Telcos do not plan their budgets efficiently
Telcos are special. Most of them have a legacy as state-owned organizations that did not operate in a free market economy and were not confronted with the same challenges as companies of other industries. Deregulation has changed their ownership situation in most countries around the globe, and the industry itself is evolving rapidly. Saturated markets, powerful vendors, and the appearance of alternative providers (e.g., OTT players like WhatsApp) are exerting enormous pressure on the industry. Incumbents in particular now face fierce competition on the market while still burdened with the inefficient structures and massive overhead that are a part of their history.
Telcos are forced to finance innovation out of shrinking budgets
The telecommunications industry in Europe has been under especially heavy cost pressure for years – at best, revenues are stagnating, but in most cases, they are in decline, an indicator of a mature market. Consequently, cost optimization becomes more important every year, and company structures that evolved during the growth phase of the business cycle must now be adjusted to align with profitability expectations. Investments in infrastructure are unavoidable and must be combined with modernization and the incorporation of technological developments that promise lower production costs for services. The dilemma: current cost levels must be lowered while additional investments are essential – seemingly mutually exclusive demands. Is a resolution at all possible?
We think it is – by optimizing telcos’ financial planning approach. Owing to the circumstances described above and the rapid technology changes in the industry that make additional investments necessary, planning that is reliable and efficient in equal measure is extremely important.
The constant dilemma of resource allocation and budgets
Planning and budgeting do not typically fall under the category of year’s most popular activities for anyone working in a big organization. Ensuring efficient and smooth reconciliation of the frequently contradictory demands from the finance department, the business units submitting requests, and the recipient business units is a daunting challenge. As difficult as this task is, however, the ultimate goal of any plan is, of course, to ensure that the actual results do not significantly deviate from the estimates in upcoming periods.
Putting telcos’ history behind them
During the analysis of current cost structures, the fiscal accounting methods previously used jump out at the analyst, and one means of realignment with huge potential is revealed. It is common practice to fall back on budgets from previous years as the initial framework for the current planning period rather than starting over from scratch. Quite often, departments will submit a funding request in the same amount as the previous year (or even increase it) even if there have been substantial changes (e.g., restructuring). This is usually a consequence of managers’ fear of “losing” budgets if they spend less than what had been allocated to them. Moreover, departments tend to build (significant) buffers into their budget requests (see Figure 1); sometimes this is intentional, but it can also result unconsciously from a lack of alignment in planning assumptions when interactions with other units (which drive complexity) are necessary. Identifying these inefficiencies within the budgeting process requires a lot of expertise and time – but this is the potential we want to exploit.
Figure 1: Bottom-up Planning Approaches: Shifting Focus from Risk Aversion Toward Customer’s Willingness to Pay
Traditional planning approaches are time-consuming
Of course, there are traditional methods that can be used throughout the planning process to tackle these challenges. One option would be a “zero budgeting” approach, which essentially ignores whatever has been budgeted and planned in the past. Every resource requester is required to explain anew why the requested funds would be money well spent. Even if this approach is followed, however, certain aspects of the past cannot be ignored and/or changed. Moreover, it cannot work unless the staff are willing to try new approaches and to take risks. We must never forget that bringing about (cultural) change is difficult and is rarely to be achieved without sustained and active battling of the attitude that “we have always done it that way”.
Another option is to combine a bottom-up and a top-down approach to planning: management expectations must be clearly formulated, and possible buffers arising from risk-averse bottom-up planning must be identified and reduced. The process also ties up additional resources and causes the finance department to challenge all assumptions of business units without exception – circumstances that might have a negative impact on the atmosphere in the company and over time generate a culture of mistrust between departments.
There is an easy way out
No management in larger corporations will agree to remove the top-down input from the planning process, but there are ways to provide more freedom for making decisions at the level of accountability for costs; this in turn opens the door to a creative process that can pursue disruptive paths on the planning journey.
Targets can exercise enormous power – and that is true in both negative and positive terms. If, on the one hand, the stretch is too harsh and overly ambitious, the results will be frustration that will likely trigger non-productive discussions about achievability. On the other hand, targets with a realistic stretch encourage employees to undertake a search for solutions that is highly oriented to results, an approach that ultimately benefits the company. Obviously, setting and achieving realistic targets is the way to go. Two simple concepts can help: target costing focuses attention in the costing phase, and a demand-based charging model acts as a reliable control mechanism.
Focus on what is important: the customer!
When any organization is seeking to implement meaningful and realistic targets into its planning process, the target costing approach is the ideal concept. The focus on cost design is based solely on the end customer’s willingness to pay for the subject of interest. Whether this customer is a consumer or an internal department is irrelevant; the idea that whatever is being planned must also be paid for is simple, so it is very easy to grasp and not likely to be challenged very much by the business unit representatives.
Once everyone involved understands the principle of the customer’s willingness to pay, it becomes much easier to develop ideas and approaches for the optimization of processes, the realization of savings in sourcing, or the scrapping of product features that are not required (column sections in yellow on the right-hand side of Figure 2 below). It is possible to create easy-to-use checklists for a company’s core business portfolio items to make sure that unnecessary costs are avoided throughout the design process of a product or service.
Furthermore, this approach can help identifying important trends. If the customer’s willingness to pay for a whole set of similar services weakens, a provider’s own cost structures must be challenged and re-evaluated. Taking action before rising cost pressures force hasty decisions to make drastic cuts and changes can help, especially as such decisions may save money in the short term while proving detrimental in the long run (e.g., cutting back on R&D funding when faced with mature market environments).
The target costing approach transforms all of the energy put into the planning process into customer-focused idea development. Departments display growing willingness to shed their defensive attitudes towards their budgets and cooperate closely with the finance department to realize the best possible outcome for the company. Furthermore, departments no longer benefit from “safeguarding budgets”, but feel free to make resources available to other organizational units if savings are realized in the product/service design process as a whole. Management can use the forecast periods to redistribute any budgeted funds that are no longer required in the department to which they were originally allocated: transparency and flexibility take the place of mistrust and control!
Demand-oriented internal charging is the game changer
If all of the positive effects described above are to be realized, it is essential to make sure that the product/service which is being designed will also be charged according to demand. Only if the unit requiring the product/service is charged in line with demand (i.e., at a market price level) can the willingness to pay be determined and applied reliably. Once this has been achieved, every product/service must be designed from this perspective, and planning will become more reliable.
Figure 2: Pricing Services and Products with Target Costing: Deliver Market Price Level by Focusing on Willingness to Pay
This fundamental principle also ensures that companies must provide internal services at a price that is in line with the customer’s willingness to pay (in this case, another department of the same company). Models that pass on the full costs of a service plus a mark-up (see left-hand side of Figure 2) result in cost sensitivity that is close to zero on the part of the producing unit since it can be certain that all incurred costs will be borne by the receiving unit. As if this were not enough, it is not at all uncommon to find several margins being added on top as soon as more than one internal unit is involved in the added-value process. The receiving unit is expected to pay a price that includes several internal margins, ultimately driving up the end customer price without adding any genuine value. As soon as this dynamic process changes and departments must produce services at prices in line with the customer’s willingness to pay, the producing unit bears the entrepreneurial risk since it is forced to design the service to be cost-efficient or it will not be able to “sell” this service at all. This pressure creates the previously mentioned positive creativity, leading to better solutions for the company.
Experience from implementations
All of the aspects of this concept have been successfully implemented in one of Europe’s largest telco provider. The best news first: there is no need to implement any additional tools! A mindset change is “all” that is required to leverage the benefits of target costing, but the model described above for pricing services on the basis of actual demand and willingness to pay is quite simple to understand, and convincing the organization of its benefits is not a difficult task. Of course, good understanding of the underlying business is essential as well.
Case 1: Avoiding internal planning iterations
The initial figure given in a bottom-up budget request for a service amounted to €7 million and included multiple buffers. In the course of determining potential customers’ willingness to pay, it became obvious rather quickly that no one would be willing to pay the price that would have to be set for this service if these costs were to be earned back. A quick look at the actual amounts spent on the previous version of the service revealed that the willingness to pay was much lower.
This finding proved to be an ideal starting point for discussions leading to a complete revision of the way the service was constructed. Throughout the process, commercial and technical positions as well as the finance department were deeply involved, and an architecture that made the realization possible at production costs of only €1.5 million (less than a quarter of the initially envisioned costs!) was found – without suffering an endless series of iteration cycles.
Case 2: Squeezing the supplier
Internal planning iterations are one thing, but there is also potential in the dealings with external parties. In another example, we dealt with a service that played an enabling role for a number of other end customer services. The initial vendor offer was €7 million, and it was not at all clear whether this price was justified or not.
We therefore decided to focus on the willingness to pay for the services that were enabled by the supplier’s solution and used this in the negotiations with the vendor. Showing that we could not accept the initial offer because the price of the end customer services would be higher than the willingness to pay increased the pressure on the vendor throughout the negotiations. Step by step, the price was lowered, and the vendor developed a more innovative risk-sharing approach that resulted in a contract worth €0.4 million as an initial invest – the rest will be based on actual demand and use.
In summary: the path to efficient planning
If they want to be ready to face the current and imminent changes in the industry, telcos will have to become more efficient in their planning process:
- A change in mindset to favor customer-focused costing enables competitive services in a business environment that is perhaps of the greatest relevance for the digitalization now going on.
- Moving from a cost center-driven culture towards a more entrepreneurial one by introducing demand-based charging allows the implementation of a target costing concept that will ultimately lead to more customer-centric products at a price matching the willingness to pay.
- Achieving this requires a transformation of the finance department from a constant business challenger into an internal consultant who can give guidance and advice on how to reach the target costing base required to meet willingness to pay expectations rather than distributing top-down targets.
- Ultimately, planning accuracy will increase due to the elimination of “bargaining chip buffers” in bottom-up planning.
Special: Interview with Lothar Nießen, Deutsche Telekom AG
Lothar Nießen, Deutsche Telekom AG
Lothar Niessen is a senior financial manager (strategic projects) at Deutsche Telekom AG and responsible for the finance stream of one of the company’s biggest and strategically most important projects. He is largely responsible for concepts to improve monetization of investments in project scope as well as for the validation and sign-off of business cases. In his current project, he has developed demand-based intercompany charging and a customized target costing approach that are being applied in this endeavor.
Detecon: Mr. Niessen, you have spent a large part of your career at Deutsche Telekom. What are the biggest challenges in planning from your point of view?
Lothar Nießen: I think there are two major drivers here, and both of them are typical for large international organizations like Deutsche Telekom. First, there is quite a tight time schedule for the planning because the results are discussed with the many stakeholders involved in the process, and that takes longer than the planning itself. Second, I often observe that during the planning process people do not really follow economic principles like the minimum or maximum principle. If you do not start from one of the two perspectives, the result of the planning will include unaligned planning assumptions, and they typically include much higher cost estimations than necessary.
Detecon: There is evidently room for improvement – how will you resolve this dilemma in your project?
Lothar Nießen: It is horribly inefficient! The project I am now working on plans to spend huge sums – more than one billion euros – within the next five years. This is the high-level estimation, at any rate. We decided, however, that there might still be room for optimization of the anticipated spending, which is why we introduced the target costing approach to our planning methodology.
Detecon: So far, so good, but target costing is not exactly revolutionary – a focus on the customer’s willingness to pay is at the heart of the idea, right?
Lothar Nießen: Basically, that is correct. Target costing itself is no revolution – but if you combine this concept with demand-based intercompany charging, the revolution begins to take shape. I can give you an example. If one unit at Deutsche Telekom receives services from another, there are usually two alternatives. One is that they work out a contract that clearly defines the solution that is to be provided and sets a fixed price as well. This alone is horribly inefficient because it keeps lots of people busy negotiating intercompany contracts! The other approach is for the producing unit to charge the receiving unit for whatever costs it incurs plus a margin. The latter is usually unhappy because the price is high. And why wouldn’t it be? The producing unit has no incentive whatsoever to control its costs because they can be charged to the customer.
Now, if you change the game and shift some of this risk to the producing unit by introducing a unit-based charging mechanism, the producer will gain more if it can produce at lower cost, so it has an incentive to keep costs under control. The receiving unit is happy as well because it obtains the service at a lower price.
Detecon: This sounds reasonable, and basically, you are talking about a free market economy principle. Introducing this kind of mechanism must be a nightmare.
Lothar Nießen: Absolutely not! Target costing helps us a lot here because it is very easy for producing units to understand at the beginning of a project that there is a definite willingness to pay. This functions as a pre-defined budget available for production of requested service (maximum principle). Alternatively, however, we can start with a defined demand for the requested service and try to produce it as efficiently as possible (minimum principle). This awareness at an early stage is a tremendous help to the team while it develops the most beneficial business model in cooperation with the vendors as well. This typically leads to more flexible contracts that anticipate certain risk profiles within the value chain, helping us to minimize sunk costs in projects that are not commercially successful and significantly helping us in monetizing the investments in our platforms.
You described this as being like a free market economy – that fits quite well, and every one of us knows this principle because we profit from it in our personal lives every day. But it is true that, to a certain degree, we need to work on bringing about this mindset shift. I am happy to have a Detecon team with me who support me in driving this; they provide great added value to the project.
The good thing is that the adaptation of an everyday concept is easy to grasp and people understand it quickly. It also builds a lot of trust and creates transparency within the company and the project planning cycles because project managers have a vested interest in aligning planning assumptions right from the start. They know that if they are transparent about the money they need for certain parts and focus on designing a service that is below the willingness to pay, the plan is unlikely to suffer additional cuts. The planning process becomes far more efficient, and there are fewer frustrating internal discussions.