“When you realize that the net you’re building is 20 yards behind you, it becomes a lot easier to decide to fly without it.”

So says Kurt Kuehn, CFO of shipping giant UPS. He’s describing the company’s new view of budgeting, planning, and forecasting. “Normally, we are very obsessive about building good and accurate plans,” he says, but as the recession dragged on, “we realized that trying to build a forecast was almost a waste of time. We didn’t have enough precedent or trends to do anything viable.”

The past two years have turned budgeting inside out at most companies. As sales fell and markets dried up, spending levels had to be continuously revised, and visibility was almost nonexistent. Companies tried all manner of workarounds and improvisation, and most came away with the same conclusion: it was time to rethink the whole thing. How could budgets be made more flexible? Who should be involved? What could be included or left out? And how often should the effort be undertaken or revisited? Now, with the recovery under way, many finance executives say the changes they made to their budgeting-and-planning processes out of desperation are here to stay.

Flex Spending

That’s music to the ears of Steve Player, founder of consultancy The Player Group and program director of the Beyond Budgeting Roundtable. He has long encouraged companies to abandon their budgets, so in a sense 2009 was, as he says, “a watershed year. A lot of people were de facto running their companies without budgets. They made the change out of necessity and found it isn’t so hard.”

Indeed, in 2008, Kuehn and his colleagues at UPS decided to essentially abandon their budget. Instead, they adopted a more flexible approach focused on operating leverage, urging every function and business unit across the $45 billion company to adjust their costs to declining revenues. Rather than tying people to budget numbers that were rapidly disappearing in the rearview mirror, “we sent a very broad message that the goal was to make sure that as revenues shrank, costs were also reduced,” says Kuehn.

Managers committed to the dramatic change without much hesitation. “There was so much fear in the market that we got people’s attention quickly,” he says, although he acknowledges some challenges in helping people think through what spending could be cut or delayed. Eventually, however, “the fact that everybody was in it together made it less painful when we did have to make cuts.”

UPS reported a strong first quarter that trounced analysts’ estimates, but Kuehn hopes to preserve this new mind-set. “Rather than assuming a traditional budget increase year over year, now the assumption is that your expenses won’t increase. We’re going to continue to constrain expenses wherever possible,” he says. Kuehn plans to watch for opportunities to invest in the business during the recovery, but, he adds, “we’ve got to make sure these are conscious decisions [to invest], rather than everybody going back to a given annual budget increase.”

Higher Frequency

In addition to taking a more flexible view of what type of budget suits their companies now, many CFOs are stepping up the frequency of budget revisions and forecasts. “The idea of completing a budget cycle and then putting it to rest and monitoring to that set budget has become fairly passé, based on what we learned in 2009,” says Janice DiPietro, national managing partner, consulting, at executive services firm Tatum. “The world is just changing too fast.”

Player urges CFOs to adopt a rolling forecast that focuses on high-level numbers rather than thousands of individual line items. “One of the problems with budgets is that people try to jam a lot of detail in there. When you’ve got too much to do, it’s best to take a step back and focus on the key drivers. By taking the forecast up a level, you have time to think about the important stuff.”

DiPietro agrees, although she says too few companies have managed to make the switch. “There are organizations that do have a more rolling approach, but it’s not mainstream. And frankly, that is the approach companies need to take,” she says. “The process needs to be more frequent.”

Player also advocates developing numerous scenarios. “If you can’t predict the future, how can you at least be ready for it?” he asks. “You can do that by understanding the different possible futures — by constructing scenarios in a wide range.” While most companies that engage in scenario planning construct three possible outcomes, Player suggests five to seven, including an upside “so good you couldn’t possibly spend all the money you’re making” and a downside “so bad that it threatens the company’s survival.”

Lisa Calise Signori, director of administration and finance for the City of Boston, says she has learned that it’s never too early to start the planning process. In fact, “I would say we are in a perpetual planning cycle,” she says. “There’s no longer such a thing as budget season. It’s year-round planning and year-round adjusting.”

A Team Effort

Engaging employees throughout the company in the budgeting process — and making sure they understand its importance — are also critical steps to creating a more relevant and useful plan, says DiPietro. “You need a commitment from the most senior executives that this is a strategically important thing to do,” she says. “It needs to be more than a financial exercise. If the organization thinks that budgeting and planning is something the CFO makes us do, that’s not going to work.”

Janet Caldwell, finance chief at Kronos Foods, a Chicago-based maker of Greek, Mediterranean, and specialty foods with approximately $100 million in annual sales, says she has been pushing budgeting outside the confines of the finance department in an effort to make the budget more valuable — a tool to truly guide the business rather than an annual ritual led by the finance team and largely forgotten.

Last year, Kronos gathered all of its managers for a meeting to talk about goals and discuss the company’s strategic direction, part of an effort to lay the groundwork for a more meaningful budgeting process. Such a tone at the top “sets the right expectations for people,” says DiPietro, and signals a shift from the check-the-box exercise budgeting has often been.

Caldwell tries to act as a facilitator in the process, using an “interview style” in which she asks sales executives and business-unit heads where they see growth coming from in the year ahead. “We don’t say, ‘You need to grow X%,'” she says. “It’s a combination of a bottoms-up and top-down approach. We meet somewhere in the middle.” The finance team provides detailed customer and product data from the prior year as a starting point for the discussion.

The CFO and her fellow finance staffers also question the sales staff about their expectations and challenge the usual assumptions as they push for realistic numbers rather than hopeful guesses or sandbagged estimates. “If someone says, ‘I’m going to grow my numbers by X%,’ I want to know which specific customers, which specific product lines, are providing that growth,” says Caldwell.

If sales managers’ initial growth estimates aren’t high enough to reach the company’s overall goals, Caldwell and the rest of the management team dig in deeper to identify less-obvious opportunities for new or expanded business. “We’ll sit back as a team and say, ‘OK, what other strategies can we employ to grow this business?'” she says. But, she notes, the final numbers ultimately belong to the sales team.

To give herself and the company’s board and investors a level of comfort, Caldwell reviews the budget and identifies areas where budgeted numbers may be a stretch, but also finds spots where she can see upside beyond what’s budgeted. “My goal is to have a budget with some risk, but also some opportunity,” she says.

Once the budget has been agreed upon and revised, Caldwell also regularly revisits the plan. Last year, she reforecast three times. She’s already started her second round of forecasting for 2010.

The Quest for Better Data

In an attempt to better understand the impact of macroeconomic trends on their business and improve their ability to plan, finance executives at Houghton Mifflin Harcourt decided last year to cast a wider net to include not only more people, but also more data in their budgeting process. As the nearly 200-year-old conglomerate struggled to determine the impact of the recession on its venerable textbook-publishing business, “We realized that our current tools weren’t what we needed to help us understand how bad it could get,” says Hazel Hughes, senior vice president of finance and business control at the company’s K-12 division.

The finance department had traditionally relied on historical data, textbook-adoption calendars, and pipeline information from the sales force to construct its budgets. But by early 2009, it needed to look outside the business for clues about its future. “We needed to find out more about how our customers were being impacted [by the recession],” says Hughes. “They were missing billions of dollars in tax receipts and they were still trying to educate kids.”

This realization led to a quest for new inputs to the budget that executives hoped would give them better insight into what to expect in the year ahead. The finance and strategy teams began scouring news reports for information about states’ budget woes. Finance staffers studied GDP data and state and local tax data, and compared them with historical textbook-sales information to help predict sales. The company also dedicated a group of employees to analyzing federal funding and grants to determine where states would — or wouldn’t — be getting their funding.

The finance team learned that it needed to move to “an entirely new level of scenario analysis,” says Hughes. “Now, we think about whether certain states may just decide not to buy social-studies books this year,” a possibility that, when the company relied more heavily on traditional textbook-adoption calendars, was unthinkable. By taking a broader view of the drivers of demand for its product, the company has been able to develop a variety of new scenarios for its five-year plan.

As jarring as the recession has proven to be, the old routines and ways of thinking about annual planning will likely take time to fade. Nonetheless, many CFOs are energized by the adjustments they’ve made, eager to think about how best to adapt their planning processes to the uncertain recovery, and encouraged by their organizations’ greater understanding of the value of the budget. Turns out that a near-death experience was just what budgets needed to infuse them with more life.

Kate O’Sullivan is senior editor for strategy at CFO.

Compensation Recalibration

If the budget’s gone, what happens to the pay that was tied to it?

Because employee compensation is often tied to budget targets, the recession-induced perpetual misses that characterized the past two years were undoubtedly frustrating for many workers. “If you’re not updating budgets and doing scenario analysis on a regular basis, you’re reporting back to folks as to where they should have been on a number that may have no relevance,” says Janice DiPietro, national managing partner, consulting, at executive services firm Tatum. “It can have a demoralizing impact on the organization.”

To avoid that, and to drive managers to pursue new goals, many finance chiefs and other senior managers have had to figure out how to adjust their compensation targets. Kurt Kuehn, finance chief at UPS, helped his company move away from its traditional annual budget and focused managers on maintaining operating leverage instead, urging them to find ways to cut costs as revenues declined. As a result, he says, “flexible targets came into play. We were asking whether people were successful in adapting their operations to match [current] revenues,” rather than how they performed versus increasingly unrealistic budget targets.

Managers at companies that adopt a more flexible, rolling approach to planning will need to think about how to provide meaningful incentive pay, says Steve Player, program director of the Beyond Budgeting Roundtable. Rather than tying compensation to a static budget, Player recommends measuring performance on metrics such as performance compared with peer companies, performance versus selected economic metrics, ability to hit cash-flow or ROI targets for a given project or business unit, or performance versus colleagues. — K.O’S.