TagDriver-Based Planning

Rethinking the Annual Budgeting Process

Human beings are creatures of habit. Once they have mastered certain habits, especially bad ones, it is extremely difficult to let go. Even though we are fully aware that the immediate, medium-term or long-term consequences of our bad behaviours are dire, we still cling unto them. Could this be because of our ignorance or maybe lack of understanding of what is at stake?

The annual budgeting process has been around for a very long time, and organizations across the globe have been using budgets to allocate scarce resources, monitor and manage performance. In a perfect stable world, the annual budget process works. Unfortunately, a stable economic environment is a thing of the past.

Volatility is the norm today

In the majority of organizations that operate an annual budgeting cycle, the final budget is fixed in nature, covering a specific time period. Finance executives and business managers spend a significant amount of time inputting and debating the final budget. As soon as the final budget figures are agreed, IT department uploads the budget on the company’s accounting and finance system. Nothing changes after this, except comparing actual performance to budget.

The challenge for many finance executives is which approach to use to prepare the budget. Base plus or zero base? Many make the grave mistake of using prior year’s actuals as the base for formulating the current year’s budget and then make arbitrary adjustments. This approach is acceptable in an environment where market conditions are stable, predictions are easy to make and key budget assumptions remain valid for the entire budgeted period.

Unfortunately, volatility is the norm in today’s global economy. Increasing global pressures, uncertainty, ever-changing consumer behaviours and disruption are all rendering initial key budget assumptions invalid by the time the final budget is completed.

The result is often an outrageously inaccurate budget with little management commitment and minute relevance to the organization’s strategic plan.

This new dynamic global economy calls for modern approaches to budgeting, planning and forecasting. Organizations need to be adaptive, ever ready for unpredictable events and quickly responsive to changing marketing conditions.

In his book Thinking, Fast and Slow, Daniel Kahneman talks about the Knowing Illusion.

The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact we understand the past less than we believe we do.

What we see is all there is. We cannot help dealing with the limited information we have as if it were all there is to know. We build the best possible story from the information available to us, and if it is a good story, we believe it.

Paradoxically, it is easier for us to construct a coherent story when we know little, when there are fewer pieces to fit into the puzzle.

The fact that we think we have a clearer understanding of the past does not automatically mean that we are capable of comfortably predicting and controlling the future. Learning from the past is a reasonable thing to do, but it is also important for us to understand that this can have some dangerous consequences.

If we lack knowledge of all the information there is to know, the limited information we have on past performance can mislead us during budgeting and planning processes and negatively affect future outcomes.

Link Budgets to Strategy

Despite the widespread challenges of the annual budgeting process and prominent rise of the beyond budgeting proponents, the annual budget still has a place in the hearts of many finance executives.

They are not yet ready to ditch the budgeting cycle completely, it is too risky for them to run the business without a financial plan.

Rather than ditching the budgeting process entirely, implementing driver-based budgets and rolling forecasts can help organizations address the challenges of the traditional budgeting approaches.

Although most of the variables in the budget are financial, it is important to also take into consideration non-financial information as this is key to developing an understanding of business performance drivers and constraints.

Very few organizations make an attempt to link budgets with their strategy, in fact the planning process is influenced more by politics than by strategy. Leading organizations are using the Balanced Scorecard to strategically allocate resources.

Linking budgets to strategy helps management and their subordinates identify the organization’s critical success factors and how they relate to the KPIs used to measure company success. This in turn, will help them design initiatives needed to close the gap between current performance and desired performance.

Aligning spending with strategy also helps fund only those initiatives deemed strategic and with the potential of propelling the organization forward. This is in direct contrast to the base plus and zero base approaches which allocate resources on the basis of chart of accounts line items, resulting in the funding of non-strategic initiatives and wastage of resources.

Implement rolling forecasts

Compared to traditional budgets which cover a fixed period, rolling forecasts allow organizations to get a vision of the future and support improved decision making. By using rolling forecasts, the company will be able to project performance four to six quarters ahead.

Each quarter the plan is reviewed, and key decision makers are able to understand problems, challenges and trends sooner than later, and change directions or fund strategic projects based on current economic conditions. Instead of reacting to changing business conditions, executives will become more proactive in their approach.

One of the advantages of rolling forecasts is that they are driver based. Drivers help eliminate detail when creating a realistic expectation about the future resulting in managers focusing on what is vital for the success of the organization.

With time, the drivers are evaluated to determine if they are still a key predictor of higher performance. If not, new drivers will be identified and selected for monitoring.

As volatility and uncertainty continue to increase, organizations need to be prepared always in order to navigate successfully towards the future.

Why Implement Continuous Rolling Forecasts?

The annual budgeting process has been around for decades and still forms part of the performance management framework for the majority of organizations. As the economic environment has evolved and become more dynamic, has the budgeting and forecasting capabilities in your organization also evolved and adapted to this change?

Unfortunately, for many organizations, the annual budgeting process still rules. Despite the evident drawbacks of the traditional budgeting process and developments in financial planning technologies, there is still widespread reluctance by top management to embrace alternative planning processes. The traditional annual budget used by many companies is static in nature, not aligned to strategy setting and execution, and focuses mainly on cost reduction as opposed to value creation.

In today’s volatile, uncertain, complex and ambiguous economic environment, in order to make effective decisions, management must be able to understand and respond quickly to the impact of competitive forces and rapid changes affecting their businesses. They must be able to look into the future, assess risks and potential opportunities and proactively manage them. Different decisions require different time horizons and planning capabilities.

The problem with the annual budget is that it distorts this long-term visibility and stifles innovation. Much emphasis is placed on the current fiscal year, which is normally twelve months. As a result of this short-term focus where management is driven to achieve the predefined annual targets, a culture of predict-and-control becomes prevalent. The focus is on making sure that the forecast numbers are achieved.

What do I mean by the above? In the traditional budgeting and forecasting processes, management come up with an annual performance targets, mostly financial, broken down in a twelve-month period. Every month, actual results are compared against planned results and variances (Monthly and YTD) identified. The computation for the monthly forecast therefore becomes:

forecast

 

The problem with the above approach is that the forecasting process is disconnected from the specific drivers of the business. It fails to understand that the purpose of forecasting is to map the strategic direction of the organization, identify risks and potential opportunities, and coordinate future activities. It is not a performance evaluation tool and a re-validation of the company’s commitments. When forecasting is used as a performance evaluation yardstick, chances are that management will purely focus on achieving the targets set at the beginning of the year.

What is critical to note is that forecasting should be based on real business demands and the real business environment. At the same time, rewards must be according to the value created and not based on meeting set financial targets because the later can easily be gamed.

Does this therefore mean that the traditional annual budgeting and forecasting process should completely be abolished? Some scholars and professionals have called for a complete elimination of the entire process raising some of the issues already mentioned here. I personally believe that combining a number of practices such as driver-based planning, rolling forecasts, Strategy Maps and their associated Balanced Scorecards is key to addressing traditional budgeting and forecasting drawbacks. No one practice offers a remedy for all these issues. Remember enterprise performance management (EPM) is the integration of various managerial techniques to support strategic decision-making and improve performance.

 

The Benefits of Implementing Rolling Forecasts

Enables Management to Adapt to a Changing Economic Environment

One of the mostly mentioned disadvantages of the annual budget is that it is static in nature and ignores changes in the market place. Targets are set based on the various assumptions identified at the beginning of the year and by the time the final budget is signed-off, most of these assumptions are out-of-date and irrelevant.

For example, in many companies, the annual budgeting process lasts on average between three and six months, and sometimes even longer. The process is back-and-forth with revision after revision. In today’s volatile economic environment, a lot can happen in the six-month period which has far implications on the strategic performance of the business. Because of the amount of time taken to agree and sign-off the final budget, these changes are not factored in.

Implementing continuous rolling forecasts offers a remedy for this issue of adaptability. Most continuous rolling forecasts are prepared at least four to eight quarters past the current quarter’s actual results. This gives management greater visibility into the business and prepare agile responses to changing market conditions.

Even at the time of budgeting, at the end of the second quarter of the financial year, you would have already gained insights that relate to first half of the next fiscal year and this immensely reduces the time required to produce the final budget.

Management need to be able to look at what is possible, rather than merely react to what has occurred. Hence the need for forward-looking forecasts which act as early warning systems when you have drifted off-course.

 

Allows Management to Perform What-if-Analysis

Most budgeting and forecasting processes are a series of one-off annual or quarterly events. They are prepared based on historical data imports from the company’s ERP system thereby ignoring the key business drivers of the business. Plans are often extrapolated from historical performance and end up being a simple accumulation of financial trends.

With rolling forecasts, management are able to focus on key assumptions and drivers of strategic performance, model possible future outcomes and identify the events that might trigger them, evaluate the impact of these events and design contingency plans to remedy the negatives.

Unlike budgets that may have hundreds of line items to focus on, continuous rolling forecasts focus on the strategic key business drivers. This reduces the amount of time spent on planning and frees up time on other initiatives that drive greater value and high performance. Because rolling forecasts challenge management to have a continuous business outlook, the focus is on leading indicators which helps the organization identify future performance gaps and re-adjust.

 

Shifts Management’s Mind-set from Annual Planning to Continuous Planning

Traditional budgeting often creates a fixed performance contract that limits an organization’s ability to be responsive to ever-changing market conditions. Because of this, there is natural tendency for management to ignore changes after the fiscal period even if they do have negative impact on the performance of the business.

On the contrary, rolling forecasts help management eliminate this annual mind-set, are aligned to business cycles and help managers continuously look into the future and proactively design counter-measures to remedy the drawbacks of the annual budget.

As already mentioned, it is time-consuming to produce the final budget and get it signed-off. By the time the budget is finalized, the market has changed dramatically and its assumptions are out of date. Because the budgeting process is an annual exercise, there is no room to adjust the levers that drive business performance.

Quoting a great quote by one of the Chinese Philosophers, Lao Tzu:

A good traveller has no fixed plans, and is not intent on arriving.

 

The same applies to businesses. The fiscal year end must not be the destination. It is therefore imperative that management considers all scenarios when making key strategic decisions. By implementing rolling forecasts and continuously updating the forecast to reflect current business conditions, management will be able to mitigate the risks of traditional budgeting and forecasting inaccuracies.

In order to fully benefit from rolling forecasts, the budgeting and forecasting capabilities must form part of the organization’s integrated enterprise performance management (EPM) framework. Additionally, there must be strong executive buy-in with regards to use of rolling forecasts to drive business performance. This buy-in is key to ensuring greater acceptance of the use of rolling forecasts by the organization’s business unit managers.

I welcome your thoughts and comments.

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.

Breaking Free From the Shackles of the Annual Budgeting Process

It is a fact that no one can predict the future with certainty. But does this mean that the management teams need to steer their organizations with a rear view perspective? The answer is a big NO. Management need to at least anticipate different future scenarios that the organization is exposed to and formulate effective strategies capable of addressing this uncertainty.

Unfortunately, most organizations remain tied up to the annual budgeting process. They spend months drafting the budget and then monitor performance against it. The problem with monitoring performance against the annual budget is that it makes managers focus more on hitting the numbers at the expense of the long-term interests of the business.

Instead of taking a long-term view of  enterprise performance and considering all the factors (Qualitative, Quantitative, Financial and Non-financial) that can help management make effective decisions, trapped into the shackles of the annual budgeting process, management end up making short-term tactical decisions that have devastating effects in the long run. Sometimes they just add a percentage point (for example, the inflation rate) to last year’s budget numbers to get to the current year’s budget numbers. The problem with this approach is that it ignores all the other important drivers of value creation and their impact on business performance.

By the time the separate business units submit their budgets for consolidation, most of the assumptions used to prepare these budgets are no longer valid. So what should organizations do in these turbulent and uncertain times? Instead of waiting for the future to present itself and then react to this future, organizations need to be proactive and adaptive. Sketching the future with a range of likely outcomes based on a variety of options helps managers make confident decisions and also enables the organization to respond rapidly to unpredictable events that can easily erode value overnight.

As clearly stated above no one can predict the future with certainty. I am not advocating that managers predict these events accurately. Instead, managers need to continuously look ahead and use all the information at their disposal to formulate decisions that maximise the potential of the business. This will in future help evaluate the alternative courses of action available to deal with negative events when they happen.

It is important to note that effective decision making is driven by information. The information needs to be timely, accurate and of reliable source. Today, various business intelligence and analytic tools can be used to capture, store, analyse and interpret vast amounts of data for sound decision making. When making strategic, operational and tactical decisions, management need not rely only on information about what happened in the past. They also need information about what they believe might happen as well and this information comes about as a result of effective forecasting.

Implementing scenario planning, rolling forecasts and driver-based forecasts helps management escape the perils and consequences of the annual budgeting process.  These tools help managers organizations anticipate the future, steer their organizations in the right territories and in turn drive business performance.

Without some ability to at least anticipate the future (For example changes in regulations, the economic environment, customer tastes, social attitudes, technological developments, political environment, competition and other industry and market dynamics.) it is difficult for the organization to survive. It is therefore important for managers to transform their planning and forecasting processes if they are to succeed in strategic execution, risk management and performance management.

Breaking free from the ropes of the annual budgeting process requires management to view the planning and strategy execution with different lenses. It is all about strategic change management. They need to present a strong case throughout the organization on why the current processes have run their course and need transformation. Effective forecasting is not a Finance function alone. Input from other functions is critical to enable a 360 degree view of the organization and drivers of value creation. Some of the factors pointing to the need to move from the static budgeting process to rolling forecasts and driver-based forecasting include:

  • Rapid changes in the modern economy. Today organizations can rise up quickly and at the same time disappear overnight because of failure to anticipate the future. The global economy and its organizations are now so interconnected that it can be dangerous to make wrong assumptions about the business environment more than a few months ahead.
  • Effective forecasting shields the organization from the drastic effects of today’s turbulence and uncertainty. Sometimes it is not the case that the organization is weaker or that the market is underperforming that leads to failure. It is simply that the systems management is relying on for decision making are outdated. Being unable to effectively forecast and respond to the future exposes the business to serious risk of loss and in extreme case failure.
  • Growth in amount of data. Amount of data available has increased. Adding a percentage point to last year’s numbers is misguided. It fails to take advantage of all the structural and non-structural data that plays an important role when it comes to effective decision making. Effective forecasting systematically and rationally helps managers assemble information that gives them visibility about what lies ahead in terms of likely outcomes, potential risks and opportunities.
  • Increased shareholder expectations. As providers of finance, shareholders are constantly looking for a satisfactory return on their investment. Should the organization fail to deliver on this it is most likely to see the back of its financiers. The investment community is always looking for quarterly feedback in the form of earnings reporting. Thus the assumptions used in the annual budgeting process need a constant assessment as failure to do so can leave the organization with an egg on its face. A profit warning as a result of failure to anticipate the future can drive down organization value immensely.

It is therefore important for managers to have a reliable projection with some ranges around it, a reasonable idea of the drivers of uncertainty and a compelling plan of how they intend to mitigate risks or exploit opportunities.

As the modern business economy continues to evolve managers must recognize the drawbacks of the annual budgeting process and importance and advantages of effective forecasting. It is also important to take advantage of credible EPM technological solutions in the market, if implemented correctly, allows managers to see over the horizon. These systems also help provide real time information that can be used for effective strategic decision making.

I welcome your feedback and comments.

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