Integrated FP&A: How to Close Complexity Gaps

Dean Sorensen, Founder of IBP Collaborative

It is said that a picture is worth a thousand words. In the case of the one on the right, it is especially true of how Financial Planning and Analysis (FP&A) executives can drive significant value for global organizations. How? By enabling them to avoid unintended consequences of decisions that erode value. In other words, by enabling them to effectively manage complexity.

Research consistently shows that managing complexity is a key concern of global CEOs. And for good reason!  The cost of complexity can be significant – upwards of 5% of sales. Moreover, it’s a pervasive problem that erodes value in different ways, as illustrated below in exhibit 1.

These different forms of value erosion all stem from one common challenge. That being, an inability to plan and manage outcomes – especially the relationship between financial and operational ones.  Helping organizations manage this relationship, and thereby avoid unintended consequences that cause value erosion, is the central point to the value of strategic FP&A functions.  It’s also the core idea of this article.

Why Can’t Organizations Manage Complexity?

As complexity increases, financial and operational outcomes become highly interconnected.  Organizations have difficulty achieving financial objectives (eg. margins and costs) while also achieving strategic (eg. growth, customer service) and operational (eg. quality and service levels) ones.  Complexity blurs the “line of sight” between conflicting objectives.  When this happens, unintended consequences become more common.  Four factors account for the vast majority of unintended consequences.  These factors, along with the capabilities required to address them, are illustrated below in exhibit 2.

One major obstacle impairs the ability to manage outcomes in complex organizations.  That being, the processes, models and structures that they to plan, manage and govern their business.  More specifically: immature and outdated ones that obscure risk, reinforce functional silos, sub-optimize resource allocation and impede change.  The underlying problem: inadequate planning and performance management (P&PM) integration!

What Comprises Fully Integrated Processes?

Integrating strategic, financial and operational P&PM processes is not a new idea.  In the manufacturing sector, Integrated Business Planning (IBP) has long been advocated by Sales and Operations Planning (S&OP) pundits and software vendors.  Other integration terms include Integrated Performance Management, Integrated Financial Planning and Integrated FP&A.  What often results from these different terminologies is confusion.  Why?  Because there is no universal definition of what fully integrated P&PM processes mean.

This confusion has led to one reality for many global organizations.  Efforts to improve P&PM processes through integration have stalled.  They’ve been unable to make meaningful improvements to resource quantification and strategy and profit alignment – two objectives that define the degree of P&PM process integration and maturity.  These terms are defined below and form the basis for the maturity model illustrated in exhibit 3:

  1. Resource Quantification: Quickly and accurately quantify financial and operational resources that support desired revenue, profit, cost, service and quality targets, across multiple functions and entities.  Component capabilities (defined in exhibit 2) include integrated scenarios and connected outcomes and tradeoffs.
  2. Profit & Strategy Alignment: Quickly reset targets and rewards, while reallocating resources across functions and entities to fund objectives and optimize operating results and project portfolio ROI.  Component capabilities (defined in exhibit 2) include cross-functional governance and concurrent processes.

Despite implementing P&PM technologies and approaches (eg. rolling forecasts, driver-based planning, zero-based budgeting, activity-based costing/planning, risk-adjusted planning, balanced scorecard), processes are still fragmented, which is represented by the “X” on the chart.  As a result, complexity-driven gaps remain.  This is depicted by the difference between points X and Y on the chart, with the latter representing fully integrated processes.  Note that this maturity model is explained in greater detail in this YouTube video – click here.

When P&PM reaches a fully integrated state, there are no differences between strategic, financial and operational processes.  In manufacturing, for example, supply chain planning and cash flow forecasting are supported by one model.  Rolling forecasts and sales & operations planning become part of a single process that features integrated scenarios.  Such processes allow organizations to simultaneously answer the questions in exhibit 3.  Even in the most complex of circumstances where multiple changes (eg. pricing, sourcing, volume, mix, M&A, new products, customers & channels) are happening at the same time.

What results from fully integrated processes is a “single version of the truth”.  Like “fully integrated”, this term has been liberally and inconsistently used to describe different forms of maturity.  A more complete, yet simple definition, is when organizations can simultaneously and collectively answer the questions in exhibit 3.

Analytics & Process Maturity

Analytics is a key driver of such mature P&PM processes.  While Predictive Analytics and Machine Learning contribute to such maturity, the real driver is Prescriptive Analytics – tools that quantify the best outcome among different choices, using mathematical modelling techniques.  What’s different about them are the questions they answer:

  • Predictive Analytics: How can we sell more?
  • Prescriptive Analytics: Do we have capacity? Will it increase profits?

Another way of describing Prescriptive Analytics, from a P&PM perspective, is this: tools that enable mature forms of driver-based planning.  What’s different about these driver models is that they provide a realistic representation of a business, from both financial and operational perspectives.  Examples of capabilities comprising these models are provided below:

  • Dynamic Drivers: Models that translate the impact of upstream driver changes on downstream activities by simulating the flow of goods, services and resources across value chains.  For example, translating changes to sales volume and mix into requirements for inventory, warehouse and transportation resources, warranty claims, cash flow and foreign currency exposure.  A key feature of this modeling approach is that it separates independent drivers from those that are dependent, thereby minimizing the number that needs to be forecasted.
  • Driver Rules: Rules that define how financial and operational resources behave when certain events occur.  For example, when capacity thresholds are met, these rules can define how headcount, employee productivity and (variable and fixed) employee costs behave upon adding a new shift.
  • Optimization: Mathematical algorithms quantify the best outcome for a specific target (eg. profit, cash flow, sales) given different constraints and assumptions about things like volume, pricing, selling price, mix, and service levels.

Prescriptive Analytics is not new.  Software tools have been available for years.  During this time, they’ve created $ Billions in insight-driven value.  However, Prescriptive Analytics vendors have not addressed one critical challenge: helping organizations sustain this value by effectively integrating these tools into financial and operational processes.

Strategic FP&A Value Proposition

What’s new are technologies that address this integration challenge.  The incremental capabilities (exhibit 2) they provide address complexity gaps (exhibit 3) that cost global organizations up to 5% of sales (exhibit 1).  What results are fully integrated P&PM processes that enable step change improvements how organizations to plan, manage and govern their business.

These fully integrated processes enable similar improvements in the ability of FP&A to play more strategic roles.  In so doing, they provide a catalyst for transforming Finance and FP&A into functions that drive business value.  Conversely, the absence of key capabilities (that enable these processes) does much to explain why:

  • Only 27% sustain benefits from finance transformation efforts, Corporate Executive Board
  • Only 40% of global finance executives rated their FP&A capabilities as effective, APQC

Successfully exploiting these innovations, while avoiding the missteps from others, requires a clear understanding of where the value of integrated processes comes from.  That being from eliminating functional silos that prevent organizations from maximizing the value of business outcomes.  In other words, from effective cost structure management.

Unfortunately, the vast majority of Finance-driven initiatives fail to achieve this objective.  Despite all their investments, global organizations still use planning and performance management processes that are only marginally more mature than they were 100 years ago.  The evidence lies in the unwritten rules that continue to shape organization culture.

Culture & Unwritten Rules

Ultimately, the value derived from fully integrated P&PM processes depends on management’s ability to quickly reallocate resources in response to changing market conditions.  Fully realizing this value often requires changing cultural norms that govern how people behave and make decisions. When transformation programs falter, it’s often because organizations have been unable to effect these changes.

Resistance to such change can be explained by unwritten rules – behaviors that employees believe are necessary for personal success.  Examples of unwritten rules include the following:

  • Always under promise and over deliver
  • Never submit your real budget the first time
  • Inflate your budget because it will likely be cut
  • Avoid specific measures, especially if you don’t control them
  • Always achieve your budget, because it’s what’s really important
  • Get the most people reporting to you as a real sign of power
  • Protect your budget, because you won’t get it back

Unwritten rules result from deficiencies in the way organizations plan, manage, and govern their business. Strong leadership and human performance systems can partially address these deficiencies. However, as complexity increases, the effectiveness of these efforts diminishes.  It eventually becomes too difficult to overcome one commonly-held belief that underlies many of these rules – that target setting and resource allocation is broken and unfair.

Unwritten rules and behaviors don’t go away on their own.  Regardless of systems and policies, people will not do things that [they believe] will adversely affect them.  Unwritten rules can promote behaviors that undermine the best designed planning and resource-allocation processes.  They make it unlikely to get people to:

  • Collapse budgeting cycles, when doing so impedes their ability to negotiate for resources
  • Forecast real resource requirements, when they believe that they must attain their budget
  • Make resources available to others, when they believe they won’t get them back when needed
  • Focus on enterprise performance, when functional budget attainment trumps all other objectives

Such cultural issues are often viewed as the domain of Human Resources.  However, the absence of key capabilities (shown in exhibit 2) does more to explain the presence of unwritten rules than most other factors.  In this context, simultaneously driving both process and behavior change is an important element of effective Finance and FP&A transformation.

Getting Started

To FP&A executives, the value of analytics seems intuitively obvious.  While this might be so, experience shows that the value actually realized (from their use) does not always live up to expectations.  As a result, getting funding for analytics and other finance programs aren’t getting any easier.

One way to address this situation is by focusing on a challenge that FP&A is well positioned to address: that being effective complexity management.  By doing so, FP&A is more likely to get the resources it needs to support strategic aspirations.  Especially with a value proposition worth up to 5% of sales.

Getting such an initiative off the ground can seem daunting. Especially when FP&A leaders are consumed by (day to day) tactical activities. But it doesn’t need to be a major undertaking.  The first step can be done in a matter of days.  It entails developing a shared understanding among key stakeholders about answers to the following questions:

  • What do fully integrated P&PM processes look like?
  • How do prescriptive analytics enable such processes?
  • What incremental capabilities result from process integration?
  • How will stakeholders benefit from these capabilities & processes?
  • What challenges will the processes address & what’s the value?

Armed with answers to them, FP&A leaders can quickly assess the potential value and benefits of more mature and analytics-driven P&PM processes.  In so doing, they can also make a compelling business case for resources to launch a Finance / FP&A transformation program.

Summary

The cost of complexity can be significant – upwards of 5% of sales in global organizations.  Forward-thinking FP&A leaders can play a significant role in realizing this value by leveraging technology innovations that support fully integrated P&PM processes.  In this context, analytics can provide a catalyst for transforming FP&A into a more strategic partner that drives tangible business value.

Budget Tracking with Rolling Statistical Forecasts

By Hans Levenbach, PhD, CPDF author of Change & Chance Embraced

Hans Levenbach, PhD is Executive Director, CPDF Training and CertificationProfessional Development Programs. He conducts hands-on Workshops on Demand Forecasting for multi-national supply chain companies worldwide. He is group manager of the LinkedIn groups (1) Demand Forecaster Training and Certification, Blended Learning, Predictive Visualization, and (2) New Product Forecasting and Innovation Planning, Cognitive Modeling, Predictive Visualization.

He invites you to join if you have interest in sharing conversations on these topics.

LinkedIn profile: Hans Levenbach

budgetingFor organizations with annual expense budgets, it is important to have procedures for monitoring expenditures and budget items throughout the year. It is particularly useful to have a procedure for estimating early in the year what the actual end-of-year expenditures are likely to be for various components of the budget. This allows for corrective action to be taken where necessary. It is also helpful if the estimation procedure is straightforward and systematic.

We can use simple predictive visualization techniques and exploratory data analytic methods to extrapolate expected expenditures as a function of spending year-to-date and historical spending patterns. This approach is based on the assumption that historical spending patterns remain relatively similar over time. We have observed this to be the case in different organizations in a corporation and medical departments in hospitals. Thus, future spending patterns may be predictable from past historical patterns.

Historical patterns of spending are determined by dividing the year-end expenditures into year-to-date expenditures for all months to derive cumulative proportions for year-end spending for all months in the year. The deviations from the cumulative monthly average of these cumulative proportions are then plotted to display the yearly spending patterns. See the real data examples below.

Real Data Examples. The data tables show the % of Total Budget (View) minus % of Year elapsed. Each month is taken as 1/12 of the annual Total. Upon further analysis and review, it might help to do better-weighted allocations.

With a predictive visualization of three months of actual outcomes displayed in the current year, you can see how the “pattern of drift” away and recovery has behaved for the previous three years. One way to summarize these is to say that W_Budget and C_Budget would come close to the View if they followed respective Budget T-3 patterns, but that I_Budget will have to do something quite new to get to the View.

We make the following judgments based on the first three months of the current year’s data. It appears that

  • W_Budget is headed for 90% - 95% of View
  • C_Budget is headed for 95% - 100% of View

BUT, It also appears that I_Budget is headed for perhaps 70% of View.

budgeting

Exploring Forward-Looking Budget Profiles

Once three or more years of monthly (or quarterly) budget patterns have been observed, you can begin to monitor current budgets with rolling forecast profiles using statistical forecasting models. Statistical forecasting models not only provide forward-looking budget patterns (forecast profiles) but can also establish uncertainty ranges on the projections. Using well-documented, valid and objective state space forecasting models, you can create credible “budget profiles” and ranges for tracking year-to-date budgets. The Budget View are the percentage difference between actual monthly expenditures. The Systematic View is the percentage differences between model projections and the actual monthly expenditures. The 12-month Views were created before the actual expenditures were booked. In this example, we might say that:

  • Budget view for February was overstated by at least five percentage points at the time of creation, based on the likely budget pattern
  • Systematic View appears to be about twice as precise (accurate) as the Budget View
  • Both Views were over-forecasts of the actual expenditures
  • For an unbiased View, the Budget patterns should vary around the zero line

Seven Essential Tips for Strategic Finance

by Michael J. Huthwaite, Founder and CEO of FinanceSeer LLC 

Over the past 15 years, I have had the amazing opportunity to work with numerous Corporate Finance teams from around the world in an effort to help them get the most out of their strategic modeling practices. Over this time, I have uncovered a common pattern of reoccurring misconceptions and pitfalls that I believe routinely inhibit companies from maximizing their strategic modeling capabilities. 

In hopes of eliminating these common mistakes, I want to share with you a presentation that I often give to individuals looking to enhance their way of thinking about the very important area of Strategic Finance. 

#1 — Why the strategy SHOULD hang in the balance

I tend to find that although most people can probably agree on a definition for “Strategic Planning”, agreeing on what form of analysis should be performed is often a bit more contentious. 

That's because, for most people, Strategic Planning is characterized as a “Strategic Guidance” exercise, where the focus is on performing market research, evaluating benchmarks/comps, understanding competitive advantages and analyzing a business’s strengths and weaknesses.  Typical owners of an organization’s Strategy Guidance document might be the Chief Strategy Officer (CSO) or even the CEO. These people tend to have deep knowledge in their industry and might use any number of tools or services to help them develop their guidance documents. 

However, organizations that solely equate Strategic Guidance to Strategic Planning also run the likely chance of creating a “strategy gap”, where the content/context in the guidance documents don’t provide enough information to accurately set achievable targets for the Budgeting process or the guidance is ultimately deemed “pie-in the-sky” because it hasn’t been thoroughly tested.  As a consequence, Strategic Guidance on its own can often just sit on the shelf, regardless of the amount of thought and skill that went into producing it. 

To avoid a strategy gap, Finance departments need to take the lead in the parallel exercise of Strategic Finance.  This is primarily a top-down financial modeling exercise where assumptions from the Strategic Guidance and elsewhere are used to drive integrated financial statements that (once agreed-upon) should act as a high-level target for the all-important Budgeting process. 

The most common areas of analysis for Strategic Finance are long-range planning/target setting, acquisition/investment screening, treasury planning, executive compensation planning and valuation analysis. 

One of the keys to successful Strategic Planning is to maintain both a good balance yet distinct separation of Strategic Guidance and Strategic Finance.  This often requires strong communication and coordination between Finance and other internal/external industry experts responsible for producing the Strategic Guidance. 

# 2 – Why Goldilocks got it all wrong

Bottom-up budgeting and top-down planning (Strategic Finance) sit at the opposite ends of the financial planning spectrum and serve two different yet necessary purposes.    

The purpose of top-down planning is to set long-range operational targets that justify investment and capital needs.  While bottom-up budgeting’s primary purpose is to increase the likelihood in the short-term that those targets are met or exceeded by establishing accountability at lower levels within the organization.   

Taking a middle-of-the-road approach to planning sounds great, but in practice, it is often the worst approach to take.  It’s not detailed enough to assign accountability and measurability to actuals yet too detailed to quickly set targets and become directionally correct when running scenario analysis.

It’s important to note that there should always be room to evaluate and optimize the level of precision of both bottom-up and top-down tools.  Having agile tools in place that allow you to make changes over time is critical.  In fact, I have never run into a company that got it right the first time. 

However, one must always resist the temptation to compromise in the middle.

#3 – Christmas in July

There is often a great deal of confusion in the term “top-down” planning.  It's not uncommon for people to think it’s an approach taken by management to enter numbers at a higher-level and then allocate them down the throats of the subject matter experts (SME) who are sitting at the Cost Center level.  However, this is not the case and trying to do so would lead to disaster in the long-run. 

It’s important to realize that top-down planning is done because the leaders at the top know that when they accept capital from shareholders and banks that they are beholden to providing a return that would increase Shareholder value in the long-term and would keep the company afloat.  Therefore, it makes sense that top-down planning is about setting clear and measurable targets without providing restrictions on how the SME is going to reach that target. 

This is why it is important to realize that top-down planning must be a cascading exercise, where small teams discuss, debate and form consensus from the top and then hand off those targets to the next level down the management hierarchy where a new leadership team can discuss ways in which they could use their knowledge to reach those targets by setting their own targets for their LoBs. 

I like to illustrate this point using a Christmas tree, where the star at the top is typically Corporate Finance and the bulbs below represent secondary cascading management units.  It would be chaotic to have 40-50 people all running scenario analysis concurrently.  Instead, it’s more often a case of 5-10 peers debating targets before it is cascaded to the next small team.  

When it comes to new business ideas, investment proposals and acquisitions, it’s ok to have BUs submit their own ideas (as they are probably highly knowledgeable about the products and markets relating to the deal).  However, I have also seen it many times where the cascading target includes additional acquisition placeholders that point out the size and shape of the business that should be acquired but don’t have a particular target in mind. 

#4 – Why “Simple” does not mean “Simplistic”

Recently there has been a lot of buzz on making software “simple”.  The term conveys a sense of efficiency and intuitiveness which is critical for busy users who don’t have the time to invest in becoming a super-user on day-one.  In the minds of many business professionals, “simple” is now synonymous with “effortless”

However, the natural impulse is to also think that simple means simplistic (or less content).  Yet, this is not the case.  “Simple” is actually a design language that takes complex subject matter and makes the experience look effortless to the end-user.  In fact, to accomplish this it actually requires more thought and effort on the part of the developers, usually resulting in more functionality or smarter usage patterns.  As a result, “simple” actually means “smarter”.    

For example, recall the netbook craze of a few years ago.  These (often smaller) PCs were marketed as internet focused machines, but, in reality, were nothing more than low powered PCs.  Along came the tablet, with touch screens and purpose-built apps and they blew away the netbook. 

The pitfall I see all too often when dealing with Strategic Finance is that companies try to take bottom-up budgeting tools and simply apply less content to them in hopes of achieving an intuitive or effortless top-down model.  Yet, bottom-up tools don’t provide additional intelligence to the top-down process.  As a result, companies aren’t getting more with less, they are just getting less.

#5 – Why are we constantly “dealing” with ad hoc analysis

Anyone who has taken part in Strategic Finance knows that a large part of the analysis is looking at new deals (new business ideas, investments, acquisitions).  These deals can come and go in rapid succession or they can sometimes languish around for months before either getting eliminated or green-lighted. 

This issue poses a big challenge for server-based technology (technology used for most budgeting tools).  That’s because server-based technology often centralizes the data forcing users to create placeholders for the data first prior to entering the data.  That approach doesn’t make sense if the deal has a chance of being discarded quickly or if the people that need to review that deal are different from deal to deal.  This form of agility is not what centralized budgeting tools were designed to do.

The reality is that when it comes to Strategic Finance, most companies still gravitate toward spreadsheets despite the well-known pain points.  One of the few benefits to a spreadsheet is that it is a document-based technology.  When dealing with a document, users are free to save and share with whomever they want or, of course, they can throw it away or archive it and recall it later.  This approach is far more flexible for the needs of Strategic Finance.  

#6 —The truth about “Single Version of the Truth”

In the business world, we hate the unknown.  So in the short-run, we try to eliminate it by holding people accountable to certain expectations, all the while making sure we can drill down into the details to find out what’s not going to plan.  Predictability and accountability are a good thing in Finance. 

However, in the long run, it becomes more difficult to eliminate the unknown.  As a result, we have to think more creatively and opportunistically and realize this environment creates more room for discussion, debate/influence, and consensus building.  Paving over this basic communication requirement with rigid workflow management functionality and centralized data submissions is not helpful for Strategic Finance. 

We need to embrace solutions that complement both our short-term and long-term requirements so that we can optimally plan for all time periods and stop continuing to apply a “short-term fix”. 

#7 — Spend less time getting there and more time looking around

Many people think that Strategic Finance is an exercise that is typically performed either just before or just after the annual Budgeting process and that’s it, back on the shelf it goes.

Although this can certainly be the case, successful Strategic Finance teams often benefit the most when they are able to continuously screen for opportunities and threats that are a result of fluid changes in market conditions. This is not to say that companies should be constantly updating their strategy, but instead they should be in a perpetual screening process, ready to take advantage of opportunities when they arise.

Black Swans are a perfect example of the need to screen for opportunity and risk.  By definition, Black Swans cannot be detected by statistical software.  Their likelihood would deem them an outlier and without any real context around the situation, they are either ignored or undetected.  The only way to find a Black Swan is to look for it.

Sometimes we spend so much time focusing on climbing the mountain that we fail to spend the time looking around once we get to the top.  In all likelihood, that vantage point might just be the competitive advantage we need.

Conclusion

I hope the topics covered in my article cause you to reflect on your own Strategic Finance activities.  Is your Strategic Finance effort getting the level of attention it deserves? Or like many organizations, is it getting crowded-out and distorted by other adjacent activities? 

If done correctly, Strategic Finance can represent an immense value-add to your organization while at the same time, reduce the costly time and effort of the Budgeting process.   Make a conscious effort to consider these seven essential tips and I’m sure confident you will see the benefits. 

How much managerial courage resides in forecasting?

By Stéphane Bonutto, CFO at Oerlikon Balzers

forecastingGenerically, forecasting is about planning the Profit and Loss statement (P&L) for a defined upcoming period. Letting budgets, mid or long-term business plans aside, most practitioners consider a full calendar year (CY) or an x-month rolling (e.g. 12MR) period for their forecast scope. Depending on the organization type subject to forecast, and on the overall enterprise structure, the forecast scope can encompass the full P&L or a portion of it. Logically, the key performance indicators on which most forecasting attention is placed should be the ones reflecting where the managers of the Reporting Organization have the highest influence.

In practice, these definitions can become secondary to the question, how much truth, message or even political content a forecast can – or has to – convey: in short, how much managerial courage it takes to deliver a forecast. Certainly, it depends who is the Reporting Organization and who is the Consolidating Organization. I find the forecasting situation of a Reporting Unit with responsibility for local sale, production or service, the one where the question about message and courage in the forecast is arising with most tension since it is located in the heart of the overall Enterprise. The Local Unit aggregates the result of the operational business it is responsible for and delivers the result to a Mother Organization, who can be a Regional Organization, a Company Division, a Corporate Function, or the Corporation itself. It is also subject to the level of expectation placed by the Mother Organization.

A forecast is an act of truth

Fundamentally, forecasting a P&L is about estimating revenues of sales, costs of goods sold, and SG&A costs (selling, general and administrative expenses) for the upcoming period. At first glance, a tempting and apparently time-saving approach for the Organization might look like a summarized P&L for the forecast period, based on the estimation of a few KPI’s done by the Finance Department. A rather recommendable and common approach is, however, a more detailed P&L elaboration, reflecting fact-based past experience, the best available knowledge and the soundest assessment of future environment and business development.

Thereby, the forecast should not be the sole work of the Finance department of the Reporting Organization, for it may not have all elements available to make its own assessment of the business development. Far more it should be the result of a joined teamwork encompassing additionally the managers of sales, operations, human resources, purchasing and supply chain, with the sign-off from the general management. Further, a forecast as a bottom-up exercise considers market conditions and customer demand, production capacities and machine requirements, human capital situation, prices and availability of material and supplies.  The purpose of this enumeration is not to make an exhausting parameters list, but rather to reinforce that the view on these parameters should be consistent and agreed between the managers of the Reporting Organization. For instance, there is little value in reflecting a sales level based on customer requirements when a bottleneck may arise in the availability of necessary machinery. Equally, a forecast inconsistency may result from a workforce planning based on hiring requisitions issued to secure workforce, when an expected production fluctuation may suggest the necessity to reduce the number of worked hours for the next times.

After this effort, a forecast aims (or should aim) at telling the truth about the evaluated parameters and at providing an honest view about their expected development. In this sense, the forecast is a realistic exercise.

A forecast is a message

Change lies in the nature of rolling forecast and calendar year outlook. At each month end, actuals replace expectations on all P&L lines, deviations occur and trends are gradually revealed. The need to deliver a realistic forecast calls for an upward or downward reassessment of the P&L for the overall forecast period based on actual variance, with a more or less significant variance level for the overall forecasted period. The question comes up, how much of the past month variance should be reflected in the total forecast period, i.e. shown as performance, and how much should be absorbed, i.e. retimed. I have come across enterprises or organizations within the same company, where a fluctuating forecast and a stable forecast from the Reporting Organization are differently received by the Consolidating Organization.

Some Consolidating Organizations perceive a fluctuating forecast as an honest approach. Their expectation towards Reporting Organizations is to receive the best of their knowledge and expectation for the future period, so as to consolidate the truest picture of the overall perimeter and see to which extend positive and negative variances can compensate by themselves. They also see it as their role to manage the resulting favorable or unfavorable total variance, and decide to which extent they should maintain or adjust their forecast to the next organization level in the company.

Other Consolidating Organizations perceive a fluctuating forecast as a lack of self-confidence from their Reporting Organizations and view stable forecasts as a sign of reliability. They expect the local Units to manage the fluctuations by themselves and to adjust the forecast only when enough facts are accumulated so that the magnitude of the necessary change makes it worth revising the numbers.

While the latter approach suggests a higher level of responsibility of the Reporting Organizations compared to the former, it requires a high degree of maturity from the Reporting Organizations, regarding the actual data transparency from the ERP system, the planning ability from the controllers, and the availability of an adequate forecasting tool. These conditions are key to make Reporting Organizations able to forecast bottom-up, calculate scenarios, and assess financial up- and downsides resulting from possible sales and cost driver developments.

Besides the necessary conditions to make this approach a sustainable one, the expectation of stability in the reported forecast, placed by Consolidating Organizations, can influence the forecast content or message delivered by the Reporting Organizations, depending on several factors: whether Reporting Unit managers are optimistic or conservative nature, whether the actual situation suggests an up- or downside for the forecast period compared to budget, and depending on the point in time in the calendar year.

A forecast is a situational behavior

Several moments in the calendar year can be considered determining to assess the content or the message conveyed by a forecast: the early start of the year, the middle of the first half (H1), the budgeting timeframe and the very last forecast rounds in the year.

A conservative Reporting Unit is likely to show prudence right at the beginning of the year. In an unfavorable actual situation compared to budget, this prudence may result in an early forecast drop below budget and potentially in another drop during H1. In a favorable actual situation, the prudence may be shown by keeping the forecast at budget level and to maintaining this level as long as possible. When the time comes to establish next year’s budget, the Consolidating Organization will likely feel the need to push for some prudence release, calling it at times “sandbagging” elimination. How much was adequate prudence and how much was exaggerated, will come out during the latter part of the year, along with the judgement capacity from the Consolidating Organization.

The optimistic nature of a Reporting Unit is likely revealed in an unfavorable actual situation vs. budget by maintaining the budget level for quite some time, thereby delivering the message of the ability to compensate the accumulated gap during the rest of the year by actions on sales and / or cost. A moment of truth is the timeframe before budget: In order to set a realistic starting point for next year’s budget, it should sound logical to release part of the forecast risk at this time. This may be perceived by the Consolidating Organization as a kind of “sandbagging” to build next year’s budget, who is likely to oppose or show some resistance to a reduction at this time. It then takes managerial courage from a Reporting Unit to go for a forecast reduction. On the other side, pursuing too far in the year on a too high level probably does not make the discussion easier when the forecast must badly be reduced: The closer yearend approaches, the more Consolidating Organizations perceive forecast reductions as bad surprises and can interpret them as a lack of reliability from the Reporting Units. So it appears important for a Reporting Unit to seize the right moment for a forecast reduction and to show courage by releasing the risk to the highest extend at once, since the alternative - a gradual risk release late in the year - may be received by the Consolidating Organization as a “sausage cutting” approach and may worsen the mistrust feeling.

The situation of an optimistic Reporting Unit in a favorable financial situation vs. budget may at first appear ideal since a forecast increase can take place early in the year and may be reinforced a few months later. This situation, however, bears the risk of over-judging the forecast period and should call the Consolidating Organization for prudence, latest at budgeting timeframe, to avoid building next year’s budget on an overoptimistic starting point. Such a budget may result problematic to reach during the following year, especially if conjuncture would happen to cool down.

Conclusion: Towards a forecast culture

Considering forecasting as an exercise to assess future financial performance as accurately as possible through a bottom-up approach based on actual facts, it appears necessary for an Organization to become conscious of its own culture.

For a Consolidating Unit, it seems necessary to identify the prudent or optimistic nature of Local Unit managers and accordingly interpret the message behind the reported numbers, depending on how challenging the situation of the Unit vs. budget is. Equally, it seems advisable to foster a culture of trust where Reporting Units are encouraged to tell the truth and avoid inducing Units to deliver opportunistic or even politically driven forecasts. For a Reporting Unit, it appears necessary to understand the expectations placed by the Consolidating Organization, i.e. to which extent forecast fluctuation or forecast stability is being appreciated. It equally takes managerial courage to keep optimism in a forecast as to deliver bad news at the right point in time.

A clear discussion seems advisable upfront between the involved Units, related to which level of the Organization is expected to manage the financial risk and up to which amount. Equally, an ongoing evaluation of up- and downsides (risks and opportunities) vs. the delivered forecast numbers on sales and cost is an advisable practice, so that quantified scenarios are available and a consensus can be reached about how to best reflect the financial performance of the overall Organization throughout the year, in favorable as in challenging actual situation.

Evolving FP&A: Why Prediction Is Important

By Karl Kern, Founder/President, Kern Analytics LLC

predictionAs an FP&A practitioner, I am called upon to make predictions on behalf of clients. Two of the more prominent predictions I am asked to make are Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) and cash flows.  I am asked to make these predictions in order to determine valuations and financing requirements.     

Prediction Entities       

What I describe above is precise in that it focuses on a specific type of entity, startups.  Startups, however, are not the only entities that require predictions.  Small businesses require predictions in order to determine the timing of cash flows for paying employees and vendors.  Middle market companies require predictions in order to compete against smaller, more agile businesses or larger, wealthier businesses.  Large businesses require predictions in order to exploit potential growth opportunities. 

Businesses are not the only entities that rely on predictions; we as individuals rely on predictions to conduct tasks like going to work, meeting with friends, or dealing with adverse weather conditions.  These examples serve as reasons for why prediction is important however I found other reasons that give it credence in our work as FP&A practitioners.

We Tend not to Take Prediction Seriously...

I found the other reasons in a book written by Nate Silver titled The Signal and the Noise.  Nate Silver gained prominence in his work on predictions during the 2008 and 2012 presidential elections in the United States.  His book addresses not only elections but topics like finance, sports, and weather.  What may seem funny is the other reasons that I’m about the present do not come from the chapters in the book but praise for the book by Bill James; Bill James is most known for his work in transforming the way Major League Baseball games are played through his work with statistics.  In his praise of the book, Bill James made two statements that I find relevant to the importance of prediction.  The first statement is “Projection, prediction, assumption, trepidation, anticipation, expectation, estimation…we wouldn’t have eighty words like this in the English language if it wasn’t central to our lives.”  The second statement is “We tend not to take prediction seriously because, on some level, we know that we don’t know.”

The Uncertainty is Real

Why do I consider Bill James’ statements so important?  When we consider the first statement I previously provided a number of examples that support the importance of prediction but there’s one example that makes our work as FP&A practitioners vital.  Our work focuses on creating insights into the strengths and weaknesses of the financial health within businesses and without these insights businesses will fail and stakeholders like employees and communities will suffer.  When we consider the second statement we as FP&A practitioners must acknowledge that uncertainty is real.  We must acknowledge that we don’t know for certain whether one customer or several customers will stay in business and that can mean sales predictions could turn for the worse.  We must acknowledge that we don’t know for certain whether a service provider may institute price increases which can turn expense predictions awry or a supplier may discontinue shipments which can cause a ripple effect among production and selling functions.  Bill James’ statements give us some food for thought: people want to know what tomorrow will look like but no matter how hard we try giving people a precise tomorrow is impossible.

Making predictions is an important part of our work as FP&A practitioners.  Its importance is due to need but need can be hindered due to incomplete knowledge. Our work, therefore, must focus on maximizing the positive and minimizing the negative about prediction.

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