Product Management© 2013 Johan Oskarsson

THE AGILE BUDGETING

JOHAN OSKARSSON

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Innovations require you to change directions with both your product and strategy as new information comes to light. A budget process needs to support this agility, it should roll with you, help you learn faster and trigger creative behavior.

The AgileBudget

Budgeting is a big part of an organization, it consumes a large amount of peoples time and sets constraints on plans and projects. It can, in worst case, determine what the organization should do a year and a half in advance. The budget process can also add to command and control behavior, strangling innovation.Budgeting may not be the only thing holding you back, but it can certainly be a major issue. Personally, I want to know if money is being used wisely, if we spend it on things that matter for us, not only right now but also in the long run. I want to know that we are making more money than we spend. I want to know what the forecast is looking like. I want to know if we should regroup our forces in some other direction to react to opportunities or threats.

What I don’t want is to be controlled by an estimate that does not make sense anymore. I don’t want a business case that is based on early assumptions long past their expiration date, that have become false realities my project revolves around. I don’t want to spend endless of hours gathering data, re-estimating, debating why I should get more funding to keep my current commitment on annual basis. I don’t want performance targets that aim to keep my budget.

I’m pretty clear on what I want and what I don’t want and I’m not the only one. That said most companies budget process is more like what I don’t want. They often stand in the way of agility and doing what is right to do. They are designed with good intentions but often have counterintuitive side effects, resulting in us spending more money instead of using wisely.

The annual budget process has some nasty side effects that are hard to see because it all seams to be logical at first sight. It also has a long legacy in the traditional way things are done.

The biggest of all fallacies is that you can predict how much innovative projects will cost a year in advance. Most projects are late and over budget because of unknowable factors that make predictions obsolete.

A second fallacy is that a budget stops you from spending more money than you can afford. I sometimes wish I was bugged with a secret microphone linked to the CFO when I hear people say “We have to spend our budget in order to get the same amount next year”. Consider what behavior this triggers, and if it encourages money to be used wisely.

Another problem is that the budget is claimed as someone's property, usually a manager, to do with what he or she believes is best. This encourages command and control behavior from that manager, since they are responsible to keep within the budget, and, in worst case, are rewarded if successful.

The budget process can be an enabler of agility and innovation, or it can be an obstacle people have to overcome. I prefer a more innovative budget process and this article aims to provide some guidelines for developing this.

[wikipedia.org]

“No complaint … is more common than that of a scarcity of money.”

Adam Smith, “The Wealth of nations”

Income statementA product or a product line should somehow contribute to an organizations profit. Whether it contributes directly or strategically should be known. An Income Statement, also known as Profit & Loss statement, is a good way to come to grips with these questions. An income statement is not very different from your household budget. In fact many homes could benefit from using this technique to keep from entering the luxury trap. I wish my parents had used it when we were kids, we would have had a lot more respect for where money come and went.

The income statement consists of two parts, income and expenses. It tracks products or business performance over a period of time. It’s a periodic statement that can illustrate trends a cross-functional team would be very interested in. Even if I have never heard anyone address it directly, the idea that “Money that’s someone else’s concern”, is an attitude I’ve observed frequently. Maybe this is because so few have insight into the money process. Often all that’s communicated is the CEO quarterly numbers. These are both uninspiring and mean little to the average Joe. However money is a shared resource and should be treated as such, it’s everyone's business as it directly effects how we spend our time.

The income statement usually has the same components. It shows the Total Revenue (number of units x price). The cost required to produce the product known as COGS and the difference or Gross profit. It shows Expenses such as R&D, sales, etc. Some use Earnings before Interest and Taxes, Depreciation and Amortization (EBITDA). The most important part is the Net Income which tells you if you are making money or not.

The income statement can be used together with a rolling budget with a time window looking back a short period, and forward a longer period. It is more important to look forward in order to plan and facilitate direction changes when needed, than focusing on analyzing the past. Questions remain weather we invest harder in future innovations, or focus on sales and marketing to boost short term revenue? These are the responsibility of the cross-functional team.

Imagine that there is an annual budget and it is fixed. A fixed amount of money is allocated to each different part of the organization. Imagine that sales of a new product line are not taking off. The income statement shows the loss of the first three moths. What are you going to do? Stick to the plan and begin the next projects, or do you shift focus to find out why sales haven’t performed as planned? Did you develop something that no-one wanted. Did you spend to too much money before testing your assumptions? Did the sales force have to cut prices in half in order to meet their sales targets and keep their bonus.

The income statement is a great method for getting everyone involved and to alert you to changes from forecast. It can be used to track trends and work to relatively reduce cost and increase revenue. It is a periodic, rolling and iterative tool supporting your agility and ability to create value.

[garyhamel.com]

“Most companies are run by executives who know everything about cost and next to nothing about value.”

Gary Hamel, “What matters now”

Business Case LearningHave you ever had an idea for an innovation and gone running to your manager to present the idea only to be given a business case template. “Please fill this in and come back”. Did you loose or gain motivation? You should be more motivated. If I was the one who approved new projects I would definitely want people to understand the reasons behind their business case and to clarify and understand the assumptions of the new idea. When I went to business school I was taught that a business case should show the value of a new idea and be used to determine if you should go further with it or not. Generally this is how it gets used however I think this is the wrong approach. The value of the business case is not determined by the expected outcome, return on investment, net present value, or bang for the buck, It rests on the assumptions made. You assume that you will sell this or that amount of products, you assume that it will take this or that much time and resources. Based on what data? Early and rough estimates. The more innovative the product the more uncertain the estimates. Not that the revenue is unimportant, it’s just not the most important part. If I were to create a business case manifesto, this would be something I highlight.

Verifying assumptions early through rapid prototyping over detailed financial business cases.

Don’t get me wrong, I see the benefit in using business cases and use them frequently, but I also see them being used incorrectly, blocking innovation and creative thinking. You can get stuck in time-and-cost-only mode. Below I outline some ideas I have on different financial tools for calculating value.

Net Present ValueThis tool is good for understanding on which assumptions the new product idea is based. Focus should be on listing the assumptions and outlining actions for testing them, not the actual NPV and IRR numbers. These only become interesting when the assumptions have been verified and early risks are eliminated. It should not be used in early decision making and is not really a good tool for agile projects.

Bang for the Buck IndexThis tool has the same weakness as NPV, but adds the time critical factor which might help when time is short and cash flow is focus. It promotes maximizing value in the shortest time. But what about long term innovations? They are probably not a problem anymore, there won’t be any if this tool is used for decision making.

Return On InvestmentThis is my choice when I can choose. It is the easiest tool to use, focusing on the relationship between revenue and cost. It still requires you to understand the assumptions you make but it can also be combined with income statements as forecasts for new products, listed as separate statements for each product.

[claytonchristensen.com]

“These are not bad [financial] tools and concepts, we hasten to add. But the way they are commonly wielded in evaluating investments creates a systematic bias against innovation.”

Clayton Christensen, “HBR article: Innovation Killers”

Portfolio ManagementThe Portfolio Management function should help you understand how to collectively move forward with your products, aligning them strategically. It facilitates decision-making on projects, people and money allocation. Note that it should help you not restrict you. Moving forward is about exploring as fast as possible, anticipating and adapting when needed. Allocating money should be about the same things.Classical Portfolio Management theory is about maximizing the value of the portfolio of projects, with the goal that you spend money on the investments that bring you the greatest return. If this was the only approach it would be quite restrictive, focusing only on anticipation.

The financial methods used in Portfolio Management are financial investment and allocation methods. The different allocation methods are more or less adaptive. Developing an innovative product is mostly about exploring and adapting until you have reached the mass market and have a strong product penetration. However anticipation handles only incremental growth with relatively low risk. Innovation needs a different approach.

Strategic BucketsOne common method is Strategic Buckets. Here different budgets are separated into different “buckets” and handed over to individual responsible units to spend on investments. Each unit handles its own bucket. Usually planned annually (We know the problem with this approach).

Target levelsAnother more flexible method is Target Levels. The difference from Strategic Buckets is that the money is in one bucket only and that targets are only targets, not fixed budgets. It gives you much greater freedom to move money after opportunities.

Emergent budgetThe most flexible approach would be to have investments emerge bottom-up, from the front line in the organization. That is reacting to market opportunities, not trying to control it top down.

Top-down, bottom-up A combination of Target levels and an Emergent approach can be a good thing whether you are in the middle of a transformation or you’re a big mature company. This approach qualifies on all three parameters; exploration, adaptation, and anticipation.

The key characteristics of the Portfolio Management function are; Easy to move money as new information and opportunities emerge, Not planned in a too far advance (monthly rather than yearly), A focus on strategic investments rather than uncertain financial value.

[jurgenappelo.com]

“Apart from looking forward (proactive), and looking backward (reactive), don’t forget to try things out (safe-to-fail experiments).”

Jurgen Appelo, “Management 3.0” on Complexity Thinking

Beyond BudgetingInnovation is today perhaps the only way to stay in business. Constantly seeking new products and new business models is necessary. By following traditional plan-driven models you may wind up with a product that’s obsolete before it’s even launched. A complete management model must seed and support internal startup innovation as the only sustainable option. If the words ‘Beyond Budgeting’ suggests that we don’t manage budgets any more, this is not the case, it simply means that they are managed differently. It means that we move beyond the command and control methods that the annual budget cycle promotes.

The Beyond Budgeting model has 12 principles . These are more management principles that actual budget tools. As with any tool they need healthy management to work properly. If you follow these principles I think that the question of how to manage the budget is no longer such a problem. Check them out, they speak for them selves.

Govern through a few clear values, goals, and boundaries, not detailed rules and budgets.

Create a high performance climate based on relative success, not on meeting fixed targets.

Promote open information for self management, don’t restrict it with hierarchy.

Organize as a network of self-organizing lean, accountable teams, not around centralized functions.

Give teams the freedom and capability to act, don’t micro manage them.

Focus everyone on improving customer outcome, not on hierarchy relationships.

Set relative goals for continuous improvements, don’t negotiate fixed performance contracts.

Make planning a continuous and inclusive process, not a top-down annual event.

Coordinate interactions dynamically, not through annual planning cycles.

Make resources available as needed, not through annual budget allocations.

Base controls on relative indicators and trends, not on variance against plan.

[theleanstartup.com]

“Startups often accidentally build something nobody wants, it doesn’t matter much they do it on time and on budget. The goal of a startup is to figure out the right thing to build as fast as possible.”

Eric Ries, “The Lean Startup”

The Rolling BudgetWhere is the best way to look if you want to know where you are going, backward or forward? This question has multiple answers, we need to know where we have been, but of course we have to look forward. I guess the right answer is both, but we also need to look at where we are right now.The rolling budget follows a different cycle than annual budgeting. The annual budget usually has a cycle which follows the fiscal year. The rolling budget doesn't follow the fiscal year, but uses a time window looking forward for a period that makes-sense to you, perhaps 5 months for small fast moving companies, perhaps 18 months for large industrials. That said the rolling budget is updated as soon as you have learnt something new.

Annual budgeting reports on variance against plan while rolling budgeting reports on trends. Where traditional budgets struggle with time, cost and expanded budget requests for project overruns, beyond budgeting focuses on the best way forward and promotes creative solutions to meet ambitious targets. Look at the two charts, which one gives you the most information?

Annual reporting shows a target budget (agreed budget), the monthly spend up until year-to-date, and a total forecast which is the overrun. What will be your focus? How much time and money is needed to complete the projects, right? Is that the right focus? Shouldn’t the focus be: What have we learned? What should we

change to develop something that the customer really wants, and is willing to pay for? The rolling forecast helps focus on the future and those actions needed to adapt to new information.

[axiomgroup.com]

“The forecast shall revel issues on the radar screen early enough for us to take the necessary actions.”

Bjarte Bogsnes, “Implementing Beyond Budgeting”

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Transvisual SpendingAre you scared that costs will get out of control if people can just do what they want when it is “the right thing to do”? I’m more scared of the traditional situation where only a few people have the insight into how much money there is and they lack the knowledge of exactly how it’s spent.This is actually the case in most companies I’ve worked for and in others I know of. Not unusually the line manager has the budget for the department and the project managers have their budget for each project. People spend money every day, every hour. The only way for the managers to keep track is to control all expenses and activities. And that’s where the creativity goes out of the window. Creativity needs a fundamental prerequisite, “space to move”. People have to be able to spend time and money without asking permission before they do it. You can’t know everything in advance especially when you are not sure what you are about to do next.

That said, we need to manage this shared and limited resource. Believe it or not, there is never an endless supply of money, even if you work for one of the biggest companies. This is where Transvisual Spending comes in. When there are too many cost drivers and too few people who know about them, this is a situation that needs to change. Everyone has to know about the spending and care about it.

Transvisual Spending is an abbreviation of transparent visual spending. Transparent so that everyone can see who has spent money, when, on what and why. Usually you just get a report that money has been spent, from an unknown source and for an unknown purpose.

Visual in that it is more than just numbers on a wall, it needs to have a physical form in order to trigger your right brain, like a bucket of gold wrapped chocolate coins

By having a physical representation and transparency everyone is aware of what is going on. “Oh my, the money is almost gone. Why did you spend it on that stupid thing when we need this instead.” This initiates positive peer-pressure, helping everyone to micro manage each other in a way better than any manager could do.

There is huge difference in mindset this triggers a completely different behavior. As Bjarte Bogsnes puts it. ’The traditional question is “Do we have budget for this?”, where the question really should be “Is this really the right thing to do?” ‘. Transparency and the resulting peer supervision encourages people to ask the right question.

What do you think will happen to costs when spending is open and transparent, combined with attitudes of responsibility and accountability, when each action is judged by peers and the budget is visually accessible every single day. Will it go up or down?

[jurgenappelo.com]

“Management is too important to left to managers”

Jurgen Appelo, “Management 3.0”

The Agile BudgetingTo manage uncertainty is to manage your present, near future and visionary goals. We need to be able to make quick changes in direction, verify that we are on the right track, and continue to explore our way into the future. The Agile Budget model is composed of different models each fitting into an iterative development cycle that supports agility. Some of the models have already been described breifly. It is time to put them together.

Each agile cross-functional team is usually part of a bigger cross-functional team, call it the product team. It consists of all the people needed to produce the product; R&D, Marketing, sales, logistics, IT, etc. They form an internal ecosystem, a viable system responsible for their product. They might be part of an even bigger system, but lets ignore that for the moment. To be viable is to be self sustaining. In money terms it means you are on top of your finances and contribute to the whole organization, i.e. you make a profit.

Use the rolling budget cycle and map it to your iteration, and release cycles. For example two week sprints means updating the forecasts on a two week basis. Use a rolling window with a forecast horizon of 3-5 x release length. If you release every second month, that window would be 6-10 months. It should fit in with your strategic milestones and vision time line as well. Calculate the average sprint cost to use as a reference point. Make sure you update the forecast with future reoccurring costs like license, hardware, etc. The example below has a 1 week iteration period and monthly releases.

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Use the Income Statement to manage profit and loss and map it to release cycles. Add separate accounts for new project business cases and calculate expected forecasts of Return On Investment. This fits well with forecast periods and your agile estimation techniques, provides pretty detailed and reasonably good estimates for the next release period and rougher estimates for a couple of releases away.

The example (left) is an Income Statement for an iPhone app. They fill in actual, forecast and target for each release (period). They have synchronized the release cycles with each calendar month for simplicity. As you can see they need some drastic changes to increase Net income. Let’s hope that the other projects will deliver expected ROI. I use a Cash Flow Statement to show the actual money available. This is easy to map to the release periods. In this case the product team is low on cash and need to borrow from the corporate budget for release A and B, until they start a positive trend.

The budget is emergent and updated on a regular basis. You don’t have to ask for budget permission, you already know the answer from the Cash Flow Statement. The cash flow can easily be managed with, as suggested, a physical bucket with say candy representing the cash. Every time someone spends money on things other than “normal” expenses like salary, office rent etc, they take some candy coins. After each iteration when the product is generating some profit you fill the bucket up again according to actual. Lego or other playful items can symbolize the same thing, figure out something that is visual and fun for you.

Release A (Jan) Release B (Feb) Release C (Mar) Release D (Apr)Sales iPhone Apps Actual 400 Forecast 420 600 1000 1200 Target / period 500 800 1500 2000 Price per unit $2,00 $2,00 $2,00 $2,00 Total Revenue Actual $800,00 Total Revenue Forecast $840,00 $1 200,00 $2 000,00 $2 400,00 Total Revenue Target $1 000,00 $1 600,00 $3 000,00 $4 000,00 Diff Actual / Target 80%

Cost of goods sold (COGS) Total Material & Labor Actual $100,00 Total Material & Labor Forecast $80,00 $80,00 $80,00 $80,00 Total Material & Labor Target $50,00 $50,00 $50,00 $50,00

Gross profit actual $700,00 Gross profit (%) 88% Gross profit Forecast $760,00 $1 120,00 $1 920,00 $2 320,00 Gross profit (%) 90% 93% 96% 97% Gross profit Target $950,00 $1 550,00 $2 950,00 $3 950,00 Gross profit (%) 95% 97% 98% 99%

Expenses Marketing Actual $80,00 Marketing Forecast $120,00 $120,00 $120,00 $120,00 Marketing Target $100,00 $100,00 $100,00 $100,00 R&D Actual $3 000,00 R&D Forecast $3 200,00 $4 000,00 $4 000,00 $4 000,00 R&D Target $3 500,00 $3 500,00 $3 500,00 $3 500,00 Admin Actual $40,00 Admin Forecast $20,00 $20,00 $20,00 $20,00 Admin Target $15,00 $15,00 $15,00 $15,00 Total expenses Actual $3 120,00 Total expenses Forecast $3 340,00 $4 140,00 $4 140,00 $4 140,00 Total expenses Target $3 615,00 $3 615,00 $3 615,00 $3 615,00

Net income Actual (profit) $-2 420,00 Net income Actual (%) -303% Net income Forecast (profit) $-2 580,00 $-3 020,00 $-2 220,00 $-1 820,00 Net income Forecast (%) -307% -252% -111% -76%Net income Target (profit) $-2 665,00 $-2 065,00 $-665,00 $335,00 Net income Target(%) -267% -129% -22% 8%

Income statement

Release A (Jan) Release B (Feb) Release C (Mar) Release D (Apr)New projectsProject A Total Revenue $1 000,00 $2 000,00 $4 000,00 $8 000,00 Total Expenses $3 000,00 $3 000,00 $3 000,00 $3 000,00 ROI -67% -33% 33% 167%

Release A (Jan) Release B (Feb) Release C (Mar) Release D (Apr)Cash flow from operations Gross profit Actual/Forecast, new project return $1 700,00 $3 120,00 $5 920,00 $10 320,00 Cash flow from financing Loan incoming, repaymanet, and taxes $4 420,00 $1 000,00 $- $- Cash flow from investments Total expenses actual, new project investment $-6 120,00 $-3 000,00 $-3 000,00 $-3 000,00 Net Cash Flow $- $1 120,00 $2 920,00 $7 320,00

Investment and Cash Flow Statement

Adding budgeting to your agile process is simple and valuable. The periodic process is already there, it’s just a matter of adding the actions needed to manage the finances. There are some new artifacts and processes that are required.

For example, in the release planning process, financial forecasts such as expected revenue for existing and new products, should be added. These can be called Financial Spikes that you estimate and include in order to gain more knowledge. The DoD (Definition of Done) for these have only one initial bullet, that is to update the Income Statement.

If the Financial Spike needs to be broken down into different parts they can be called Financial Stories. These can be different depending on what is required. For example: Meet with sales force to understand market needs, help key account sales with pre-sales of a newly launched product to boost short term sales, or replace a costly license with open source to cut fixed costs.

At the end of each release, the Income Statement is updated and the figures are reviewed by the whole team at a retrospective meeting. Suggestions for making the financial balance better are gathered and added to the backlog. The Financial Improvements are planned for each iteration. The different activities can be mapped into the Agile Product Management Framework as shown on the next page. See Investment Review, Budget Review, and Spending Review

Agile teams are self-organizing, empowered, self-developing and self-directed right? Trust is a core value. What do you have to do to gain trust? Would you trust someone who does not have the finance under control? My answer would be no, I guess that each company have to figure out how to transform their financial governance to Finance as a Service.

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Agile Product Management Framework (A-PMF)

BUSINESS

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“Things change, roll with it!

PRICING ANALYZE

PRODUCT LIFECYCLEREVIEW

POSITION REVIEW

COMPETITOR STORIES

INNOVATION EXPLORATION

PROFIT & LOSS

BUSINESS MODEL

GENERATION PORTFOLIO ALIGNMENT

PROJECT DECISION-MAKING

PORTFOLIO VISUALIZATION

INVESTMENT REVIEW

WORK FLOW ANALYZE

CUSTOMER STORIES

VISUAL PRODUCT ROADMAP

SHARED PRODUCT BACKLOG

PRODUCT DESIGN

REQUIREMENT DEFINITION

SYSTEM ARCHITECTURE

ALIGNMENT

KEY PARTNER

ALIGNMENT

PRODUCT DOCUMENTATION

PRODUCT TRAINING

PRODUCT LUANCH

KEY CUSTOMER

SALES SUPPORT

PRODUCT MARKETING

BUDGET REVIEW

PRODUCT SUPPORT

CUSTOMER RELATION

SPRINT PLANNING

ACCEPTANCE TESTING

TEAM COLLABORATION

SPRINT REVIEW

PRODUCT DEMO

SPENDING REVIEW

Johan Oskarsson

@johanoskarsson

www.captaintrouble.com Inspirational sourcesManagement 3.0 – Jurgen AppeloThe Product Manager’s desk reference – Steven HainesImplementing Beyond Budgeting – Bjarte BogsnesBeyond Budgeting – Jeremy Hope, Robin FraserThe Lean startup – Eric RiesThe four steps to the epiphany – Steven Gary Blank

Thanks to David Jackson for editing and theoretical dialogues.