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Budgets are Like Battle Plans

Jerry Boebel
May 29, 2019

Blog-2019-05-29

Improvise, Adapt, and Overcome

“No plan survives contact with the enemy.” This military axiom has been credited to famous generals from Napoleon Bonaparte to the more contemporary hero, Colin Powell. Your CFO was probably heard muttering similar sentiments right around the end of the first fiscal quarter after none of the expected Federal Reserve rate increases materialized.

The expression does not imply that planning is not valuable. Quite the opposite when you consider what Dwight D. Eisenhower said as a follow up; “In preparing for battle, I have always found that plans are useless, but planning is indispensable.” If we took the advice of these historic figures and translated it to our own financial endeavors, the takeaways would be:

  • Accept the things we cannot change and deal with it (like interest rates)
  • Net revenue is your key planning target
  • Tie discretionary spending to net revenue beats or misses

The most impactful force for financial institutions outside of management control is the level of market rates. Rate levels are the wartime equivalent of bad weather. If the success of your budget was mostly dependent on your outlook for three rate increases during 2019, you’re probably not getting that performance bonus.

Strategies built on expected changes in rates typically create balance sheets with unacceptable profiles for interest rate risk and liquidity risk. These strategies prohibit you from making pricing decisions at the customer level and force you to chase specials on product. At ProfitStars®, our experience in customer profitability continues to tell us that promotions based on rate specials usually attract single-product relationships that do not persist and rank in the bottom quartiles of profitability.

One of the hallmarks of a budget (and a management culture) that can adapt to external changes is a target based on net revenue. 

Net Revenue = Net Interest Margin + Non-Interest Income – Provision and Losses

The thought here is that complete focus on growing revenue by net interest margin exclusively leads to the same results as chasing rates. Strategies that focus effort on growing fee income and managing provision have many benefits: 

  • They provide another form of diversification
  • They are less likely to make compromises on asset quality, interest rate risk and liquidity risk
  • They encourage management to focus on optimal pricing decisions made at the relationship level
  • They foster a culture where management is continually making decisions on discretionary spending based on performance year to date

Strict focus on net income can be detrimental, especially if it reduces important operating expenses. Some operating expenses are discretionary, for certain. But most, like salaries and benefits, are fixed and rising (include these in the list of things we cannot change and must deal with). Some operational expenses are investments in our infrastructure that are required for us to compete and grow. Strategies where the first tool out of the box to fix a negative variance is to cut key operating expenses are not sustainable in the long run. The same thing can be said about intentionally shrinking the balance sheet to hit a return-on-assets target. Operational expenses must grow, and balance sheets must grow along with them. Targets on net revenue are better aligned to deal with these unavoidable truths.

That leads to the last point on discretionary spending. Successful planning processes categorize all operational expenses as must do, should do or could do

  • Must do – Not spending on these items endangers the success of future periods. These are typically not discretionary and the commitment to them is firm even if it means a negative variance for that period.
  • Should do – Items ranked in order of resulting revenue growth or cost savings that we will undertake only if we have a positive variance in net revenue. As the year progresses, and net revenue performance is on target, we give these projects the green light.
  • Could do – Also known as “nice to do,” we still require a positive variance to engage. They just rank lower than the should-do’s.

Prioritizing these expenses and then making a go/no go decision based on year-to-date performance creates a discipline to the planning process and gives transparency into how spending decisions are made. The resulting discipline and transparency have a positive impact on the leadership culture of the organization.

Empowerment and ownership are two sides of the same coin. Transparency empowers a manager to bring opportunities into the planning process. She will know that she must make a strong case on the financial impacts of the expense and understand how projects are ranked. If her project is ranked as a should-do, she will have incentive to make sure she’s doing all she can for the organization to beat targeted net revenue. If net revenue misses, she understands and accepts why the opportunity was not pursued. 

Budgets that survive the entire year without change are like Sasquatch; everybody has heard of them but nobody has actually witnessed one. The budget documents you send to the board of directors at the end of each year are not as relevant as the process to monitor and correct. Sticking with the military theme, I’ll close with a reminder of the unofficial motto of the United States Marine Corp. Improvise, adapt, and overcome.

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