How much managerial courage resides in forecasting?

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.

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