In part one of this series, How to Use Annual Budgeting to Increase Total Shareholder Return I explained how most companies make minor changes in their budget allocations from year-to-year. I also referenced a recent McKinsey Quarterly study that found that over time, companies earned on average 30% higher annual total returns to shareholders by making more budget reallocations to reflect their corporate strategy, than those who did not (Hall, Lovallo & Musters, 2012). I concluded by discussing a resource allocation capability that would play a vital role in making these decisions — a feature known as optimization. In this blog, I will continue the conversation around optimization and discuss what it is, why it is so important, and where to access this capability.
Financial Budgeting and Planning: What is optimization and why is it important?
Optimization is the process of determining the best allocation of resources within given constraints. In financial budgeting and planning, the constraints would be the corporate targets and the corporate strategic goals.
Many people equate optimization with prioritization, but there is a difference. A prioritization process allocates budget to the investments with the greatest return and proceeds down the priority list until the available spending limit is reached. Even if the prioritization approach takes strategic dependencies between projects into consideration and even if this approach can incorporate alignment to corporate goals, it still often does not result in optimal budgeting. Here is why…
A true optimization approach recognizes that the best return on invested capital actually may skip some of the items in the prioritized list. For instance, if several high-priority projects require larger capital investment using prioritization may remove the option to afford a larger set of projects, representing a lower return. Whereas optimization considers every factor associated with the priority list and aligns investments with corporate goals so the company can forecast the highest return possible — making optimization very important to companies who want to align their annual budgets to their strategic goals.
A company seeking to allocate its spending optimally will have visibility into the affects of various funding levels on different investments. Companies who treat their affordability and corporate goal alignment as constraints are in a perfect position to achieve visibility on the optimal spending levels; hence, the 30% higher returns cited in the McKinsey study.
Getting Your Hands on the Right Business Application
When optimization is done and with the right software, companies have more than one choice for their budget reallocation. Forward thinking companies usually have one or more optimal spending level given the corporate goals. A well-executed process supported by the right business application can help decision makers reallocate their budgets with a high degree of confidence in the expected outcome. If this seems idealistic and unattainable, it is not.
Few applications available perform optimizations. A well-documented pitfall found in The 15 Pitfalls of Long-Range Planning, notes that many companies try to “put square pegs in round holes” — they assume that existing tools like enterprise resource planning (ERP) applications, strategic finance applications, or planning/budgeting tools will support this capability. But they do not. In fact, not many tools have optimization capabilities built-in to their product. A few do. Planview Enterprise, for example, takes a portfolio management approach to optimization and understands the need to align resource allocation and corporate goals.
This approach does not merely treat resources and goals as variables or constraints to be entered. Instead, this approach incorporates the investment and corporate alignment data and capitalizes on them. The result is a seamless integration of corporate goals and execution by harnessing the power of the planning and budgeting process.
Linkages like this empower executive teams to make decisions and increase total shareholder return by an annual average of 30%. The decision to adopt a business application with optimization capabilities is not just a bargain, it is a steal!
For more information on this subject, I invite you to read The 15 Pitfalls of Long-Range Planning white paper.
I’d like to hear from you. How could optimizing your financial budgets and planning help you close the gap between strategy and execution? What methods are working and which ones are not? Share your experiences by leaving a comment below.
Hall, S., Lovallo, D., & Musters , R. (2012). How to put your money where your strategy is. McKinsey Quarterly