categoryBudgeting and Forecasting

Are You Using Scenario Planning To Improve Decision Making?

As the business and macro-economic environment continue to change at rapid paces and increasingly getting complex, the pressure on the finance organization to support the core business by strategically addressing volatility, uncertainty and risk is also intensifying.

This fast changing environment is making it extremely difficult for organizations to forecast business performance with a greater degree of certainty. What we used to consider extraordinary is now the ordinary and the previously unthinkable is now reality. In this environment, organizations need to become more proactive, flexible, adaptable and not reactive. Traditional planning cycles such as the static annual budget are no longer ideal for this dynamic economy.

Past Performance is Not a Predictor of Future Performance

Despite significant evidence indicating this rapid change, many organizations are still relying on the annual budget for planning and evaluation purposes. What we tend to forget is the fact that the annual budget gives a false view of a stable future. By the time the annual budgeting process is over, the majority of the assumptions used to compile the budget are outdated. Additionally, most budgets solely use historical performance as a baseline for predicting future performance. Again, this ignores the fact that past performance cannot be used to mirror future performance.

Most budgets prepared by companies only have a financial focus, normally adding or deducting a percentage to previous year’s numbers. They lack specific consideration of the forces driving the business and value creation. The link between the strategy, planning, resource allocation and performance reporting processes is broken.

With the current volatility, uncertainty and complexity in today’s environment, companies need to adopt an agile mindset and new ways of planning. Working together with the other business functions, Finance can drive this process and lead its success. Taking advantage of the function’s analytical and risk management strengths, finance executives can use scenario planning to help decision makers identify and understand possible future events and their impact on strategy execution and business performance.

Scenario Planning

Instead of taking a static view of the future and basing key decisions on gut feel, scenario planning helps business leaders understand their business environment (any significant emerging threats and opportunities), identify the critical drivers of value and correlate their impact on performance, both operationally and strategically. It achieves this by enabling decision makers frame a number of questions on the strategic intent of the organization.

Regardless of your business’s industry sector, scenario planning is useful for getting different views of the future that reflect volatility, uncertainty, and complexity thereby helping you identify gaps in your organization’s ability to respond to threats and opportunities. Once you have identified the blind spots and gaps in your company’s response capabilities, you can then start building a dynamic risk management framework and gain knowledge of the risks you have direct control of or influence and those that you do not have.

When conducting a scenario planning exercise, organizations must:

  • Define the purpose and scope of the exercise.
  • Examine the internal and external environment for emerging trends and issues.
  • Identify possible realistic future scenarios and evaluate their impact on the business.
  • Formulate strategic and operational responses to each scenario.
  • Monitor performance related triggers and regularly challenge assumptions

Scenario Planning is Not About Predicting the Future Accurately

Instead, it is about understanding the environments in which your business operates, discovering new insights, and increasing adaptability to changes in these environments. By constantly taking uncertainty into account when making decisions and also encouraging alternative thinking, you will be able test and evaluate the robustness of your company’s strategies against a range of possible futures. This in turn will assist you broaden your perspective and develop robust response plans.

Critical to note is that scenario planning is a continuous process rather than a once-off exercise and must be incorporated into processes for managing the business on an ongoing basis. The macro-economic environment is constantly changing and as such, an ongoing review of the drivers of performance and trigger points is necessary.

You need to constantly ask questions on the social, technological, economic, environmental, political and legal influencing factors and indicators.

Examples of questions that you might ask include:

  • If you are an automaker, what is the impact of autonomous and electrical vehicles on our current business model? Are self-driving cars the future and how should we respond?
  • If you are consumer company, how would the organization respond to growing emerging markets and the rise of the middle class workers?
  • How would the organization respond to unexpected loss of a major contract that has sustained the company for a long time to a competitor?
  • What are the short-term and long-term implications of a major product recall on your market position, reputation and the organization’s ability to meet strategic performance?
  • What is the range of likely impacts on our brand, customers and supply chain, if one of our key suppliers files for bankruptcy?
  • What competing products or disruptive forces will have the potential of threatening and forcing us out of business?
  • What is the impact on our quarterly and annual performance targets of material short term changes in key external variables such as commodity prices, inflation rates, interest and exchange rates, GDP and consumer spending?
  • How would the organization respond to unexpected external events such as a major natural disaster, political or regulatory actions, or occurrence of a pandemic?
  • What are the likely advantages and disadvantages of moving our enterprise systems to a cloud-based platform versus retaining them in-house?
  • What are the global business implications of UK leaving the European Union, and how would our organization react to such a move?
  • What are the implications to the business of a data breach on key account information?

By systemically monitoring a series of performance related triggers, the organization will be able to anticipate major trends and changes in the industry or broader business environment, respond dynamically, gain competitive advantage and seize growth opportunities in both developed and emerging markets.

Scenario planning is more than a business threat analysis tool. It also helps you identify emerging opportunities, improve your business model and proactively address industrial and environmental uncertainties.

Improving Finance’s Financial Planning & Analysis Capabilities

As the role of the finance function continues to evolve from reporting on what happened in the past to driving business performance and creating enterprise value, the function’s financial planning and analysis capabilities need to be improved.

More than ever, increased volatility and uncertainty is placing considerable pressure on finance leaders to support business decision-makers by delivering actionable real-time insights.

Finance leaders are required to have a 360 degrees view of the risks and opportunities the organization is exposed to and respond promptly to change.

Recently, CFO Research in collaboration with SAP conducted a global survey of senior finance executives across various industry segments to better understand how finance leaders are supporting decision-making and value-creation purposes within their organizations. Based on 335 senior finance executives’ responses, the survey revealed the following four key findings:

  1. Being agile is becoming an increasingly source of competitive advantage. In a volatile, uncertain, complex and ambiguous business environment, having the ability to respond and adapt to change is the key to survival and value creation. Unfortunately, volatility and uncertainty is the norm these days. This in turn is requiring finance to provide real-time analysis and decision support. Of the surveyed finance executives, 84% are expecting senior management demand for adhoc decision support and analysis from finance to increase more in the coming years.
  2. Current financial planning and analysis IT systems are failing to deliver actionable insights. Organizational CFOs are hungry to see their functions conduct highly sophisticated, predictive business analysis, such as scenario planning, “what-if” analysis and risk modelling. However, current IT systems are falling short of intensifying demands for real-time analysis. For example, 53% of the senior finance executives responded that they are trading off sophisticated, predictive business analysis in order to produce reports in a timely manner. Furthermore, 14% are currently able to instantly respond to ad-hoc reports for business analysis via interactive, self-service interfaces. The majority (61%) of senior finance leaders are responding within one day of receiving request and 20% are responding more than one day after receiving the request.
  3. Lack of integration between financial planning and core ERP systems. Only 36% of survey respondents indicated that their company’s financial planning systems are well integrated with each other, with minimal manual intervention. Further worrying, only 15% of the respondents indicated that those financial planning systems are very tightly integrated with their core ERP systems and require minimal data migration.
  4. There is increased pressure on finance teams to drive business performance and create value. One of the critical mandates of the organization’s finance function is delivering more forward-looking and more interactive information and analysis into the hands of business decision makers. As the business environment continues to evolve, 88% of the surveyed finance leaders agree that this mandate will increase more in the coming years.

In light of these findings, what should senior finance executives and their teams do?

  1. To be the organization’s sought-after trusted adviser, finance must move beyond focusing only on the company and its profits and start seeking new opportunities to grow the business and expand. A team is as good as its leader. The finance leader must make sure that his team constitutes people with diverse backgrounds but all working towards the same goals of delivering real-time actionable insights, managing enterprise risks and creating sustainable value. It is critical to have people who possess the ability to challenge current assumptions and ask the right questions. People who do not possess a herd mentality but are prepared to go against the status quo as long as they are bringing something tangible to the group.
  2. The finance function must become agile, innovative and adaptive. Disruption in the business environment demands the function to develop new management models, standardize processes and be responsive to threats and opportunities. Keeping abreast of what is happening in the business environment, both externally and internally, helps sense and respond to changes quickly. Playing a “wait-and-see” game is no longer sufficient in today’s ever-changing business landscape. Business leaders need to be able to thoroughly scan their operating environments, understand risks and opportunities and take immediate strategic action.
  3. In order to improve the function’s financial planning and analysis capabilities, senior finance executives must ensure that their organizations have invested in IT systems that meet the demands of real-time, ad-hoc analysis. For example, the IT system must be able to conduct highly sophisticated, predictive business analysis in timely manner. Finance must be able to deliver more than just reporting on historical data and have the ability to deliver clear, actionable, forward-looking and real-time insights. Furthermore, it is important that finance provides reports and analysis that is easily understood by all managers to enable them make effective decisions.
  4. The organization’s financial planning and the core ERP systems must be integrated to ensure more effective decision-making. As the providers of information and analysis for sound decision-making, finance should ensure that it is providing one version of the truth always. It is therefore critical to have tight integration of financial systems with the other ERP systems if the function is to provide decision support and help create value. The integration of the systems should require minimal manual intervention and minimal data migration. In other words, there should be a reduced amount of time, attention and resources devoted to data migration and manual reconciliation connected with financial planning and business analysis. Having an integration of systems helps achieve consistency in processes and transparency of data throughout the consolidation data to financial results.
  5. Not all data is important for decision making, some of it is just noise. One of the barriers to improving financial planning and analysis capabilities is lack of data standardization across the organization. In today’s information age, it is critical that finance leaders and their teams are able to separate the wheat from the chaff. Data used for planning purposes must be validated and consistent throughout the company. How reliable and timely are your data sources? Also, there is need to train employees on the importance of data decision-making and data science.

As the pressure on senior executives intensifies to manage increasingly complex businesses and improve the organization’s competitive position, finance leaders will always be expected to deliver insights and analysis that are able to make the most difference to the business.

Factoring Risks into Financial Forecasts and Planning

VUCA, short for volatility, uncertainty, complexity and ambiguity is an acronym used to describe the world we live in.

Since the onset of globalization, CFOs have had to deal with a variety of uncertainties and risks. From the traditional operational, financial, credit and market risks to strategic risks, the list goes on.

Yet despite having knowledge of these risks and how they can derail the company from its successful course, very few CFOs and their teams factor risk management into their financial forecasts, budgets and plans.

As custodians of the forecasting and planning function, it is the responsibility of CFOs to ensure that risks to the operational existence of the business are identified, assessed and properly mitigated.

Unfortunately, regardless of its limitations, some CFOs still rely heavily on the annual budget to drive business performance. A lot has been proven and written on the shortcomings of the traditional budgeting process.

For example, the annual budgeting process is time-consuming and by the end of the first quarter, most of the assumptions used to prepare that budget no longer hold true hence the need to adopt driver-based rolling forecasting and planning.

To successfully take advantage of emerging opportunities and help empower strategy, the Financial Planning and Analysis (FP&A) team must embrace risk-adjusted forecasting.

Instead of focusing entirely on single-point estimates that fail to identify risk exposures, risk-adjusted forecasting enables CFOs to look at possible outcomes and probabilities based on multiple risk variables.

The macroeconomic environment is always changing and as a result CFOs ought to be proactive rather than being reactive.

It is no longer sufficient for CFOs to know what happened in the past. There is need to move on from the traditional cost-variance analysis towards a more forward-looking approach.

Thanks to developments in analytical technologies, through the use of descriptive and prescriptive analytics, CFOs are able to gain insights on why something happened as well as model the future.

In other words, technology is addressing the challenge of preparing forecasts based on gut feel.

Through risk-adjusted forecasting, forecast models can be built that are based on facts such as competitor activity, production activity, regulatory pressures, supply and demand changes etc.

Having an expanded view can help many companies address interconnected risks, some of which may have been previously identified, others that may have gone unnoticed.

Rather than entirely focusing on hitting one set of given numbers, CFOs should stress tests their forecasts and rigorously challenge the assumptions used to create those forecasts by asking the right and hard questions.

This will help identify an understatement or overstatement of risks and take corrective action. Given that growing a business brand and improving revenue growth and operating margins all come with a bag full of risks, if CFOs turn a blind eye and ignore these risks, they definitely are bound to steer their organizations towards an iceberg collision.

Risk types and risk drivers vary by company, business and industry.

Thus, it is critical for CFOs to have an enterprise view of risk if they are to be successful in addressing any material concerns facing the finance function and the organization as a whole.

At the same time, factoring risks into the forecasting and planning processes ensures effective allocation of investment resources based on multiple risk-return positions.

Identifying the various risks the organization is exposed to as well as their drivers requires both a bottom-up and top-down approach.

A bottom-up approach is helps identify, assess and evaluate the risks operating at the shop floor level. A top-down approach looks at the risks of the strategy and to the strategy and how they can be mitigated.

Understanding common risks and how they cascade and interact provides a foundation from which risk-adjusted forecasting frameworks can be developed and then set up throughout the entire organization.

Care must be taken that you get a balance on the number of risks and their drivers based on perceived importance, data availability and practicality. The idea is to get valuable insights that drive effective decision-making as opposed to overburdening the business.

Producing Reliable Forecasts That Improve Decision-Making

Although almost every organization uses forecasts to predict and manage future business performance, only a few of the produced forecasts are reliable despite the amount of energy and time invested in producing them. The problem with unreliable forecasts is that they have far-reaching strategic and operational implications.

They lead to poor decision-making which in turn costs the organization a lot of money. Analysts from the investment community closely monitor the forecasting capabilities of the companies they track.

Failure to hit forecast targets can result in the share price getting hammered and eventually a “sell” call by the analysts. This has negative repercussions on the market capitalization of the organization. Of course no one can accurately predict the future.

However, producing forecasts that are within five percent of the actual performance is considered accurate.

Accurate forecasts are a potential driver of business performance and investor confidence. They help identify opportunities to drive business improvement, manage risks, determine growth strategies and reinforce stakeholders’ confidence in the business.

One of the reasons why so many forecasts lack reliability is because the data used to produce these forecasts is either erroneous or incomplete. For example, some organizations depend largely on internal data to predict future performance at the expense of external data such as consumer demand, competitor activity, economic drivers etc.

To be able to forecast with confidence, it is imperative that those individuals tasked with the forecasting responsibility leverage information more effectively.

In addition to internal reports, they should make use of government reports, market reports and competitive data as well as data on non-economic risks that could have important impacts on markets or operations to produce forecasts. Also, operational managers who are closer to the business scene must be involved in the forecasting process.

There is a mistaken belief that forecasting is the sole responsibility of finance. Surely finance plays the leading role, but it is important to give the operational managers that drive business performance greater ownership and responsibility for key parts of the forecasting process.

By constantly liaising with their operational counterparts, finance will be able to quickly pick up changes in the business operating environment, perform what-if-analysis, update their forecasts accordingly and provider better insights that assist executives make informed decisions.

Despite the advent of reliable forecasting software, there is still a huge reliance on spreadsheets by a majority of organizations to produce forecasts. Although it is possible to produce reliable forecasts using spreadsheets, this is dependent on the size of the organization or business.

As the business grows, it becomes increasingly difficult to continue sticking to spreadsheets. This is because spreadsheets are great for building a single department budget and forecast but don’t work well for rolling up the budget and forecast for tens of departments and divisions.

Furthermore, spreadsheets are more prone to errors. Poorly constructed spreadsheets make it worse by mixing formulas and data so it is easy for users to type over formulas. Think of organizations that have lost millions of money just because one individual misplaced a comma or incorrectly typed a figure to a certain cell or row.

At the same time, it is worth knowing that technology alone is not the answer. Getting the processes and data right is a critical first step. Thus to obtain the necessary benefits, alignment of both processes and data with technology is key to avoid the risks of automating a broken process that uses unreliable data.

Then there is the issue of “sandbagging” the forecast to protect bonuses. Costs are a bit overstated and revenues a bit understated. If performance is rewarded mainly on the basis of hitting financial targets, managers are more likely to deliberately become conservative in their estimates. Such behaviour should not be encouraged.

Sandbagging and gaming interferes with good decision-making. Although such managers appear heroic in the eyes of their peers, it means that important decisions such as resource allocations and investment choices are being made on the basis of inaccurate or incomplete information.

Thus, to make better decisions, senior executives need to instill a culture where reliable forecasting is encouraged and rewarded. They should demand honest forecasts regardless they like or don’t like what they see. Additionally, incentives must be aligned to relative performance rather than targets.

As the business environment increasingly becomes dynamic and turbulent, managers and senior executives need to review the forecasting capabilities of their organizations and implement reliable rolling and driver-based forecasting.

Without reliable forecasting, key opportunities and risks are likely to be missed. On the contrary, reliable forecasts enable the organization to become sensitive and responsive to business conditions and make appropriate changes in real time.

They can improve the effectiveness of monitoring by recognizing the context of changing circumstances as these occur. This in turn assists managers to make bold decisions with greater confidence despite whichever direction the market moves.

Remedies for Forecasting Illnesses

Yesterday I wrote about the seven common symptoms of forecasting illness and how they can lead to uninformed decisions making. In an increasingly volatile and uncertain world, the ability to anticipate the future, even if only a few months ahead, can mean the difference between survival and failure. Unfortunately, future uncertainty is much greater than most managers concede. Thus if managers fail to demonstrate an understanding of the dynamics of their businesses performance stakeholder confidence can seriously be undermined. As a result, managers must place an increasingly high priority on improving their forecasting processes.

How can managers use forecasting tools to plan effectively and build better strategies? Instead of seeking predictability, managers should channel their efforts into being prepared for different incidents and the reality of change. Take for example the Global Financial Crisis of 2008. Prior the financial meltdown, majority of global policy makers and business leaders were very upbeat about the performance of their economies despite signs of looming danger. Not many people anticipated the after effects of a global financial system collapse on their businesses and as a result some reputable organizations collapsed and filed for bankruptcy while others were bought over for at cheap market values.

Volatile markets make it enormously difficult to forecast effectively. However, although many things that occur in the business world may not be predictable, their randomness should at least be modelled. For example, there are bubbles, recessions, financial crises and natural disasters which are known not occur very often but do repeat at sporadic and irregular intervals. While leaders, managers and employees are reasonably aware that these rare events can occur, and may even be able to imagine several examples, they consistently underestimate the likelihood of at least one such event including the ones they didn’t imagine occurring. This is because human beings have a tendency to underestimate the size of rare events, which in most cases, leads to negative consequences.

It is not only business catastrophes that producers of forecasts fail to anticipate. They are also unable to predict business success. For example an unhealthy obsession with a particular forecast number as well as the failure to provide enough forward visibility and discern trends in performance makes the business to miss on emerging opportunities. When preparing forecasts; managers should accept that they are operating in an uncertain world, assess the level of uncertainty they face and augment the range of uncertainty.  It is critical to have the ability to perform “what if” scenarios and change analysis. Additionally, managers should be able to re-forecast as market conditions change. This will protect managers from having a single tunnel vision about the business which in turn helps them formulate appropriate strategies to deal with rare events when they occur.

To address their forecasting shortfalls, some organizations believe that investing in latest software tools will solve their problems. Unfortunately, the application of IT solution without understanding the real problem and its source will not fix a broken forecasting process. For example, some managers believe that investing in some sort of trendy software will help them collect, consolidate and analyze forecasting data quickly enough.  This is just a quick fix which often leads to lots of numbers, gaming behaviour and wastage. If you do not first solve the root cause of the problem, there will be no reprieve.

The other quick fix that other managers resort to involve using complex statistical methods hoping that these will help them better anticipate the future. Human judgement is worse at predicting the future than are statistical models. In fact, human beings are often extremely surprised by the extent of their forecasting errors. Thus instead of using simple statistical models to forecast, some managers are preoccupied with applying complex models. Simple statistical models such as moving averages are better at forecasting than complex ones. Complex models often attempt to find non-existent patterns in past data whereas simple models ignore patterns and just extrapolate trends.

The benefits of getting your forecasting right are considerable both in terms of improvements in efficiency and effectiveness. Better forecasting results in informed decision-making. Right things will be done at the right time – there will be no surprises as well as wastage of time and resources. Improved forecasting also leads to better situational awareness which helps the organization to spot discontinuities early, avoid unnecessary costs, formulate fitting contingency plans, become agile and exploit opportunities.

Good forecasting also enhances teamwork and collaboration. If sales, marketing, operations, finance etc. are all involved in the forecasting process this leads to one set of numbers being produced and agreed upon instead of having numerous competing forecasts. Lastly, by anticipating better and responding more quickly, the performance of your business will become more certain and less prone to surprises.

I welcome your thoughts and comments.

 

 

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