Aligning costs with revenues: at a time when revenues are unpredictable, closing the gap between operational planning and budgeting is imperative, and companies simply have to become more agile at aligning controllable costs with revenues.

Delivering paramount business performance is progressively more difficult in today's uncertain economy. In business-to-business markets, deals evaporate into thin air as boards defer everything but the most essential spending. In consumer markets, customers are taking advantage of the best deals available. Meanwhile, competitors simply step up aggressive practices--doing everything they can to make their own numbers.

Since the hyper-exuberance of the bull markets in the late 1990s, some markets have gone into spectacular decline. For instance, Tech Data, the Florida-based computer products distributor and services provider, noted in its January 2003 annual report that corporate spending on computing hardware and peripherals--which rose almost exponentially towards the end of the last millennium--had fallen nearly 30 percent since its 2001 peak.

If growing revenue is no longer an option, companies can only deliver the earnings they have promised to stockholders and the analyst community by placing more focus on the things they are actually able to manage. This means creating a lean business by constantly monitoring operational resources and capacity, and keeping it tightly in step with demand.

For most organizations, this simply means managing headcount. But, depending on the type of business, it could also include bought-in or leased products or services that can be controlled in the short-to-medium time frame. This could include vehicles used in distribution or the number of telephone lines being leased at any one time. In such a situation, how can a company achieve this control--and what systems are there to help?

Some companies clearly expected that the heydays of the '90s would soon disappear, and used the time to prepare for a more difficult future. These companies deployed cost management methodologies, such as activity-based costing (ABC), driving it deep into the belly of their organizations, so that managers benefited from a broader understanding of what was profitable business and what drove costs.

Tech Data did just that. Having started a global rollout of ABC in 1997, Tech Data is still delivering satisfactory earnings while its competitors flounder and their markets stagnate.

From its 2001 peak of $20.4 billion, its 2003 revenues fell to $15.7 billion, but it managed to hold sales and general expenses (SGA) before special charges to 3.89 percent of revenue; more than a clear percentage point less than its biggest competitor.

Another company exemplary of how adopting ABC helps companies weather a downturn is Southwest Airlines. In 2002--arguably the worst year in airline earnings history, following the tragedy of 9/11/01--Southwest continued its record of 30 years of annual profits. It was the only major airline to record a profit, while its industry peers incurred losses that exceeded $10 billion.

But in most companies, the only tool they have to help with cost control is the annual planning and budgeting system. The majority of U.S. companies use spreadsheets for budgeting, often combining contributions from many hundreds of users before they arrive at the corporate P&L. Others take advantage of the newer Web-based applications and advanced work management tools to expedite the process.

But regardless of what applications they use, for most companies the budget represents little more than the consolidation of the line-item costs of individual responsibility centers. One can compare actual revenues and costs against the budget at month-end, but it fails to show what is actually driving revenues and costs and what is actually happening in the business.

This is because traditional budgeting applications rarely go beyond the financial perspective. Managers have to do their detailed operational planning offline on spreadsheets, incorporating a variety of non-financial data to model such things as, say, their staffing requirements, before they are able to reliably forecast their costs. They then either re-key or cut-and-paste their line item costs into the central budgeting application.

The implications of this disconnect between operational planning and budgeting is crippling because:

* The full operational richness of what is happening within the business is completely lost to the finance function--which sees costs compiled with little or no insight as to what is driving them.

* Managers still plan in their own departmental silos, oblivious as to how decisions that their colleagues are making upstream in the value chain are likely to impact them in the future.

The net result is that operational resources and costs are frequently out-of-step with revenues, and the amount of resources in individual departments is often poorly aligned; some functions end up short-staffed, while others have excess capacity.

At a time when revenues are unpredictable, closing the gap between operational planning and budgeting is imperative. Companies simply have to become more agile at aligning controllable costs--such as headcount--with revenue.

This is the case with Milwaukee-based Fortis Health, the largest provider of individual medical, small group, short-term and student health insurance. The company ran an adequate budgeting application, staffing models for the key operations areas of underwriting, customer services and claims, which used non-financial driver data to model headcount requirements and a separate ABC model as part of its performance management program. However, none of it was integrated, which made maintaining the integrity of the data across multiple systems a perennial problem.

As the company grew, it realized that it could no longer rely on a myriad of spreadsheets to manage its business. For example, Cathy Jorgensen, director of Performance Management, estimates there have been more than 3,000 individual spreadsheets in use by managers across the organization.

Fortis Health has implemented a Web-based application for real time enterprise planning, budgeting and forecasting to bring all these separate functions into a single application and build a dynamic operational planning and budgeting solution. The way it works now, in the first few days of each month, it generates a roiling re-forecast that spans operational staffing and financial budgeting, looking 36 months into the future.

Keeping operational resources aligned with revenues is much easier. Starting with new business sales, managers across the company simply re-forecast the key non-financial driver data every month, and everything else--including the line-item costs and the group profit and loss account--flows from that. What's more, the company is totally in touch with what is going on in the business.

Previously, for example, if the underwriting department looked to be over-staffed with a high unit cost, it would be called upon to explain the situation. That is no longer likely to be the case. Senior management has total visibility into the operation and can see that underwriting was staffed up to prepare for new business volumes that the sales department forecast many months ago but subsequently failed to deliver. It's likely to be the sales department that is in the spotlight.

Simply integrating operational planning and budgeting into a single application with a single database and having the application widely deployed to front-line business managers by the Web gives organizations the agility they need to manage controllable costs better. For many, the ability to carry out monthly rolling re-forecasts will be a quantum leap in itself.

But for some businesses, waiting for a month to pass before re-forecasting the amount of operational resource required may be too long, and they may wish to move to weekly re-forecasts, making the organization even more responsive to changes in the market.

We have long known that traditional budgeting is inefficient; it takes too long and costs too much--25,000 working employee days for every $1 billion worth of revenue, according to benchmarking specialist The Hackett Group. But increasingly, it is beginning to show up as ineffective due to its lack of fast response.

It is this failing, rather than the time and cost factors, that is driving organizations to a fundamental review of the way they plan and budget. But before rushing headlong into overhauling their planning and budgeting processes, organizations need to step back and reconsider what planning and budgeting is all about.

Fundamentally, it is not simply a financial process that is the sole domain of the finance function. It is an enterprise-wide process to ensure that there is the right amount of resources available to secure the strategic and financial objectives that the organization has set for itself. The finance department is there to coordinate the process and act as the custodian of the numbers.

It is the operational managers who know how the business works and how they plan in their department, making them well-placed to work alongside finance and transform budgeting into a value-adding process. To ignore them in the process is to court peril.

Mike Sherratt is founder and CEO of ALG Software (ALG), a provider of Enterprise Performance Optimization solutions, with offices in the United Kingdom, U.S. and other locations worldwide. He can be reached at [e-mail].