Cut your budget

Fiscal 2004 was the first full year that Tomkins, the £2bn market capitalisation global engineering business, worked without a budget at group level (although budgets are sometimes still used in individual business units). However, its removal effectively took place in 2003 as the company introduced a new approach focused on year-on-year performance improvement and value creation, supported by a monthly rolling re-forecasting system. Gluing this all together is a new incentive-compensation system called ‘bonusable profit', which has replaced the previous budget-based bonus system.

Ken Lever, Tomkins' chief financial officer, explains that one reason for abandoning the budget was that it is typically not aligned with shareholder interests.

“Within most organisations, once the budget is in place, managers tend to focus on performance to the budget rather than find ways to improve the performance of the business,” he says. “So what might happen is, for instance, a business makes £20m profit one year, but, due to forecasted market conditions, budgets an £18m profit the next. If they then get the budgeted figure, this is seen as a success and they get a bonus. They are not incentivised to find innovative ways to improve performance. We didn't see this as being aligned with the interests of shareholders who want business managers to drive year-on-year improvement in performance.

“It's about getting managers to ‘act like owners'. This is a phrase we use a lot with business managers.”

Lever adds that Tomkins also wanted to eliminate the amount of time wasted producing budgets that were already out-of-date at the start of the new fiscal year.

Perfect 10

Tomkins takes a simple approach to year-on-year performance improvement targets. Annually, each business is challenged to achieve what the organisation refers to as 10-10-10. This is:

• 10% revenue growth;
• 10% return on sales; and
• 10% return on invested capital after tax.

However, 10-10-10 does not represent an annual performance contract. Nor is it an outcome of negotiation between the centre and business units. It represents a goal for the business that, when achieved, is recognised and rewarded. Lever explains: “We don't expect all of our business to hit 10-10-10. Rather, we expect to use it as a way of communicating what's really important to the business and our shareholders. For managers, 10-10-10 then becomes a mindset for driving value into their businesses, for stretching performance and for aligning the performance of the manager with the expectations of the shareholders.”

Performance alignment is measured through the use of shareholder value-based metrics. The performance of all business areas is measured through bonusable profit (essentially operating profit minus tax and a charge for the cost of capital), cash added value (CAV, a cash-based measure of economic profit) and economic return (the return over the cost of capital).

An effective tax rate of 33% is used in the businesses, largely as a way of ensuring that business managers recognise that tax is a significant cost to the business, but also as a way to prompt managers to be more proactive in managing the tax burden, where possible.

A cost of capital rate of 8.5% is applied to the invested capital in each business. This is crucial for inculcating awareness into managers that value is only created when the return on invested capital exceeds the cost of that capital.

CAV is similar to Stern Stewart's EVA (economic value added), but is cash-based and simpler to use. Lever believes that EVA can be complex on two levels: “First, to achieve a measure of economic profit [as defined by Stern Stewart] requires adjustments to the balance sheet, which we would not make.

“Also, business managers typically will not be sophisticated financiers and simply do not understand the meaning of economic value added. We want to keep it simple.”

Tomkins' scheme is called bonusable profit and is paid quarterly. The overriding objective of the incentive-compensation plan is to reward managers for increasing the overall value created in the business, based on the margin of after-tax return on invested capital in excess of the weighted average cost of capital. Accordingly, bonusable profit may increase at a faster rate than operating profit where the margin of the return over the cost of capital increases. Lever (pictured) believes that bonusable profit is a marked improvement on the prior approach of linking bonuses to the annual budget.

“When performance to budget drove the bonus, it led to protracted negotiations before we agreed the budget,” he says. “Some of the businesses used to refer to the annual budget review as the annual bonus negotiation.”

Shared bonus

To further embed an owner-like mindset, 20% of the manager's bonus is paid in shares. This is supported by a share-match after three years. “The purpose of the share match is to get manager equity in the business and take a longer-term view of the business rather than just maximising profit over the short-term,” says Lever. “We want them to recognise that, ultimately, value is recognised by the markets.”

He claims that managers responded positively to the bonusable profit concept largely because they see the outcome as something they can both control and actually influence through their own performance-enhancing interventions. This, he says, makes it much more appealing than aligning bonuses to measures such as earnings per share, or total shareholder returns, which are largely out of their control. What's more, managers' readiness to accept the formula was sweetened because there is no ceiling on the payout, so they are incentivised to drive as much value into the business as possible. In addition, salaries are increased annually only in line with the cost of living, so managers cannot drive up remuneration through being adept at annual pay negotiations.

As well as moving from a budget to a value-based view of performance, another key change made by Tomkins was to instil a process for monthly re-forecasting, supported by quarterly reviews. Each business is required to report monthly on financial performance and to reassess their forecasts on a rolling 18 months’ time horizon. A more rigorous appraisal of performance is conducted through the quarterly business reviews.

Lever says: “We perform extensive reviews with each business covering current and projected financial results, the progress of key operating and strategic initiatives, the risks affecting their achievement and the actions being taken by the business unit's management to manage the risks and achieve their objectives.”

Lever states that the third-quarter review is more concerned with how each business forecasts likely performance over the next fiscal year. “Each December, managers put a stake in the ground as to what they forecast for the next year.” Crucially, he says, this is not a surrogate budget. “We use this as a way of confirming, internally, the guidance we should communicate to the market. The way the forecast is created does not in any way resemble a conventional budgeting approach. It is not a protracted negotiation between the centre and the business, but an honest assessment of what the business expects to achieve in that 12-month period.”

Removing the annual budget also has an impact on the resource allocation process. Lever explains that if, for example, a manager approaches him with a proposal to hire a consultancy, the decision will not be made on whether there's a budget for the assignment, but whether or not it will create value. “Similarly, the businesses decide on whether to run a marketing campaign against the same criteria; whether or not it will add value and not whether there is money in the budget to spend.”

Creating value

Lever adds that at the macro level, the whole resource allocation process is driven by the group leaders' understanding of which businesses are creating value and by how much. At the micro level, a robust capital planning process comes into play. And there is a clear distinction between sustaining capital and growth capital, as Lever explains: “For sustaining capital we have a pool of capital that businesses can spend on projects, which are not technically value creating. This will be for projects such as for plant maintenance, as one example.

“They can spend this as they will, so long as they do not spend more than the agreed pool. We don't really control that, although, of course, we do keep an eye on spending. Also, if there's a project that's over $500,000 the business has to receive central approval.”

For growth projects, business leaders must list projects over $250,000 in their rolling capital plan and the centre must sign off any over $500,000. If any new projects over $250,000 are launched that were not in the original plan, then the centre must sign that off too. “We have a fairly sophisticated investment appraisal process where managers have to show that any project they embark on is aligned to their strategy and will deliver an economic return,” says Lever.

Strategic planning

As well as moving away from the annual budget, Tomkins does not complete an annual strategic planning process. “Basically, every one of our businesses has a strategy in place that was developed in conjunction with the centre. We view the progress of the strategies and strategic initiatives on a quarterly basis. We do recap this once a year, but we don't put the businesses through a structured strategic planning process. We want business leaders to see strategy as dynamic,” says Lever.

Tomkins is seeing definite benefits from moving away from a conventional budgeting approach. “We're much more future-focused. Our businesses talk about performance improvement compared to the prior year and performance against the previous quarter's forecast. They are looking at ways they can improve the forecasting by using leading indicators for their markets. It's a much more dynamic process,” says Lever.

“In the 1990s, Tomkins was driven by growth in EPS and managers were expected to squeeze as much operating profit from the business as possible. Since 2000 the requirement has been to focus on creating value in the business, and shifting from an operating profit mindset has not always been easy,” says Lever. “The other challenge was for managers to understand that this wasn't just a finance initiative, but was of value from a business manager perspective.”