RE- INVENTING THE BUDGET
For many CFOs, budgeting is an annual exercise in torture. In Europe, a handful of companies are trying to take the pain out of the process.
By Janet Kersnar

Last October, 60 of the top senior managers of Diageo met to rethink the planning process at the ?4 billion (US$22.5 billion) UK consumer-goods giant, whose brands include Guinness, United Distillers, Burger King and Pillsbury. "We asked people to be radical in their thoughts and we wanted them to understand that this wasn't game playing," recalls Philip Yea, the company's CFO. And radical they were: by the end of the meeting, the executives had agreed to scrap the company's annual budget and replace it with a totally different approach.

As a result, Diageo joined a growing band of multinational giants that have abandoned what Jack Welch, the boss of General Electric, once famously described as "the bane of corporate America". Time-consuming, labor-intensive and seemingly never-ending, the annual budget is, at best, an excuse for senior managers to gather numbers they should have at their fingertips anyway and, at worst, one of a company's biggest competitive handicaps.

Of course, not every CFO is in Yea's enviable position of essentially starting from scratch in a brand new organization (Diageo was the product of a December 1997 merger between Guinness and Grand Metropolitan). But that shouldn't deter finance executives from taking a long, hard look at a process that often earns the finance function plenty of criticism from business-unit managers who struggle to pull together facts and figures in bouts of all-night number-crunching. "The guys out in the branches have to be working towards targets that are consistent with what they're expected to achieve on an operational level," warns Brian Lever, a consultant at PricewaterhouseCoopers. In replacing the budget with new tools and approaches, "finance is making a difference by operationalizing what from the beginning [should be] seen as a strategic tool," notes Yea.

Admittedly, the transition is far from easy. "Companies are spending hundreds of millions of dollars on these types of projects, but they fail to recognize the staying power of the budget," says Jeremy Hope of Hope Associates, a UK consulting firm that is a member of the Consortium for Advanced Man-ufacturing International (CAM-I), a not-for-profit group of companies, consultants and academics from around the world which studies companies that are transforming their budgeting processes. Hope argues that because so many companies launch re-engineering drives with neither the full support of key parts of their organizations nor a willingness to devote the necessary time and resources to the projects, "it's not very surprising that few of them succeed."

Rolling on

The good news is that there's no shortage of alternatives to the annual budget, ranging from rolling forecasts to balanced scorecards or a combination of them. In some cases, companies may choose to hang on to the budget, but to reduce the weight it has in corporate decision-making. "Replacing the budget requires common sense, not rocket science," advises Bjarte Bogsnes, now vice-president of human resources and formerly head of corporate control at Borealis, a privately owned Danish petrochemicals company. Borealis "blew up" its budget in 1995 (see box below), and is one of several companies profiled in this article that are at various stages of adopting new approaches to planning and control.

Calling for change

One of the biggest criticisms of the budgeting system is that it's time-consuming. At many companies, say experts, the budgeting process takes so long that no sooner has the final document come out of the system, than it's already out of touch with reality. That's why Ericsson, the 184 billion Swedish krona (US$21.4 billion) Swedish telecoms group, decided to revamp how it went about planning and forecasting. The most striking change: no more annual budgets.

For years, Ericsson relied on the traditional budget, which meant that long-range planning began around May, the preliminary budget was set in August, and the final budget in October or November. Presentation to the board took place in December. But in the early 1990s, Ericsson executives realized that the company's traditional planning methods were inadequate for the fast-growing telecoms market. Both increasing deregulation and ever-changing technology made it impossible for managers to stick to using the figures that were determined the previous calendar year. Worse, Ericsson has had fierce competitors, notably Finland's Nokia, snapping at its heels.

The solution was to break free from the annual cycle of planning and forecasting events. As Carl Wilhem Ros, the company's CFO until his retirement last month, explains, "We still think that the budget has a value as it gathers the organization around discussion of the bottom line. But the figures that are in the budget today don't give as much of an indication [of what's happening in the telecoms industry] as they did ten years ago because things are changing so fast."

The first step of the process now takes place when Ericsson managers set their so-called "rolling forecasts". These are tailored to the specific market segment in which they operate, such as mobile phones or switching systems, and are based on specific targets, which are a mix of financial and non-financial items. "Each quarter we update the rolling forecast, which looks 12 to 18 months ahead," says Ros. "We put less effort into the details of the budget, and more effort into the market changes," he explains. "Of course, we check the bottom line and work a little with the balance sheet, but we don't go through the details like we did before. It's more of a rough estimate four or five times a year."

This approach, says Lars Lindqvist, vice-president of business controls in the consumer-products division at Ericsson, has allowed him to be much more flexible than before."Measuring things on a quarterly basis makes you much more clear about what you need to do." He also notes that because the figures are updated more frequently, forecasting has become more accurate and the entire process is more interactive. That's music to Ros's ears. "People should be more involved in thinking about the future and it shouldn't only be once a year that they're involved," he says.

Peer pressure

Unlike Ericsson, Diageo is aiming to eventually rid itself of the budget completely. Last year, Yea's team determined that rather than using a budgeting process and a strategic planning process with annual targets, "we should try and have one single planning process of which year one was important but not so important that it stops you talking about years two, three, four and five." Since that decision, managers across Diageo's four lines of business have been studying which key performance indicators (KPIs) they want to use to track, predict and report improvements in their operations.

The overall aim at Diageo is to benchmark itself against a peer group of 20 international consumer and branded goods companies in terms of total shareholder return (TSR). By June 30th 2003, it wants to be among the top five companies out of the 20 in the benchmark.

Working towards this deadline, the four divisions will have some annual targets for fiscal 2000, which Yea says is necessary "to communicate to the outside world." But much of the intervening monthly reporting will be compared with the previous year, not to a budget.

The "backbone" of every set of KPIs, which Yea reckons will number about 20 for each business, is economic profit, which Diageo defines as the estimate of each unit's future cash flows, less its cost of capital. But while one business might want to emphasize asset improvement, another will prefer to focus on better cost management or greater market share. "We're creating a new set of reference points at the time when we were trying to do away with the old one, which was the budget, particularly the phased budget."

Is there any disagreement about what the KPIs should be? "Disagreement isn't the right word," Yea maintains. "It's about getting buy-in. What is excellent in the process is that unless everyone agrees that [a KPI] is important, it won't get attention. I don't think you can decree KPIs from the center." Even so, Yea makes it very clear that this doesn't mean the various businesses can pick and choose their targets as they wish. "It's not democracy at work. It's tailored, but agreed KPIs will be put in place by business area."

That approach, however, allows for a certain level of adaptability, a word Yea likes to use frequently. For example, a concern voiced at the meeting in October was whether all parts of the company would have to immediately drop the annual budget process. For the short term, operating companies will be allowed to use an annual plan or budget if that helps them "get their thinking together and control their short-term performance," says Yea. "Frankly they will soon find that much of that effort is redundant and once they're comfortable with the KPIs and comparisons with last year in their conversations with us, they will progressively simplify, modify and perhaps eliminate how they've been doing their planning and budgeting." Education, too, plays a big part in Diageo's transition. First, it is offering workshops and seminars to help staff understand how their actions can have an impact on their company's overall performance. Second, and perhaps more importantly, it is changing the incentive scheme for around 1,000 top executives and managers. Many experts stress that the best way to encourage people to abandon habits that are associated with the old budgeting system is to link incentive schemes to new performance-measurement targets. So while annual bonuses at Diageo were formerly based on profit and cash, they are now tied to economic profit.

What's a budget?

As Yea readily concedes, changing the mindset of a company can't take place overnight. That's why it helps to have a headstart on your competitors. After 30 years of operating as a "budgetless" org-anization, Svenska Handelsbanken, Sweden's largest bank with 929.5 billion Swedish krona (US$107.7 billion) in assets and over 8,000 employees, can safely say that it is ahead of the learning curve in terms of taking a leading-edge approach to planning and forecasting. "We are quite far away from the budgeting procedures," admits Sven Grevelius, executive vice-president of finance at Handelsbanken, with characteristic understatement.

At the heart of this philosophy lies the fact that each of its 530 branches operates as a self-contained business and is given a great deal of autonomy in its decision-making. In fact, with a very lean head office, the branch network earned 80 percent of the group's profits last year.

One of the key elements of Handelsbanken's system is the benchmarking program. Branch managers are benchmarked against one another based on their quarterly P&L statements, and the bank as a whole is continuously comparing its performance with that of its Nordic peers. The focus is on key ratios, such as cost per employee and expenses as a percentage of assets. "Cost-efficiency is a very important part of our general philosophy, as is the very anti-bureaucratic organization," says Grevelius.

But while the bank's head office isn't setting targets, forecasting for the branches or asking for aggregate figures, CEO Arne Martensson, Grevelius and his team meet regularly on an informal basis to do 'what if' scenario planning and forecasts. "Though Handelsbanken is very decentralized, it's very centralized [in the sense that] it keeps a firm grip on key figures," says Patrick Tillman, an analyst at Alfred Berg in Stockholm. "There's a lot of focus on return on equity." (In 1998, return on equity, the basis for the company-wide profit-sharing scheme, was 18.6 percent, the highest of the major Nordic banks, according to Ma rtensson's statement in the annual report.)

Whether the bank can achieve the same level of performance in the next 30 years is a matter of some speculation. Tillman says that analysts and investors are beginning to wonder whether the new system enables Handelsbanken to respond quickly enough to major changes in the sector, notably consolidation, the rise of electronic banking or new products. So far this year, Handelsbanken stock has underperformed by 15 percent relative to other Swedish banks, but the group's first-quarter earnings were strong, with a 35 percent rise in profits compared with the last three months of 1998.

For his part, Grevelius insists that the process in place at Handelsbanken is "self-adjusting" and that "if things don't go right, things will be put right quickly" because branch managers are empowered to implement changes themselves. But can the bank sustain the "budgetless" spirit among staff in fast-changing markets? Grevelius reckons it can. "The longer you succeed, the easier it is to enforce."

Janet Kersnar is Editor of CFO Europe.