Visualizing Investments in New Innovation Areas: Sources and Sinks
Clausewitz: “The process of strategy is the allocation of finite resources to achieve the desired outcome”
Most businesses today are looking to take advantage of innovation or geographic expansion to drive revenue growth, but lack methods to fund the necessary programs to support expansion. This visualization tool allows managers the ability to see into the future and justify investments in new areas. It also allows management to communicate this to shareholders and internal organizations.
This visualization tool is used to compare the product development budgets against each other and against the overall corporate model. Business units that have budgets less than the corporate average are called “Sources”. They source revenue allocations to other business units that are called “Sinks” because the budget that is generated by their sales, using the corporate average percentage, is much lower than their spending. The sum of the sources and sinks yield the overall average.
By looking at the funding levels over time, it is possible to communicate to those business unit managers how the budget was generated, reducing politics and helping all the stakeholders get on board.
What are the Benefits?
Translation of strategy into a financial model.
Communication of that model to impacted organizations to reduce politics and enable support of the vision.
More efficient budgeting process.
Ability to forecast into the future the time at which business units turn from consumers of product development budget into producers of budget.
What Business Problems Do We Solve? The challenge in today’s environment is growth. Growth in mature domestic markets is difficult because in general market segments are saturated, so innovation is required to take market share from competitors, or you need to generate a whole new market approach and create a market of one. Another challenge is that businesses are under penetrated in new markets in other parts of the geography. In some cases this might be domestic business have not expanded to Europe and Asia, or in others where they have not properly penetrated the BRIC countries.
In either case, it is a question of resource allocation. Businesses must allocate resources from existing parts of the business and point them toward new areas. In order to maintain profitability, the expenses have to be reduced in some areas to offset investment in other areas. This tool allows managers to see the reallocation today and forecast when these new areas will begin to be self-funding.
What are some considerations? The biggest consideration is the investment level required to sufficiently fund the startup programs. A business plan for the new investment area needs to be done with at least a 3 year forward look – and this business plan needs to look at all the investments required to be successful including product development, marketing, sales and capital costs. In the early years this is often dominated by product development. Management needs to judge the plan and use it to set the initial budget required. Then management needs to determine the businesses that will be used to source the required investment. The second consideration is how to modify the plan as the years lapse to reflect the changing environment and revise the model – but this becomes easier year after year as the track records are established.
There is a business with three divisions – a Cash Cow division that has about 80% of the revenue, a smaller but higher growth rate business (called “Growth”), and a new division that is being started up to go after an innovative new product space (“Startup”) – that involves the cloud and mobile devices. Going into this new area will not be inexpensive; the business case indicates that it will require $10M its first year, $10M its second year, and $15M in its third year. Given that it will take nearly a year to get to market, the first years revenues are zero, and the second year is estimated to be $5M after a conservative review of the business. However in four years, it will be the second largest and fastest growing division in the group.
How do we fund it? By looking at reallocation of resources from the Sources – Cash Cow & Growth businesses – and having them fund the new “Sink” business, which is the Startup. We are asking for less than a 10% reduction in the budgets from these two “Source” business units – we can get ½ from turnover and ½ (or another 5%) from eliminating lower priority projects. So the process has a few simple steps, completed in this order:
From a business plan determine the cash needs of the new business (Sink)
From a strategic look at the other profitable divisions, determine how much they must trip to fund the business plan
Model this over time
Socialize model with the business unit managers and incorporate into budgets – to be reviewed yearly