Budgeting vs. agile

In my previous post I have shortly introduced some basic financial principles. It might look odd that I talked about business and markets in the space that should be reserved for agile posts, but I felt that one of the reasons why many agile transformations fail in big corporations is not well understood.  Failures to introduce agile are often associated with lousy managers, complexity of organizations, corporate culture etc. That is all fine, but I believe that the root cause is in another place – in the way corporations run their businesses. This is how normally business process works, and nothing looks that fancy at the first sight:

Investors that govern large corporations look to increase their investment on a yearly basis, and in process every business unit within the organization tries to get to similar grow figures. Since companies try to get more revenues from existing markets (as emerging markets never produce enough revenues at very beginning), majority of company resources are always locked to their existing customers. One of the effects of such dynamics is that big organizations are incapable of following disruptive markets (ref: book “Innovators Dilemma”).

But there is one more important problem, and it starts with budgeting. Let’s imagine for the moment that your part of organization has made 100 million last year and that new target for this year is 110 million. The first logical thing to do you might think would be to ask sales guys (who else can bring you another 10 million next year?) is which features or products this unit needs to develop in the coming year to get to the target. Based on their feedback, in top down fashion, budget will be distributed over different projects depending on the business needs. By the time that project manager got his budget (people, material etc.) promises to the customers have been already made – how otherwise would sales guy come with 10% higher revenue for the next year? So, famous triangle of the fixed cost, timeline and content is there already at very beginning of the fiscal year!

That is not complete story. Projects that generate less money over years will get fewer budgets, without actually paying too much attention whether they still have customers on that product – who can still request new features or bug fixes. In B2B environments customers can retaliate in unexpected places and in what I call management by escalation mode, such projects can start suddenly sucking resources from other projects.

Finally what is there for project managers? On one side there is a huge pressure to make the features with committed dates and given budget, and on the other hand uncertainty that comes from running any software project. Temptation to manage projects using waterfall is clear, as managers badly need to believe that complexity and chaos of running software project can be only be put under control by paper work and Gantt charts.

There is also another option you might think would work. Let’s imagine you want to do bottom up approach, or even better, put all folks in the same room: business guys, sales guys, project managers etc.. Dynamics that you can often see then is that project managers will start whining and asking always for more resources – which will be followed by challenges from higher management to remove all “fat” which will in the end produce very nice working atmosphere for the rest of a year.

Not surprisingly, most of the books and blogs which introduce agile practices use in the examples smaller groups and single products. For many garage like companies agile brings discipline and focus to already flexible and motivated environment.

In larger established organization, dynamics can be quite different and breaking existing culture which is required to adopt agile is much harder than people might think. Very often, the problem is already there at beginning of the year, at the time that sales guys meet executives.

I always find asking the right questions more important than finding magic solutions. In my next blog post, I will add few more questions you may want to ask yourself, before you walk in the room with your agile slides.

Finance for dummies and why it should matter to you

The reason I want you to go through pain of reading this blog is because I believe that agile community is missing something when it comes to the budgeting and how the business gets funded. That very often makes agile getting into collision course with higher management, but before I go further (that will be in my next blog), sorry you need to read this one first. What I learned by reading about finance is that math was not the problem, but the language that these guys use. It’s that fancy English that you hear and then your eyeballs start rolling and next second you are lost.

So, let’s start first with some simple definitions and formulas:

Revenue (R): Income for a given period.

Cost of sales (C): Manufacturing cost, or retailing cost or something like that

Gross profit (G) = Revenue – Cost of sales

Operating expenses (OE): So called overhead of the business – pay checks, water and electricity bill, rent for the office and any other administration required for running the business.

Operating profit (OP) = Cost of sales – Operating expenses

Finance expenses (FE): Interest cost of debt (like you take a loan from the bank…)

Taxation expense (TE): On every income you need to pay the tax

Net profit (P): Operating profit – Finance expenses – Taxation expense: profit or loss. Profit is either used to reinvest in the business or it gets distributed to the shareholders via dividends.

Mark up: G/C [%] (percentage of direct cost, premium added to direct cost)

Margin (m): G/R [%] (profit as percentage of sales price)

(Here is the funny thing, you may wonder how tweeter makes money – well they don’t, but this is something else. Higher the ratio between the value of the share and the actual profit share generates, higher the growth prospects investors see in the company. In case of tweeter (or facebook), private investors gave the money to the owner in return to the part of the company – indirectly telling the market how much they believe the value of the company is – once it is listed on the stock market. That also explains why sometimes good profit figures of the company still can bring the shares down – since the share is all about the belief in future earnings)

Ok, so let’s do the quick check with one example just that you get some feeling for numbers:

If you work in a corporation that sells 10 million units for price of 1 euro per unit, and your cost of sales is 8 million with operating cost of 1 million, the gross profit would be 2 million, mark-up 25% and margin 20% and finally the net profit would be .5 million.

Ok, here is the formula of the net profit impact (R1/R2) at time T1 and T2 (ignoring TE, and FE for simplicity), where N is the volume, and S the price per unit and m is the margin (hope got this one right):

R1/R2 = ((N1 * S1  – (C1+O1)*(1-m1)) * (1-m2))/ ((N2 * S2  – (C2+O2)*(1-m2)) * (1-m1)).

So, let’s assume for the moment that C, O are not changing and m is very low and volumes N very high (which is more or less true for high tech companies):

R1/R2 (C,O) is approx N1/N2 * (1-m2)/(1-m1)

What happens if another company enters the same market and brings the price down to 90 cents?

Your gross profit goes down from 2 to 1 million, your mark-up down to 12.5% and margin to 10%. If you want to sustain the same revenue of 0.5 million, you would probably need to sell now 20 million units of the same product instead of 10m.  Smaller the margin, more volume you have to produce, in order to sustain the same net profit. How are you going to do that if other guys have just cut the price? Well you can decrease it further and then you need even a bigger volume. You got the picture? Or you can just stay cool and hope your product is of a better quality. Then you better be sure that customer thinks the same – so this is why companies talk “customer first”.

Another option is to cut the cost of sales (if that is a high number), in companies that means squeezing your suppliers. If that doesn’t work, well you need to cut the operational cost – which can mean less travel, sometimes lay offs, moving to low cost sites or something like that.

So congratulations, this was your first lesson.

Things that can vary in this formula is cost of sales (which depends on whether you produce goods or not, whether you have dedicated sales channels etc.), whether the cost of sales increases with volume or not (in software that can vary from the cloud services where you need huge farms that are big original investment but can scale well or minor cost if you just download applications), operational cost, different tax regimes, and whether you reinvest or distribute profit to share holders. Each of these variations can produce new effects and that is the reason why all these finance books are thick, but remember, underlying principle is really simple.

Next to things mentioned above, very important is the concept of cash flow, ROI and stuff like that. If you really got intrigued by this blog, I suggest you read that too, it might help you next time understand quarterly results of your company.

In my next blog I will explain how budgeting process often collides with the basic principle of agile/project management and why we should consider different project management techniques for different parts of the organizations.