Budget Stress Testing (#291)
/In this podcast episode, we discuss budget stress testing. Key points made are noted below.
The Effects of Not Stress Testing a Budget
It’s the one thing that most organizations don’t do. Instead, the management team fiddles with the numbers to arrive at just the right combination of projected sales and profits and cash flows. This usually results in a business that’s running pretty lean. They try to shave a few expenses here and there, maybe buying some lower-quality materials for their products, perhaps running the administrative staff a little too hard. Maybe they can run the sales staff with one fewer person, or put off some building maintenance for a year. We’ve all seen it, and usually the management team gets away with it. But not all the time. Sometimes, the result of this kind of behavior is a complete collapse.
The problem is that management is not stress-testing the budget. It’s simply shaving expenses down on the assumption that nothing bad will happen. And in your typical year, that might be a reasonable assumption. Over any stretch of 365 days, a low-probability event probably won’t occur. For example, if the risk of flooding in any given year is 10%, then something bad happens only once every 10 years, so why spend money to prepare for it at all? But every now and then bad things happen, and the losses can be catastrophic.
Taking a Longer View
A better approach is to view the budget over a much longer period of time. Let’s keep going with the flooding example – and especially because a lot of businesses are subject to flooding risk. You’re the CEO of a business that’s located in a flood plain. The business moved there three years ago, and you just found out about the flooding danger, as well as the probability, which is 10% per year. If you’re prudent, you’ll reserve some funding in every single annual budget to mitigate that flooding risk, because you know it’s going to happen – just maybe not in the next 365 days. This might mean an ongoing plan to move the most expensive machinery to an upper floor of the building, or installing pumps in the basement, or installing backup power generators. Or, of course, starting to move to a different location that’s not in a flood plain.
Yes, these are expensive steps. And yes, from a stress testing perspective, they need to be done. When viewed over any one-year budget period, these actions will drive down planned profits. But when viewed over a longer period, they increase profits, because over the long term, the business is avoiding a catastrophic loss.
Value Enhancement through Stress Testing
Let’s take this logic a bit further. When viewed from a longer-term perspective, stress testing is really focused on increasing value. That’s right, spending money now to avert losses at some indeterminate future date should increase the value of the business. Therefore, if you’re looking at some sort of risk that has an extremely low probability and will be very expensive to guard against, then maybe you don’t spend any money on it. Like guarding against a hail storm in an area that’s never experienced one. So, I’m not talking about spending money indiscriminately on all kinds of risks – just the ones where there’s a long-term payoff.
Where to Apply Stress Testing
Where else can stress testing work? At the department level, you’ll want to examine any situations where a key skill set is concentrated with just one person. That’s a definite risk, since that person could become disabled, or die, or leave the company. In this case, you need to evaluate the cost of bringing in a backup person or cross-training someone else who’s already there. There probably aren’t too many positions like this in a business. Maybe it’s a salesperson when sales are highly technical. Or maybe it’s a mechanical engineer in the research and development group. The CEO needs to know where these weak spots are, and guard against them with some targeted spending.
Let’s look at equipment. The most critical equipment is anything that has a long lead time, either for maintenance parts or to replace the machine entirely. This usually means highly specialized equipment. If you have anything like this, consider investing in a spare unit. If the existing equipment happens to be very high-end, this doesn’t mean that the backup also has to be high-end. It could be fairly basic, as long as it’s functional enough to keep the company going while the main unit is being repaired or replaced.
The same approach goes for suppliers. I talked about this a bit in Episode 287, which was Pandemics and Business Planning. Figure out where there’s most likely to be a failure in the flow of supplies, and work on either replacing that supplier or signing up a backup supplier. This can be difficult to figure out, because a supplier could be situated in a flood plain too – which is not entirely obvious. And nowadays, you have to consider the risk of borders being closed due to a pandemic, or maybe a trade war. These issues have a major impact on the budget, because the current suppliers are probably the lowest cost. So, if you need to switch suppliers, you’re probably going to be using more expensive suppliers – which impacts the cost of goods sold.
So in short, the senior management team, and especially the CEO, needs a really good understanding of where the risks are in a business, and prudently make investments to mitigate them. Yes, this will reduce profits over the short term, but it should do the reverse over the long term.
Stress Testing in a Changing Environment
Which brings up an interesting point. Some business leaders claim that their business models change so fast that there’s no point in even producing a budget that covers a full year – because they don’t know what they’ll be doing in a year. My comment is that these are usually startup companies that might end up pivoting three or four times before they figure out a viable business model. If so, they don’t really need to worry about budget stress testing. Also, since they’re startups, they probably don’t have any excess cash and so can’t afford any risk mitigation expenditures anyways.
But startups don’t stay that way forever. The business matures after a couple of years, and then there aren’t any more pivots. Instead, everything settles down, and the CEO is in a better position to analyze risks and guard against them.
Stress Testing as a Competitive Advantage
Another thought on stress testing is that doing so can give a company a major competitive advantage. The reason is that some – if not most – competitors are not doing this, so when they get hit by a major negative event, the companies that have done a better job of minimizing their risks will be in a great position to either scoop up more customers or buy those competitors for a really low price.
Stress Testing Assumptions
It can help to include stress testing assumptions in the budget documentation. To get back to the flooding example, this could be a statement that there’s a one in ten chance of flooding each year, and if the business floods up to one foot deep, that will cause a half-million dollars of damage. And if the business floods up to five feet deep, then the damage figure triples. To mitigate this risk, the budget includes five specifically identified expenditures.
This documentation helps to roll forward knowledge of the budget stress testing from one year to the next. And it’s especially helpful when someone new takes over as CEO, so they can understand why the company is spending more money in certain areas than might otherwise appear to be necessary.