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How to measure performance.

For the first time, a benchmark is being established for evaluating the effectiveness of finance departments. It's based on a quantitative and qualitative study of 27 U.S. companies over the past three years.

Robert W. Gunn

Vice President

A.T. Kearny, Inc.

In a worrisome economy, companies need a sharp and sophisticated financial operation. This need has driven change in how finance is structured and how it operates.

Financial operations are moving out of the back room. Confronted by new technology, new competition, and a heightened concern for the bottom line, Corporate America is integrating finance into the fabric of its business. The result is a new strategic role for the finance department, and a new organizational structure to enable it to carry out that role.

What steps are some of America's leading companies taking to sharpen the effectiveness of their financial operation? That was the subject of a special panel at FEI's recent Current Financial Reporting Issues Conference.

Called "Organizational Strategies for the 1990s," the panel presented a blend of organizational concepts and how those concepts are being applied in a practical way. Are there benchmarks against which to measure the performance of the finance function? A review of the changing finance role in 27 companies suggests some answers. Also examined were how finance is helping General Electric achieve its productivity goals and how it is helping AT&T confront a new competitive environment.

The articles to follow were adapted from these three presentations.

What does the finance function contribute to U.S. business? Does it really make a difference?

Research conducted by my firm among 27 companies since 1987 shows that finance does make a difference. The finance function has a unique role to play, and it makes a unique contribution that can be measured.

Indeed, when finance plays an active role in management, we can see long-term benefits to the business in terms of earnings per share or an increase in shareholder value. But to identify what we call "functional excellence" requires an understanding of the management policies and practices that drive the numbers.

Three premises helped us to evaluate the impact of finance.

First, finance is the most important staff function; it sets the tone for all line/staff relationships. This premise comes from a 1986 survey of 71 CEOs conducted by the American Productivity Center. When asked to name the most important staff function, these CEOs identified finance at a rate better than three to one over the next most important function.

As a further reference, these CEOs were asked to identify their biggest challenge. They named three. First, developing staff effectiveness, as measured by business impact. How does an executive know he o she is getting a return for this investment? Second, finding quality people. That, we know, is one of the cornerstones of functional excellence. And, third, increasing productivity. Of course, it's harder to evaluate productivity in a staff function, especially when the output is an intangible, but it can be done.

Second, functional excellence, business performance, and productivity go together. When we reviewed 90 business units in the 27 companies, we found only one case where a whiz-bang finance function was having an impact, but it was doing so with costs that were out of sight. Financial executives recognize that they can't just throw dollars and people into fixing problems, and they know that if they can't manage their own shop, they won't have the credibility they need to work in partnership with line management.

Third, in a matrix environment, finance has direct-line accountability both to line management and to top management-the CEO. Given the quality and sophistication of the people in the finance function, we have found it's easy for them to exist in what is called a double-hatted environment, in which they have solid-line relationships both ways.

One more point. Unique challenges confront the finance function as we enter the 1990s. The first is downsizing: when staff can't work any harder, it has to change and do things differently. Second is decentralizing staff functions, in order to position accountability further down in the organization. But for finance, that's precisely the wrong way to go. The finance function needs to be strongly managed from the top. When you decentralize finance, you end up in the worst of all possible worlds-high costs, poor functional capability, and an inability to impact business results. The third challenge is global growth. The increase in international business brings unique pressures on the finance function.

So, looking into the 1990s, we see these three broad challenges: How does finance achieve further productivity after going through downsizing? How does finance support more decentralized business units? And how does finance respond to the new world of international business? These points will be addressed as we go through the study results.

What does the finance function cost?

When we studied the cost of running the finance function as a percentage of revenue for the 27 companies, we were struck by the spread among the firms. The cost ranged from .86 percent of revenue to 3.54 percent, with a median of 2.05 percent (rounded to 2.1 percent). We tried to correlate that cost with different measures-for example, product lines, number of subsidiaries, number of operating plants, internal streams-but, frankly, we could not come up with a correlation that made sense. What we did come up with, I'll review shortly.

It is interesting to add in the costs of information technology, which typically amount to 2.4 percent of revenue, and human resources, which amount to 1.5 percent. That means an average of about six cents of every revenue dollar is going to the primary staff functions. A company has to get value out of that investment.

But to explore further how much finance costs, you should separate the corporate side from the business unit side. The 27 companies show that finance costs a median of .3 percent of revenue on the corporate side and 1.8 percent on the business side.

This explains why you must be cautious in decentralizing the finance function. Most of the people and the dollars are spent on the operations side, not on the staff side. indeed, many of the 27 companies in our data base have done an outstanding job in improving productivity at the corporate staff level, but haven't really touched their biggest opportunity, which is at the operations level.

Of course, there are political, or territorial, issues here. Management may not be in the best position to judge what is appropriate to spend-or to judge what is needed to build capability into the finance function.

Another measure of finance is the cost per finance employee. Again using medians for the 27 companies, we found a fully loaded cost for salary and wages to be $40,000 per

finance employee,

plus computer support

of $15,000 and

administrative overhead

of $13,000

per finance

employee. That

computer number

is not the entire IT

budget, only the

portion that relates

to finance.

We've also broken down 15 finance activities into three buckets, representing accounting, analytical, and transactional activities. This shows transactional activities to be .8 percent of revenue, about 40 percent of the finance cost; analytical activities to be about 35 percent; and accounting to be the remaining 25 percent of the finance cost.

Companies are struggling to manage their international finance costs, because they're typically higher than domestic finance costs. From our 27-company data base, we have good headcount figures, showing U.S. operations have 260 finance people per $1 billion of revenue, while international operations have 330 people per $1 billion. We're planning to do an empirical study this year on these costs. Certainly, the changes coming in Europe demand solid information. (We're also planning to update the quantitative portion of our research on U.S. companies later this year, and we're going to include new companies.)

How does the cost of finance correlate to an organization's operation? The table on the following page shows the company's philosophy on the horizontal axis, placing companies with increasingly centralized decision-making on the right and increasingly decentralized decision-making on the left. The vertical axis shows a company's structure moving from a business unit focus (decentralized operations) at the bottom to a functional or corporate focus centralized operations) at the top.

The companies in the lower lefthand quadrant-beginning with GE, Allied, and United Technologies-are the most decentralized around business units and most oriented to an autonomous decision-making philosophy. They also have the highest cost for the finance function-a median of 2.7 percent of revenue (compared to the norm of 2.1 percent). The companies in the upper right quadrant-beginning with IBM, Procter & Gamble, Ford, and Exxon-have a median of 1 percent, while those in the middle, the lower right quadrant, have a median of 1.7 percent. in fact, this proves what I've already said-decentralization costs money.

The argument is made that a decentralized operating environment prompts better performance, because the company is closer to the market and its requirements. A study of 10-year return on investments (from 1980 through 1989), however, shows that the return on equity (ROE) of decentralized companies is almost three percentage points less than that of centralized companies.

So I have a hard time buying the argument, promulgated by business management, that decentralization produces a better business performance-at least as it relates to the finance function.

The second premise again

Functional excellence, productivity, and business performance go together, we said. When we talk about functional excellence, we look for an overlap between what happens in corporate and what happens at the operating level. We want plans developed around the major components of the finance function-accounting, audit, financial planning, tax, and treasury. And when all accountabilities are defined, we want to see finance working across the company's operations in a way that appears seamless.

Functional excellence calls for human resources. This is a building block of the finance function, and it requires a clearly articulated plan for attracting and developing the best people. A review of the 27 companies shows that aggressive rotation of the top 10 to 15 percent of the staff, using a two- or three-year time frame, is the only way to develop people with both breadth and depth. The amount of time a CFO spends on this effort is critical.

Productivity, our studies show, depends on a supply-side mentality. Output is hard to measure, but if you build a great capability, you're going to increase the demand for your services. So you need to watch headcount and costs on a companywide basis.

Sharing of resources is another avenue of productivity for transaction-driven activities. Sharing and consolidating is the hallmark of a sound finance function, according to our studies. Buried one level down is the investment in systems and data architecture. if the finance head isn't taking a lead role as the chief information officer, one client said, then the corporation will end up in a high-cost environment, operating in multiple general ledgers.

Business performance is the third leg of this triangle. Solid information provided to line management on a timely basis is the ticket to a strong working relationship between the CFO and the CEO. It is the first of five keys to a solid business partnership. Second is leveraging that knowledge, balancing it with fiduciary responsibility. The third key is involvement in decision-making. Is the CFO invited to the party for his analytical capabilities? Fourth is being in the inner circle, being part of the decision loop. Finally, the CFO becomes a change agent, where he or she is affecting the company well beyond the traditional boundaries of the finance function.

We've evaluated the 27 companies according to these three criteria. The finance functions of five companies are in a "world-class" category. Four companies are "near" world class. And 16 are "aspiring" to be world class. Our ratings are certainly a judgment call, and the results do not mean a company is good across the board.

But finance does make a difference when you look at 10-year results for ROE, earnings growth, and shareholder value growth. Companies with a world-class finance function outperform companies with a near world-class finance function. And those at the near world-class level outperform those at the aspiring level.

Where is the average of the Fortune 500 on this table? it's below all three groups, as shown in the table on the previous page. This is partly because we selected companies for the sample that had demonstrated some kind of leadership in managing the finance function.

What can companies that wish to improve the performance of their finance function do? We recommend the following steps:

Review the effectiveness of your finance function.

* Develop a plan.

* Examine your management of human resources.

* Consolidate transaction-based activities.

* Revisit policies and procedures.

* Assert stewardship for data,

* Redefine information requirements and practices.

* Change the CEO/CFO relationship.

The CFO is the key to the finance function achieving its unique role. And the stronger the finance function, our research shows, the stronger the corporation is going to be.
COPYRIGHT 1991 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Finance Reshapes Its Corporate Role
Author:Gunn, Robert W.
Publication:Financial Executive
Date:Mar 1, 1991
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