Five Issues to Explore to Improve Your Target Setting Process
Throughout my career, I have yet to find a company or business unit that enjoys the annual budgeting and target setting process. Typically, the consternation revolves around a few familiar areas, such as anxiety that unrealistic targets will impact incentive compensation, or that business unit forecasts don’t mesh with the external reality for the company, or that participants’ contributions to the process are not valued or heard. To complicate matters, the finance department is usually expected to referee and figure out the final direction on its own.
As a result, an organization often blames the process, the timeline, or the finance systems for the inefficiency of target setting. While assigning blame is tempting, identifying the real issues with the target setting process is the first step to correcting them.
1. Absence of market data
I have sat through target setting meetings where market conditions and market growth are not mentioned. Whether you are a market leader or at the back of the pack, competitor and market data are the basis of a comprehensive strategy. Is the market growing ahead of inflation? Is your target market spending more on your services or product types? In regulated industries, is the market becoming easier or more difficult for new entrants? Are key competitors launching new products over the next year? Is consolidation occurring in the industry? These questions and conversations should occur during a healthy target setting cycle, and preferably, at the beginning.
This data will also serve as a reality check for the final target. For example, it’s perplexing to see companies call for double-digit organic revenue growth when their market is growing at 2 percent, and they cannot explain who they are taking share from and how. Hope is not a strategy. Target setting without market data can lead to plans that fall short of what’s needed to drive the business forward.
2. Follow the leadership
A common problem in large and small enterprises is that leadership often expects the business unit operators to create corporate strategy from the bottom-up. A sound target setting process requires a reconciliation of the perspectives of all stakeholders. Does leadership expect to beat the market or grow with the market while focusing on infrastructure investment? Is there a focus on overall inorganic growth? A collaborative process involves business unit operators, leadership (and possibly the board), and even some external perspectives, such as shareholders.
Corporate leadership should establish a point of view that combines both market data and leadership expectations. While not providing exact numbers, business units that receive concrete guidance are far more likely to develop targets that land close to a reasonable range set out by leaders.
3. Narrow focus on incentive compensation results in narrow targets
Linking incentive compensation and target setting is part of the budget process. However, ignoring other factors limits the productive discussions of what is achievable for the business over the next year.
Of course, goals should be challenging for the business, but not unachievable. Target setting should result in more than an incentive compensation design — it should address elements of the business as a whole. Measures could include gains in market share, progress on major multi-year initiatives, or customer satisfaction. Introducing these items into incentive compensation targets will not (and should not) lessen the pressure of hitting a certain revenue or operating profit number, but by broadening the design to more comprehensive measures, it opens up budget discussions and broadens the focus.
4. Relying on faulty data
Prior-year actuals are a blessing and a curse. On one side, the data is accurate and reliable relative to other forecasted inputs. However, assuming the previous year will largely repeat itself could invite a large gap in your annual budget before it starts. For instance, did you have an unusually large order from a customer, or a large capital project, or a restructuring project that eliminated some future expenses? Unfortunately, in the absence of market data, prior-year history becomes an even more trusted source, regardless of its inherent problems.
However, prior-year data can benefit the target setting process with a couple additional steps. First, remove one-time items from the prior-year period that have no chance of repeating. Next, consider strategic decisions in prior-year actuals. If there is a strategic move to discontinue a relationship with a customer or vendor, note that outcome in the data.
Taking yearly circumstances in to account does not excuse the business from overcoming the impact of the one-time items or strategic decisions. It is just a step in a healthy budget process that creates a real picture of what is possible.
5. Developing a collaborative process
Given the nature of the budget process and the financial information involved, naturally, the finance leadership should be the custodian of the budget and target setting process. But it should not own the budget entirely. That ownership belongs with the business itself and is shared among all the business leaders.
The budget process is only as good as the engagement from the entire business team. Without the whole team committing to realistic action plans and weighing in on strategic decisions, the annual plan becomes a numbers only exercise. The result is a business team with no buy-in (e.g., “well, I can’t hit that number, it’s finance’s budget”). The quality of the target is then in jeopardy, and the likelihood of a cohesive business marching towards a single goal is in doubt.
How we can help
While annual budgeting and target setting can be daunting, an experienced, operational CFO can help improve the accuracy and smooth out a rocky process. But experience is something that comes over time, and some organizations are working with a process that needs help now.
CLA supports organizations with industry-specific benchmarking tools and strategic insights gained over many years of experience. We approach the annual planning process by gathering a comprehensive view of your business, the market, and internal and external expectations before we begin. By focusing on understanding you, we can apply our knowledge to the opportunities that fit your unique situation. An outsourced CFO can often provide and objective perspective that can lead to a more collaborative process. A skilled and trusted facilitator can gather candid input and encourage full engagement from the business leadership team. The result is often an annual plan that leadership and stakeholders can believe in and execute.
- Keith Davidson