Stop budgeting, start improving
In my last post, I argued that companies cannot keep their costs under control by attacking them directly. The typical approaches of budget cuts and layoffs generally do not result in sustainable changes to their cost structure – costs creep back little by little. Instead, companies must make fundamental changes in the way they work – how they market and sell, handle orders, bill for those orders, produce and distribute their goods, and serve customers after the sale. If they eliminate waste, errors and time from these processes, they will achieve cost efficiency as a by-product.
This is not the way organizations try to contain their costs. The mistake they make is to keep tight control over the budget in an attempt to reach their target cost. They are guided by the organizational spreadsheet view – a hierarchy of cost numbers running from work groups and departments up to the top of the organization. It is a common worldview among company executives and the business schools that prepare them.
Certainly, organizations need financial targets and, when they are under pressure, cutting expenses is much quicker and easier. But the narrow-minded approach ends up being wasteful, and there is a better way to do it.
Take the case of ThedaCare, a health system in Wisconsin, which eliminated its budgeting process in 2010. According to ThedaCare's CFO¹, Tim Olson, senior management saw it as a significant waste of time. With 4 hospitals, 22 medical locations and more than 5,000 employees, ThedaCare's managers spent 10,000 hours a year generating budgets and another 10,000 hours explaining, managing and arguing about them.
The organization replaced the budget with a quarterly forecasting and planning process. Managers no longer need to collect 7,000 piles of budget data. The new plan includes a brief look back at the last eight quarters and a look ahead at the next six. Managers look at the numbers at a higher level than before. For example, they are monitoring cost per unit of service (not just cost per department) to ensure that cost increases (e.g., due to inflation, salary increases) are offset so as to maintain the margin in an environment of downward price pressure. When managers see problems ahead, they launch an improvement process – not expense cutting – to close the gaps. ThedaCare also introduced a daily financial management tool for department managers. Around 200 department managers now have a standard dashboard. Since roughly half of their costs are people, the dashboards help them significantly in monitoring labor costs.
Group Health Cooperative, a nonprofit health system in Seattle with 10,000 employees, has also eliminated its budgeting process. In 2009, the organization started using the run-rate² methodology, which tracks spending each quarter. This reduced the administrative burden of budgeting and freed managers to improve processes. Now they focus on what they must do differently to achieve a different result. CFO Ric Magnuson says the change forced managers to develop a much clearer understanding of the work in their departments, particularly to identify which activities really matter. There are challenges. Some people like to do budgets, work with numbers and keep score rather than roll up their sleeves and help with the dynamic work. What is going on?
A company's leaders need to be accountable for financial results. But as Orest Fiume, one of the founders of “Lean Accounting”, told me: they should not manage their business day to day by the numbers. (Lean Accounting redesigns a company's performance measurement system to encourage continuous improvement.) A performance measurement system needs to include both financial targets and process improvements. Financial targets are much easier to set, but they are also much less useful as a tool to help managers achieve them. The process performance improvement part is where it is hard to change the work activities that lead to results. Determining which operational changes to make is difficult, and these changes are usually made through trial and error.
ThedaCare and Group Health still have an annual planning cycle, in which targets are set and gaps in revenue, profits and other indicators are identified, and they monitor their performance quarterly. But instead of cascading the high-level targets down into detailed departmental targets and budgets and monitoring those detailed budgets, they select the highest-level gaps and assign multidisciplinary process improvement teams and projects to close those gaps. They then monitor these projects, their impact on the process and financial performance every quarter, paying greater attention to process measures. The leaders' daily role is to check the progress of these improvement activities. It is not to sit in their offices reviewing budgets. (For more discussion on eliminating budgets and transforming performance management, see Beyond Budgeting Round Table).
Organizations today must focus their leaders on improving service, cost and quality, not on budgets and spending. This change will require personal transformations for most senior executives, especially for the CFO. That will be the subject of my next post.
Question: Have you seen organizations whose senior management has shifted its attention from budgeting processes to defining and monitoring continuous improvements in time, cost, quality and other operational indicators?
Portuguese translation by Tamiris Masetto Manzano.
Translator's notes (Portuguese version):
- CFO – acronym for Chief Financial Officer, the highest financial position within a company.
- Run-rate methodology – a method used to analyze the company's current financial performance and forecast the coming quarters.
