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Sarbanes Oxley : US Treasury : Configuration Management
Accurate Forecasting
A Fundamental Part of Financial Management
By
Tony Vadasz
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Tony Vadasz
Practice Director
Parson Consulting
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Budgeting and performance management have been on the minds of many organizations recently. Some companies have abolished budgets while many more have introduced scorecards and key performance indicators in an attempt to create new business performance management (BPM) frameworks. 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 actuals reporting. Forecasting is only now beginning to be recognized as an essential part of financial management and control by CEOs and CFOs, particularly those who have suffered profit warnings or ?surprise? results.
This article explores Parson Consulting?s philosophy on fore-casting: the importance of its accuracy; the value of improving effectiveness (behaviors and process) before efficiency (technology); and achieving greater overall business performance through improved forecasting capabilities.
Why is forecasting important?
A company?s ability to forecast accurately is a critical component of its overall financial control and BPM framework. By improving the quality and the accuracy of their forecasts, organizations can more easily see what interventions are required to meet their business performance targets or what key messages may be required to manage shareholder expectations if the targets are missed (or exceeded)!
Regulatory regimes such as the Sarbanes-Oxley Act in the USA and Higgs in the UK are pressuring companies to improve the speed, quality and accuracy of their forecasting and the communication of material events and financial implications to the market. The ability to forecast accurately also brings with it significant financial benefits, as it enables 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. Despite its growing importance, accurate forecasting remains elusive for many companies. A recent study by Parson Consulting shows that over a third of the S&P 500 ?miss? their forecasts by more than 10%. In some industry sectors, the inaccuracy was well over 40%.
Clearly, different industries face varying market forces and levers to manage their financials. Yet, most analysts and observers will concur that a well-run company?one with strong business and financial controls?should be able to forecast its perfor?mance accurately despite the external business environment.
If many companies should do better at forecasting profit, very many more should work to improve the quality of cash flow forecasting, something that is coming under ever-increasing scrutiny since the corporate failures of seemingly profitable companies during the late 90s.
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 aspired or expected performance using driver-based scenarios
• Understand how operational or leading drivers impact its lagging financial performance outcomes
What does it mean for Group and Business Units? Forecasting is important at both the group (enterprise) and business unit levels. An accurate forecast will help the group:
• Effectively manage investor expectations
• Optimize its corporate financing
• Re-plan and re-allocate resources across the portfolio of business units to better manage future performance
• Regularly review the performance of business unit general managers
• At the business unit level, forecasting helps:
• Align key business functions and processes to ensure sales forecasts (demand side) are appropriately translated into requirements for operations (supply side)
• Management proactively monitor performance value drivers, profitability, and cash flow
What exactly is a forecast?
Some companies confuse the role of a budget with that of a forecast, which can have serious adverse consequences. To create a budget is to set the aspired or targeted outturn for a period, together with the planned events, activities, and interventions required to achieve it. To create a forecast is to articulate an objective and realistic assessment of the organization?s likely outturn on the basis of actual trends, current assumptions, and plans and budgets, in the absence of additional management interventions.
Internal Forecasts
If management is to make timely and effective interventions, it must have sight of where its business is likely to be heading. If business units submit ?aspirational? forecasts, management will not have an accurate line of sight until, perhaps, it is too late. By the same token, management should not encourage its business units to treat forecasts as budgets or order business units to ?increase? their forecasts without the assurance that the new predictions will be achieved.
External forecasts
The forecast a company should release externally should be the aggregate of the objective and accurate internal forecasts of the group companies plus the probable incremental value of the interventions senior management will now take. Anything else is a gamble.
Invest in process improvement before technology Discussions about reforming forecasting and planning processes often revolve around reducing the time spent on such activities (i.e., improving efficiency) by investing in new technology; however, accurate forecasting will rarely result from the mere implementation of a new system. A more successful approach will focus first on changing people?s behaviors and making the process itself more effective. This can be accomplished by ensuring that the group works with business units to:
• Define the unit?s business-wide forecasting framework and introduce a standard, repeatable process
• Establish levels of sign-off and accountability (for example, from sales or operations management) for forecasts that make their accuracy a key performance indicator in itself
• Enforce cross-functional collaboration through regular, pre-set 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
Functional staff that work deep in the operations of a business unit frequently try to massage the numbers in an attempt to minimize variances. If sales demand is over plan, they try to rein back the forecast. If sales demand is below plan, they try and 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. Finance is an obvious choice for this critical role, but often finds itself too busy to assume the responsibility. Organizations can promote more diligent fore?casting by uncoupling the timing of the forecast from the period-end rush. This would allow Finance to assume a more advisory role in the overall forecast renewal process.
Once forecasting has been made more effective, the next step is to review its efficiency by equipping Finance with enabling technology. A recent report1 shows that over 64% of companies use spreadsheets for budgeting and forecasting and only 21% use a dedicated application. Working this way requires Finance to spend much of its time number crunching and maintain?ing fragile forecasting spreadsheet models. Automating the forecasting process through the use of a dedicated forecasting application will release Finance from its scorekeeper role and enable its managers to better fulfill the value-added role of evaluator and challenger, helping the business optimize performance.
Best practices in forecasting
In Parson?s experience, best practice forecasting is based on the following key principles: - Forecasting is NOT an afterthought to be tacked onto the end of the period-end reporting process, but is a critical process in its own right. In turn, business units must be given time to consider and submit high quality forecasts.
- Forecasting should be carried out frequently. Many companies have now positioned forecasting as a critical business process that is repeated at least on a monthly basis.
- Forecasts should ?roll? by articulating an objective and realistic assessment of performance up to 15-18 months ahead of time.
- Forecasts should start with the main business drivers, which in most (but not all) businesses revolves around sales.
- Forecasts should be articulated in terms of the company?s complete business performance management framework, including both leading indicators and lagging financials.
- Forecast accuracy must be measured and should become one of the key business indicators for which business unit general managers are held accountable.
- The mid-year 18-month forecast should form the basis for building the following year?s budget. It shows the gap between the current trend and the aspiration of management for next year?s budget, and therefore forewarns management of the level of intervention needed during the budget process to bridge the gap.
Conclusion
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; it cuts to the core of how well companies are run. Parson encourages companies to integrate forecasting into their BPM frameworks so that it has the same precedence as actuals reporting, planning, and budgeting. We believe 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 route will not only help organizations increase their forecast accuracy, but also will enable Finance to fulfill its role as a proactive business partner.
Tony Vadasz
Practice Director
Parson Consulting
Tony Vadasz is a practice director in Parson Consulting?s European region. He has spent the past 15 years helping global organizations enhance their operational and financial performance through improved planning, budgeting, and forecasting.
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