021 will be more certain than 2020. We all hope there will be a vaccine, but even then, it will take a while before enough people on the planet are immunized and we all can get back to normal.
Knowing that there will also be the US elections and that extreme weather will happen more frequently, how are you going to plan for 2021? What year are you going to use to extrapolate your forecasts from, 2019 or 2020?
According to McKinsey, most CFOs recognize that current budgeting practices are not suitable at this moment. However, the solution is less clear.
Innovation has always been uncertain
Not having past data to extrapolate from, is a common problem in the world of innovation.
It has made it difficult to plan for and defend innovation investments in the normal annual budget cycles. However, this year the innovation team may have a leg up. Their models could be useful for the rest of the organization.
What you can learn from innovation portfolio management and budgeting
Below is a short summary of how innovation portfolios and budgets are typically defined and managed, in this case applied to the case of budgeting for 2021.
1. Have strategy guide your actions
When things are uncertain, you need a north star. A north star everyone in the organization can aspire to before you plunge into the budgeting details. Your strategy is your north star. It can be simple, yet it needs to be concrete. What are the overarching objectives and goals for 2021? What would you like to accomplish?
For example, 'survive 2021' as a strategy won’t help. It is too vague and does not give your employees any direction on how to do so. Should a business unit invest or should they cut costs? Should your employees keep working from home, should they put in additional hours, or should they look for another job?
Your strategy needs to inform everyone in the organization where you are heading so that it can guide your employees in their day-to-day decision making. It could be, for example, we plan to survive the coronavirus crisis by generating 5% of our business from new offerings and cutting 10% of our costs, while maintaining 85% of our current business. It would be even better to use actual numbers because it may not be clear what these percentages represent.
You want to have concrete high-level goals for the year. I am not saying the goals above are a great strategy, but they inform employees what to do and how to prioritize. They should be looking for new opportunities and reduce costs. It also tells them that they cannot ignore the current business, as 85% of revenue is still expected to come from the existing business.
So for 2021, what would you like to achieve as an organization? What are your business goals?
2. Plan at different levels
For the execution of the strategy, innovation portfolios are typically planned at three levels. The so-called Horizon 1, Horizon 2, and Horizon 3 levels. Horizon 1 represents things that will have an impact this year. Horizon 2 projects will impact the business in the next 2-5 years and Horizon 3 projects are long-term plans. The purpose of these different horizons is to make sure you can tackle small issues quickly, while you also can address the important long-term stuff.
At the project level, multiple planning levels are also used, but for another reason. Typically, there are two planning levels at the project level: project or milestone and team level plans. Team level plans inform the team members what to do on a daily, weekly, or monthly basis - depending on which project management approach you use. Milestone or project level plans inform all the stakeholders about the progress of the project. In this case, you use different planning levels to make sure that ripples in your planning remain manageable. Many fluctuations in the planning can be leveled and handled by the team. That saves the team from taking along all stakeholders on what often can feel like a rollercoaster ride.
The goals of planning at different levels is to give you enough flexibility, agility, and control to deal with issues that come up in the short term, enable you to tackle important and/or urgent issues, while not losing sight of the overall direction.
What does this mean for your budgeting for 2021? It means that you are better off not applying the typical waterfall approach, in which senior management sets their goals and then asks everyone else to fill in theirs to make sure that everyone's goals add up to the goals set by senior management.
Instead, you will set out the plan at the higher level for the organization and the business units. You may add quarterly goals, if that is what you typically do. However, don't go into the nitty-gritty details what needs to happen at the business unit or project level to make these goals happen. That level is planned out at most for the next two weeks to three months, depending on the dynamics of your industry and/or the lengths of your project sprints. In other words, you plan and evaluate at the lower levels in much shorter time cycles.
If this sounds familiar, it should. As that is how your IT teams use agile project planning, with 2 weeks sprints and daily stand-ups to discuss what has been done, what needs to be done, and to make sure everyone is aligned.
3. Use reverse incomes statements
So, how do you plan out the details? How do you plan forward, if you cannot use last year's numbers?
Realizing how useless financial projections are, Rita Gunther McGrath and Ian MacMillan suggested to essentially reverse the sequence of these calculations for innovation projects.
"Its logic is elegantly simple. If the project teams all know how good the numbers need to look in order to win funding, why go through the charade of making and revising assumptions in order to fabricate an acceptable set of numbers? Why not just put the minimally acceptable revenue, income, and cash flow statement as the standard first page of the gate documents? The second page can then raise the critical issues: “Okay. So we all know this is how good the numbers need to look. What set of assumptions must prove true in order for these numbers to materialize?” This approach is called creating a reverse income statement (source).
When using this reverse income statement approach, the project team is asked to create an assumptions checklist—a list of things that need to be proven true for the project to succeed. The items on the checklist are rank-ordered, with the deal killers and the assumptions that can be tested with little expense toward the top."
If you want to maintain a 10% profit margin and 5% growth from new products, you then calculate backward what that means. How much revenue would you need from new offerings? How much work would that equate to in the coming year?
In other words, you calculate backward from what you want to achieve. State what the implications are for your daily work and then list the assumptions that must come true to make it happen.
And during your planning cycles, it is the testing of these assumptions that you are monitoring. For example, the 5% revenue from new offerings, means that you would need $2M in new revenue, or the equivalent of 10 projects of$200k each, which means that by January you should start 20 exploratory initiatives at a minimum and have these trimmed down to the most promising 10 projects by the end of Q1 (for more details, see the cost of innovation).
4. Budget while keeping affordable loss in mind
Affordable loss is an entrepreneurial budgeting principle. Instead of calculating upfront how much money is needed to launch a startup, how much time should be put in, and then put a lot of energy into raising sufficient money to cover these costs, the effectual entrepreneur tries to estimate the downside and examines what he or she is willing to lose. The entrepreneur then uses the process of building the project by bringing other stakeholders on board and leverage what they can afford to lose together.
An estimate of affordable loss does not depend on the future or on predictions, but on the existing organization. What's considered an affordable loss varies from person to person, business unit to business unit, and organization to organization, as well as across life stages and circumstances.
For the example above, this could mean that you would suggest spending 20 times 20 hours, for the equivalent of $40k to explore 20 new opportunities and find new ways that could lead to generating the 5% of new revenues, worth $2M in 2021 and more than $10 million over the course of the next few years.
That is, ask for funding that would enable you to reach this first milestone at the end of the first quarter - explore 20 opportunities and select the most promising 10. While $40k is not nothing, it is a relatively small amount of money compared to the $2M in new revenues that you are targeting. What more, those engaged in these exploratory projects will learn a lot from the whole experience, regardless of the outcome.
For Q2, you would use a similar reasoning, to justify the next trench of expenditures. For example, spent 10 times $10k on the selected projects to create detailed business cases and launch pilot projects.
In other words, you look at what it will take to prove a project is worth more investments, instead of looking at the overall potential of each project to justify whether the investment is worth it. This way, the bulk of the investments only needs to be made after a team has shown that the growth projection of the $2 million in new revenues for 2021 is realistic and plausible.
5. Assume you are wrong
Gut feelings and instincts work well in known environments. Like firefighters running in burning buildings and surgeons dealing with a patient in a life-threatening condition.
None of these scenarios are the same, but firefighters, surgeons, soldiers etc. are trained to rely on their instincts in these circumstances. They have too.
However, uncertainty, like we face now, is different. Nobody has been trained for this – with perhaps the exception of pandemic flu experts. When the situation is unfamiliar, you cannot rely on your instincts or gut feelings.
When things are uncertain, it suits you well to assume that your projections and assumptions are wrong.
In the innovation world, we understand the importance of testing your assumptions and having a learning mindset. You base your strategy on a set of assumptions about the future that could be wrong. That is perfectly fine, as long as you write these assumptions out and put them on the wall in front of you. Because in uncertain situations, realities change and your assumptions may no longer be valid.
It also means, that when testing assumptions, don't try to prove yourself right but try to prove yourself wrong. The latter is more definite and therefore can save you a lot of resources.
Budgeting for 2021
While we cannot be certain - because we have never done it ourselves either this way - we assume that using the innovation budgeting principles described above can come in really handy when budgeting for 2021.
Decide what you want to accomplish and how much are you willing to invest to achieve those goals next year. And beyond that, leave it open how exactly you will get there. That gives you a lot more flexibility. Then start many projects that could help you achieve those goals and after initially exploring various opportunities, rein these projects in, and identify the 3-4 most promising opportunities you will pursue for the remainder of the year.
Create a detailed project plan and business case only for these more promising initaitives, using tools such as affordable loss, reverse income statements, and discovery-driven planning. That way, you will have maximum flexibility to go after new opportunities, get the most out of your budget, and keep maximum control.
