Operational Metrics and the Financial Plan

Part Four of a Five-Part Series by ActSeed’s Dan Jacobson

In my previous article I provided an approach for creating integrated functional strategies and goals.  This article describes how to use these functional strategies and goals as the input to define operational metrics and create a financial plan.

Spreadsheet software makes it easy for anyone to spin up a financial model and “show” interesting results.  However, your credibility will be challenged unless you can communicate and defend your financial presentation and the  reasonableness of your model’s underlying assumptions.  I recommend that you follow the general approach outlined in the following graphic.

Process_Operational_Financial_Modeling

Assign one person with central coordinating responsibility.  It may seem obvious to have your senior finance person take the lead.  However, don’t hesitate getting someone from the outside involved if they have relevant experience, a general understanding of your business model, good spreadsheet modeling skills, and the ability to engage with your functional managers.  Make sure you start off with the proper expectations.  You may not need a full set of financial statements, or that need may be some time in the future.  Think a step at a time and focus first on operational metrics and a cash view of profit and loss.

Key Inputs:  Your coordinator should start with clear expectations for timeline and an understanding of the functional plans. 

Step One:  The coordinator should determine the time increments to be used for planning, for example monthly for 3 years or quarterly for two years, depending on the desired use for the final deliverables.  Then the coordinator should work from functional plans to construct a basic metrics interpretation of the cost drivers and assumptions for each cost driver by major category.  Major categories might include headcount by role, outside service or development costs, contract labor, equipment costs, raw material, purchase of partial or final assembled components, channel partner costs, IT infrastructure and services, commissions, training, etc.   At this point, the coordinator should focus on the operational activities that will drive costs included in Gross Margin.  In situations where functional plans describe alternatives, such as “build it ourselves” or “outsource”, these options should be included in the metrics model.  Organize your model horizontally to display Units (for example headcount by role), Unit Costs (for example the monthly base salary for each Unit), and if the cost is fixed (a one to one basis to Unit increases), variable (relative to a relationship to another Unit such as production), or step variable (relative to Unit breakpoints such as sales thresholds).  A simply conceived spreadsheet will allow you to efficiently engage each functional lead in the interpretation of their functional plan.   

Step Two:  The coordinator should meet with each functional manager responsible for the completed functional plans.  Given top management’s plan for sales and production, the coordinator should engage the functional manager in the build-out of the metrics model for their functional plan.  The discussion should focus on refining the list of cost drivers, estimating the units relative to the sales and production targets over the planning timeline, and expectations for direct costs (but not yet fringe benefit or other corporate overhead) for each cost driver.  The coordinator should challenge the functional manager so that the units and costs are reasonable given the sales and production targets.  Also the challenge whether the model is complete and captures all inputs and costs.  The functional manager needs to understand that this rough metrics model will become a basic budget for their operations and adjustments, and that this is not just an academic exercise.  Finally, the model should include referenced footnotes that describe basic assumptions that drive the metrics model.      

Step Three:  After completing the function-level metric model, the coordinator should create a consolidating spreadsheet tab that portrays a company-level view of the sales and production targets, units, and units costs on a cash basis for the specified time increments.  This spreadsheet tab should also include a quarterly or annual summation of units and costs.  As a second effort, the coordinator should create an additional corporate tab for costs such as management, space, utilities, employee acquisition or fringe benefit costs, insurance, and other overhead.  Some of these overhead items (for example employee fringe benefits) can then be allocated back to the functional models (for example as a percentage of direct labor).  If distinct functional options exist (for example “build it ourselves” or “outsource”) two or more consolidated tabs should be created and marked accordingly.  The summary model(s) and updated functional models will be easier for the coordinator to model the impact of changes in assumptions.

Step Four:  The next step is a review of the rough cut model with management.  This discussion should begin with a review of the functional metrics models, assumptions, and the summary model(s).  The key questions for management should be “Are we capturing all cost drivers?”, “Are our assumptions reasonable?”, and “Does this model accurately represent our business and expectations for operations and expenditures?”  Responses might lead to some refinements in how the model captures and consolidates metrics and costs.

Step Five:  After the model is determined to be workable, the next step is to seek management challenge for key assumptions and impacts on targets and costs.  This is essentially the real “what if” phase of refining the model.  A few examples of challenges here might include “What if we slow down our timeline for market introduction?”, “What if we use more contract labor?”, and “How can we reduce our pre-breakeven cash burn to the funding level we have or anticipate?”.  Each of these macro questions will have impacts on assumptions for each functional model.  This step enables management to refine or model alternatives and challenge the functional managers.

Step Six:  Next is a second round of discussions with functional managers to answer questions and focus on how the functional plans can be reasonably refined to meet the modeling objectives of management.  In other words, “Given management’s refined plans and constraints, what is the level of activity and costs that will allow you to achieve these targets?”.  Functional managers need to understand that this step in the process will require them to make commitments for reaching targets and operating within constraints.  In some situations this may result in push-back to management, indicating with supporting justification, that “This is the most efficient plan and use of all resources to achieve company-wide targets”.

Step Seven:  Input from functional managers should be incorporated into the functional and consolidated models.  Care should be taken to maintain version control over all models.  In my fifth and final article I will present some ideas for managing documents, collaboration, editing, and approvals.

Step Eight:  The new iteration of the model should be reviewed with management to demonstrate the impacts of changes and the commitment and input from functional managers.  This may be done in a meeting where functional managers present their refinements and assumptions.  There may be additional iterations, but the end product should be a dynamic model that can be used in budgeting, operational projection, and financial presentation.  Management needs to declare that one version of the model is “official” and that the underlying assumptions will be the standard for budgeting and projection.  And as plans change, this model will be the basis for modeling current and future state for these changes.

Develop Deliverables – Operational and Metrics:  The coordinator can now interpret the final model into performance targets, budgets, and metrics for each function and also for the company.  This deliverable can remain in spreadsheet format or be incorporated into a formal budget and financial management system.  Then each functional manager can be accountable for monthly and annual performance to plan.  And as circumstances change, these changes can readily reflected in the functional and company level models.       

Develop Deliverables – Financial Model:  The coordinator should work with the senior finance officer or outside resources to make the model adjustments required for the desired set of financial projection deliverables.  These adjustments might address cash to accrual basis for accounting, capitalization, depreciation, valuation of intellectual property, estimates of tax liability, or a myriad of other topics that do not directly impact the scope of influence for functional managers.  In many situations, an accurate projection of cash sources and cash uses may be adequate.  In the other extreme, a full set of independently reviewed financial projections (profit and loss, statement of changes in cash, sources and uses, and balance sheet) might be required.  Once again, it is critical that you begin this exercise with a clear definition of the final financial deliverables required.

This structured approach will deliver many benefits to your company.  Even if you do not need a full set of projected financial statements you will have developed a clear and shared company-wide view, commitment among management and functional managers, and mechanism for review and refinement.  Stakeholders outside of your company will appreciate and value this analytic interpretation of your company’s plans.

One thought on “Operational Metrics and the Financial Plan

  1. Joan Smith
    on said:

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