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producing budgets that were already out-of-date at the start of the new fiscal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.”