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Financial management – You don’t have to countalot

Just a few years ago any FD who suggested giving up budgeting wouldl for your average FD in the UK, but to a handful of Scandinavians it represents the future of financial management. Will it travel? have been eyed by the other members of the board as a likely candidate for the funny farm. Now, however, the notion is sufficiently intriguing that senior financial executives from major corporates are gathering together to examine just that possibility.

The Beyond Budgeting Round Table*, which began its work at the beginning of the year, has won support from companies as diverse as BG Transco, Boots the Chemist, Royal Mail, Rugby Group, Standard Life Assurance, Texas Instruments, United Distillers and Van den Bergh Foods, part of the Unilever group.

“All the surveys suggest that most large companies are very dissatisfied with their budgeting processes,” says Jeremy Hope, a chartered accountant and management consultant whose Transforming the Bottom Line was selected as one of America’s top 30 business books in 1996. “Budgets typically take three to six months to complete, drive everybody crazy in the process and achieve very little in terms of added value once they are completed.”

Hope is fascinated by the experience of Scandinavian companies such as Borealis (see panel, page 34), and IKEA. The world’s largest furniture maker and retailer scrapped conventional budgeting in 1992. Now managers keep costs within defined revenue ratios.

Hope quotes with approval Jack Welch, chief executive of US General Electric, who said that conventional budgets are “a ticket to the bone yard”. Instead, Welch has introduced “stretch targets” for key measures such as return on capital employed, sales growth and cost reduction. The targets are highly ambitious and designed to make managers question everything they do. But, significantly, managers are not punished for failing to meet them. GE’s approach has recently underpinned another year of outstanding results with turnover up 15% to $91bn and net earnings up 14% to $8.3bn.

With results like these, no wonder others are keen to unlock the secrets.

During the year, the Round Table is focusing on five key purposes of budgeting – target setting, resource allocation, performance improvement, management reporting and financial forecasting. The aim is to discover how those companies that abandoned budgeting now handle these functions.

Colin Masterson, director of financial control at National Power, who has joined the Round Table, hopes to discover what those companies who abolish budgeting put in its place. “Clearly, there is still a requirement to manage the business and that includes costs as well as other things,” he says. “We would like to know how it is done.”

National Power has adopted a more flexible budgeting process. It now places more emphasis on three-year rolling budgets. It reports forecasts, rather than year-to-date figures to the board. And it gives business units the responsibility for making sure forecasts are accurate.

All this is part of its drive to become a more flexible organisation so that it can hit its strategic target of being the UK’s lowest-cost electricity producer. In search of this aim, cost management was a top National Power priority in the past. But Masterson acknowledges: “There is a law of diminishing returns when you set out to control costs. We feel we need to go beyond that now.”

This chimes closely with the heart of Hope’s message that traditional budgeting is a barrier to change. He points out that many companies are trying to move their management culture away from one based on compliance and control to one that embraces enterprise and learning and all levels.

It is only by making budgeting – or whatever replaces it – go with the flow of change in business culture that it is possible to spring the trap and create the kind of new decentralised organisation that can succeed in today’s changed business conditions.

At this point, it is important to get the definitions correct. Hope makes it clear that he is not talking about the budget as a forecast. “We are talking about a budget as a commitment, a constraint and a measurement framework,” he says. “It’s the whole micro-management process that typically grinds its way through the final six months of every financial year.”

In fact, few companies stop to consider just how much management time and commitment is consumed by creating a budget. In a typical large company, various drafts of the budget will go round the company anything from three to six times. Moreover, because business conditions change more quickly, by the time a company is only a little way into its financial year, the budget is out of date.

But if you scrap the budget, doesn’t anarchy break out? “We don’t think so,” argues Hope. “If you think about it, the budget not only defines the ceiling for expenditure but it also sets the floor. Remove the budget, and you take away the floor as well as the ceiling.” Companies adopting the new approach find front-line managers questioning costs they previously had little interest in removing.

Part of the reason companies keep old-style budgets is because they don’t trust their managers, argues Hope. So abandoning the budget implies placing a great deal more trust in middle and junior managers to operate responsibly and effectively. This may be one reason why the vanguard of ‘beyond budgeting’ is Scandinavia, where a culture of trust seems to be ingrained in more companies than other parts of Europe.

Certainly, several of those companies that have binned their budgets have reaped big benefits. For example, Danish contract cleaning company ISS has grown into a $2bn multinational with 115,000 employees by placing responsibility for controlling costs at the front line.

But business ideas, like fine wines, do not always travel well. Can the new approach to budgeting succeed in the UK? Hope believes there is no reason why not. “Already, we can see patterns from the companies that have done this and they really have liberated their front-line managers,” he says. Yet before they abandon budgets, most FDs are going to want to know how three important functions take place in the post-budget era: allocating resources, measuring performance and controlling costs.

As far as allocating resources is concerned, Hope argues this should not be a once-a-year exercise anyway. Moreover, there is a strong case for decentralising resource allocation. For example, the US-based GE has freed managers from central control over investment decisions. The board sets the vision and direction, but front-line managers take decisions on which are the most profitable projects to invest in.

But Hope warns: “You can’t just gather everybody together and tell them you’ve thought up a great new way to run the business. It takes a long time. You have to retrain your front-line managers to act in a different way. It doesn’t happen naturally.”

When it comes to measuring performance, many companies are shifting away from monitoring financials only to a balanced scorecard. At National Power, for example, they monitor progress against targets in five main areas: achieving current business performance, sustaining and developing capabilities, positively influencing stakeholder impact, changing the business and developing people.

Hope argues that when it comes to measuring performance, conventional budgets take too narrow a perspective. Companies generally measure themselves against their own targets or past performance. What they ought to do is measure their performance relative to their peer groups. “If you are in a business unit network, for example, you need to compare yourself with others at the same level,” says Hope. “This sets a much sharper level of competitive edge than trying to beat the budget.”

Even controlling costs can be managed more effectively, argues Hope.

“You trust people to manage the business units well. You give them stewardship of their money but monitor cost trends in the business cycle.” A lot of FDs may feel uncomfortable with this approach. “You can’t have what you had in the budgeting era, with the detailed level of control, and have the benefits of the new,” he says.

But alongside greater trust runs a system of fast and open information.

The idea that business information belongs to the unit that produces it has to be abandoned alongside the budget. Instead, information is shared around. In this environment, the FD soon spots if costs in any area are going seriously awry.

The post-budgeting era poses serious challenges for senior finance professionals. Robin Fraser, a lecturer on CIMA’s Beyond Budgeting Mastercourses and a member of the Round Table, says: “The FD is less involved with number-crunching and cost management and becomes more a facilitator of holistic integrated management systems. He is not just focused on the finances, but more on broader performance management.”

These are early days and the Round Table has just completed its first study visit – to Swedish ballbearing manufacturer SKF. But the participants seem in little doubt that their work is going to have some far-reaching results. Binning the budget could be the start of a management revolution.

* The Beyond Budgeting Round Table has been launched by the Consortium for Advanced Manufacturing International to investigate budgeting, develop practical approaches to overcome its limitations and help members move towards a more value-adding approach to management. More details are available from Jeremy Hope Associates on (01274) 533012.

Borealis: Liberating performance measurement

Finnish-Norwegian petrochemicals giant Borealis, with sales of £1.3bn, abandoned its traditional budgets in 1995. It is now in its third year under the new regime and Bjarte Bogsnes, vice-president of corporate control, says the new approach improves financial management because performance measurement is now more transparent.

“We were extremely dissatisfied with traditional budgeting because it was not effective as a financial control tool,” says Bogsnes. He points out that there is a fundamental conflict in conventional budgeting, especially target setting.

“You want ambitious targets for people but the most likely outcomes for financial forecasts. The two are not the same.”

Borealis has overcome this problem by separating the two. It now has a rolling financial forecast. “Every quarter we make a forecast based on our latest information about the market, production, investment and other factors,” explains Bogsnes.

The forecast covers the next five quarters and provides profit and loss, cashflow and balance sheet. “It is a very simple process but is good enough.

Anyway, we found making annual budgets on revenue prices was meaningless because nobody knew the way the market would go,” he says.

To raise ambitions and stimulate change, Borealis sets both financial and non-financial targets based on a ‘balanced scorecard’ relating to customers, business processes and people. As far as the financials are concerned, the company has introduced relative targets, with more ambitious aims when the market is high than when it is low.

The way the old budget was constructed – from the bottom up – tended to filter out ambitions because each successive layer of management builds in its own safety-net. Bogsnes believes the new top-down targets are more ambitious. But he points out they are matched by giving unit managers a new freedom to meet their targets in their own ways.

Getting rid of budgets does not seem to have damaged cost management.

By giving individual business units tough profit targets, cost management tends to take care of itself.

Alongside benefits of improved financial management and target setting, Bogsnes says the new approach uses significantly less resources than the old budgeting process. It is difficult to separate out the specific impact of the new approach, but alongside the creation of a European service centre and new accounting systems, it is likely there will be a 30% reduction in head count in the corporate control function in the next two years.

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