Forecasting: A Cinderella Discipline1 June 2005
In the flurry of activity that precedes publishing year-end results, financial forecasting is often a low priority. It takes a back seat to its 'ugly sisters', budgeting and business performance management. Tony Vadasz, Parson Consulting, explains why forecasting needs to be higher on everyone's agenda.
Forecasting has often been treated as budgeting's poor relation. But the importance of its accuracy and the need to achieve greater overall business performance through improved forecasting capabilities have never been more pronounced. It may be time for forecasting to go to the ball.
Organisations have recently turned their attentions to budgeting and performance management.
In order to create new Business Performance Management (BPM) frameworks, some companies have abolished budgets, while many more have introduced scorecards and Key Performance Indicators (KPIs).
As the spotlight shines on budgeting and BPM, forecasting largely remains in the shadows – an afterthought often tacked onto the end of a period's actual reporting.
However, forecasting is now emerging as an essential part of financial management. For CEOs and CFOs, particularly those who have suffered profit warnings or 'surprise' results, controlling the company's forecasting is vital.
WHY IS FORECASTING IMPORTANT?
An accurate forecast is a critical component of a company's overall financial control and BPM framework.
When the quality and the accuracy of forecasts are improved, organisations can see more clearly what decisions and actions management should take to ensure the company meets its business performance targets and what key messages may be required to manage shareholder expectations if the targets are missed (or exceeded).
Accurate forecasting also provides other significant benefits, enabling operations to run more smoothly and profitably. For example, production runs can be planned with more confidence, thereby improving factory efficiencies and reducing inventory levels.
Over the past two years, regulatory regimes, such as Sarbanes-Oxley in the US, have been pressuring companies to improve the speed, quality and accuracy of their forecasting and communication of material events and financial implications to the market.
Despite its growing importance, accurate forecasting remains elusive for many companies. A recent study by Parson Consulting shows that one-third of the S&P 500 'miss' their forecast by more than 10%. In some industry sectors, the inaccuracy was more than 40%.
Although different industries face varying market forces and levers to manage their financials, most analysts and observers will concur that the ability to forecast accurately is a mark of a well-run company – one with strong business and financial controls.
The quality of cash flow forecasting has come under ever-increasing scrutiny since the corporate failures of seemingly profitable companies during the late 1990s.
In our view, a well-managed and controlled company that integrates forecasting as part of its BPM framework is able to:
- Identify its key value and cost drivers and develop appropriate performance measures
- Encourage 'human performance' around these key performance measures
- Plan and budget its performance effectively by articulating its aspirations in terms of the key performance measures
- Simulate (as part of the planning or forecasting process) its desired or expected performance using driver-based scenarios
- Understand how operational or leading drivers impact its lagging financial performance outcomes
REFORMING THE FORECASTING PROCESS
The process of reforming planning and forecasting often revolves around reducing the time spent on such activities by investing in new technology.
However, accurate forecasting is seldom the result of the mere implementation of a new system. A more successful approach is to focus first on changing people's behaviours and making the process itself more effective. This can be accomplished by ensuring that group works with business units to:
- Define the unit's business-wide forecasting framework and introduce a standardised, repeatable process
- Establish levels of sign-off and accountability (for example, from sales or operations management) for forecasts that makes their accuracy a KPI in itself
- Enforce cross-functional collaboration through regular, preset meetings such as monthly sales and operations planning meetings
- Equip key staff involved in forecasting with the training and skills required to do a diligent job
- Promote a culture of realism and honesty in forecasting
This last objective is perhaps the most difficult to address, since it is not so much about an organisation's competency but rather its culture.
In too many organisations, budgeting and forecasting take on the attributes of a game of poker, as senior business managers try to out-manoeuvre each other. As a result of gaming, the whole company becomes riddled with hidden 'contingencies', 'tasks' and 'challenges' – all of which amount to risk.
This makes the CFO's role of managing the stock market's expectations fraught with danger.
On the one hand, the 'portfolio effect' mitigates the risk, but on the other, it is in each and every CFO's interest to reduce the portfolio's spread of risk. Profit warnings frequently result from the realisation of risks that had previously been hidden from group and, obviously, where 'overs' did not offset 'unders'.
A FORECAST FIDDLE?
Functional staff who work deep in the operations of a business unit frequently try to massage the numbers in an attempt to minimise variances. If sales demand is over plan, they try to rein back the forecast. If sales demand is below plan, they try to talk the numbers up.
Such forecasts need to be evaluated and challenged locally prior to review by higher management at the group or division level.
The finance department is an obvious choice for this critical role, but often finds itself too busy to assume the responsibility.
Organisations can promote more diligent forecasting by uncoupling the timing of the forecast from the period-end rush. This allows finance departments to assume a more advisory role in the overall forecast renewal process.
THE RIGHT TOOL FOR THE JOB
Once forecasting has been made more effective, the next step is to review its efficiency by equipping the finance department with enabling technology.
A recent report shows that over 64% of companies use spreadsheets for budgeting and forecasting while only 21% use a dedicated application.
Working this way requires the finance department to spend much of its time number crunching and maintaining fragile forecasting spreadsheet models.
Automating the forecasting process through the use of a dedicated forecasting application will release the finance department from its scorekeeper role and enable its managers to better fulfil the value-added role of evaluator and challenger, helping the business optimise performance.
THE GLASS SLIPPER: ACCOUNTABILITY
Times have changed for BPM. Today's CEOs and CFOs are increasingly being held accountable by investors for the accuracy of their forecasts. Identifying and addressing the root causes of inaccuracy results in more than just better forecasts and fewer errors; it is a strong indication of how well companies are run.
At Parson, we encourage companies to integrate forecasting into their BPM frameworks so that it is recognised as being on a par with actual reporting, planning and budgeting.
It is unlikely that the implementation of a new system in itself will result in better forecasts. Instead, we advise companies to invest in improving the effectiveness of forecasting first before addressing efficiency.
This will not only help organisations increase their forecast accuracy but also enable their finance departments to fulfil their role as a proactive business partner