In my last post, I argued that companies can't keep their costs in line by attacking them directly. The typical approaches of budget cuts and layoffs usually don't result in sustained changes to their cost structure — the costs creep back. Instead, companies must make fundamental changes to the way they work — how they market and sell, handle orders, bill for those orders, manufacture and distribute their goods, and serve customers after the sale. If they remove waste, errors, and time from these processes, they will get cost efficiency as a byproduct.
This isn't the way many organizations try to contain costs. The mistake they make is to keep a tight grip on budgets to try to achieve their cost targets. They're driven by the spreadsheet view of the organization — a hierarchy of cost numbers that roll up from work groups to departments to the top of the organization. It's a world view common in the C-suite and the business schools that prepared them.
To be sure, organizations need financial targets, and when they are under severe pressure, slashing "overhead" is far faster and easier. But the tight-fisted approach winds up being wasteful, and there is a better way.
Consider ThedaCare, a healthcare system in Wisconsin, which eliminated its budgeting process in 2010. According to ThedaCare's chief financial officer, Tim Olson, top management viewed it as a significant waste of time. With four hospitals, 22 physician locations, and over 5,000 employees, ThedaCare managers spent 10,000 hours a year to build their budget, and another 10,000 hours to explain, manage, and argue about it.
The organization replaced the budget with a quarterly forecasting and planning process. Managers no longer have to collect 7,000 lines of budget data. The new plan includes a rolling look back at the last eight quarters and a look forward at the next six. Managers look at numbers at a higher level than before. For example, they're monitoring cost per unit of service (not just cost by department) to be sure that they offset cost increases (e.g., due to inflation, salary increases) to maintain margin in an environment of downward pressure on prices. When managers see problems ahead, they launch a process improvement initiative — not budget cuts — to close the gaps. ThedaCare also introduced a daily financial management tool for department managers. Some 200 department managers now have a standard dashboard. Since about half their cost is people, the dashboards largely help them monitor labor costs.
Group Health Cooperative, a nonprofit health care system in Seattle with 10,000 employees, has also thrown out its budgeting process. In 2009 the organization moved to a run-rate methodology, which monitors spending quarter-over-quarter. That reduced the administrative burden of budgeting, and freed up managers to improve processes. Now they focus on what they must do differently to get a different outcome. CFO Ric Magnuson says that the change has forced managers to develop a much better understanding of the work in their departments, particularly which activities truly matter. There have been challenges. Some people like doing budgets, working with numbers and keeping score, rather than rolling up their sleeves to help streamline work.
What's going on here?
A company's leaders need to be accountable for financial results. But as Orry Fiume, one of the founders of "Lean Accounting," told me, they shouldn't run their business day-to-day by the numbers. (Lean Accounting redesigns a company's performance measurement system so that it encourages continuous improvement.) A performance management system needs to include both financial and process improvement targets. The financial targets are far easier to set but also far less useful as a tool to help managers achieve them. The process performance improvement part is critical to changing the work activities that lead to the results. Determining what operational changes to make is difficult and often accomplished through trial and error.
ThedaCare and Group Health still have an annual planning cycle where they set targets and identify gaps in revenue, profit, and other metrics, and they monitor their performance quarterly. But instead of driving the high level targets down into detailed departmental targets and budgets and monitoring those detailed budgets, they take the high level gaps and charter multidisciplinary process improvement teams and projects to close the gaps. They then monitor those projects and their impact on process and financial performance quarterly, paying most of their attention to process measures. The role of leaders day-to-day is to check progress on these improvement activities. It isn't to sit in their offices reviewing budgets. (For more discussion on eliminating budgets and transforming performance management, see the Beyond Budgeting Round Table.)
Organizations today must focus their leaders on improving service, cost, and quality, not on budgets and expenses. This shift will require personal transformations for most C-level executives, especially the chief financial officer. That will be the subject of my next post.
Question: Have you seen organizations whose top management shifted their attention from the budgeting process to setting and monitoring continual improvements in time, cost, quality and other operational indicators?
This blog first appeared on Harvard Business Review on 10/11/2011.