Margin Management

Frustrated with trying to run your company on a budget? Jim McManus has a better way: focus on gross margin.

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So you've at last put the finishing touches on your annual budget. My condolences. If you're like most chief executives I know, you probably feel as though you've just been through the business equivalent of an extended workout with Marvelous Marvin Hagler. Not only are you sore from bloody battles with department heads (when has any manager ever asked for less than the year before?), but even if you've won, as CEOs often do, what do you have to show for it? A budget based on assumptions that may or may not bear any resemblance to what will actually happen in the next 11 months.

Pointless and painful as the annual budgeting process often seems, it is one of those rituals that most CEOs feel compelled to go through. How else can they keep a lid on costs and maintain some measure of control? Well, consider James McManus. Four years ago, he began eliminating traditional budgeting at his company, Marketing Corporation of America (MCA). He swears now that it was one of the smartest moves he ever made.

McManus, you may recall, is CEO of a highly successful miniconglomerate in Westport, Conn., which he founded in 1971 ("Face-to-Face," September 1986). Until 1984, his budget process was little different from most. Year after bruising year, he would sit down with his managers and haggle over numbers. Should this department be permitted to add three people or four people? Why should so-and-so get a $10,000 raise? Why not $5,000? Was first-class air travel really necessary?

The process took time and a steep psychological toll -- all the more so because McManus was going up against smart, articulate salespeople, well versed in the art of persuasion. That, after all, was why he had hired them in the first place. But his greatest concern was that the resulting budgets did not adequately reflect what was happening in the real world. While the market continually changed, the budget "gave a false assumption of predictability," says McManus. And, more often than not, "I was too far away from the situation to have a right to a point of view."

Some of MCA's key managers shared his concern. One of them was John Luther, the head of MCA's 10-year-old development-consulting division, which advises companies on new-product and business strategies. Although the division was earning about 20% on revenues, budget constraints had kept Luther from rewarding consultants as well he would have liked. As a result, some top employees had been lured away be competitors willing to pay significantly more. Without sufficient incentives to hustle new accounts, moreover, the division's growth had stalled. Luther, who was working harder and enjoying it less, was worried.

Finally, he took his concerns to McManus, saying that he needed more operating room so that he could provide additional incentives and perks for his staff of 15. McManus was sympathetic, but leery of committing himself to higher fixed costs. The problem got him thinking, though, about alternatives. One idea that sprang to mind involved getting rid of traditional budgeting altogether. What if Luther simply agreed to deliver a certain percentage of sales to the corporate kitty? The margin would obviously have to be high enough for MCA to cover corporate overhead expenses and pretax profits, but why not let Luther decide for himself how to spend whatever else the division made? That way, he could pay higher salaries, offer bonuses, or what have you. Theoretically, he could even move down the road to cheaper offices. He could do pretty much anything he wanted, so long as MCA received the agreed-upon margin.

After much discussion, the two men decided to take a leap of faith and give the plan a whirl, settling on 15% as the magic number. In late 1984, Luther installed a new incentive program in his division, and sales took off. Over the next two years, the division's revenues grew at an annual clip of 30%, allowing Luther to pay out fatter bonuses than he had ever dreamed possible. MCA, meanwhile, has continued to receive 15? out of every dollar generated. As for McManus, he's been able to sit happily on the sidelines as routine decisions -- about adding staff, say, or raising prices -- are made without him.

Indeed, margin management (as the system is called) has worked so well that McManus now uses it with 10 of MCA's operating units, including the real estate, market research, advertising, and computer-software divisions. In each case, he negotiates a sensible margin with the division manager, who takes over from there. Not that budgets themselves have been eliminated. Every spring, each division manager still comes in with a sheet of preliminary projections for the coming year. (The company operates on a fiscal year ending June 30.) But so long as the division is sustaining the agreed-upon margin, and sales are continuing to increase at an annual rate of at least 5%, the budget discussion is usually quick (less than two hours) and painless. Its focus, says McManus, is on questions of strategy and quality control, rather than numbers. He and MCA's president, Bob Kamerschen, ask managers if they see any unusual risks in what they're doing. "If the answer is no, we say, 'Have a good year."

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