TagFinancial Planning and Analysis

The Accuracy in your Forecast Matters More than the Forecast Itself

One of the roles of the FP&A function is predicting future business performance and help business leaders prepare for an unplanned future through forecasting and decision support.

Although anticipating the future is challenging given today’s fast-changing environment, looking ahead is increasingly essential.

The world is far, far more complex than we think. Unknown unknowns and known unknowns have replaced the routine, the obvious, and the predicted.

Resultantly, many of the assumptions on which important future business decisions are based are easily refuted with the passage of time. For example, one of the most common outcomes of the typical business planning process is a hockey stick forecast.

These forecasts usually show significant business growth and profitability prospects. The last few years of actual results are flat, and then magically shoot up for future years just like the blade of a hockey stick.

It’s a rare experience to come across a forecast that shows a downward spiral of business performance.

Businesses leaders often present a positive outlook of enterprise performance even if the odds of achieving their bold aspirations are slim. This is emblematic of human’s limited ability to accurately predict the future.

Tunnel vision

In his book The Black Swan, Nassim Taleb demonstrates how humans suffer from the delusion of knowing. We underestimate what the future has in store.

In the same manner, we tend to develop a tunnel vision while looking into the future, making it business as usual, when in fact there is nothing usual about the future.

Instead of acknowledging our unknowledge of the future, we continue to project into the future as if we are experts at it, using tools and methods that exclude rare events or outliers.

Although these rare events are most of the time external to the organization, they play a significant role in influencing the operational and strategic performance of the business.

The problem with many business performance forecasts is that they tend to focus on a single point destination or outcome, including a few well-defined sources of uncertainty ( known knowns) at the expense of others that do not easily come to mind.

The goal is not to predict or forecast all improbable events but rather to have an open mind and acknowledge that the likelihood of your actual future being different to your predicted future is considerably high.

Think of new products that failed to hit the mark with customers, projects that experienced cost overruns or took longer to complete, companies that failed to survive their forecast horizon etc.

The list of forecast horror stories is endless. I am sure in 2003 the thought of Lehman Brothers going under five years later was a laughable idea and outside the company’s projections.

Mitigating the tunnel vision

When it comes to forecasting, most of us adopt the inside view to assess the future performance of the business or any other project.

In other words, we tend to plan and forecast based on the information in front of us, neglecting some sources of uncertainty outside the plan itself. Daniel Kahneman, the well-respected psychologist has termed this WYSIATI – What You See Is All There Is.

As a result, we produce plans and forecasts that are unrealistically close to best-case scenarios. However, there are many ways for any plan to fail, and although most of them are too improbable to be anticipated, the likelihood that something will go wrong is high.

The cure for tunnel vision is taking an outside view of that which is being forecasted. Optimism bias often gets into the way of accurate forecasting leading to some of the horror stories mentioned above.

Thus, to avoid falling victim to optimism bias it’s important that you go through all the statistics of projects or initiatives similar to that being forecasted. This will help you identify an appropriate reference class and use the statistics to generate a baseline prediction which acts as an anchor for further adjustments.

Measure your forecasting error

Even though the world is complex and constantly changing, many planners are still adopting a simple view of the world as evidenced by their click and drag forecasts projecting into the long term future. Simply extrapolating projections from one year into the next is a mistake.

The accuracy of forecasts is more important than the forecast themselves. Do you attach possible error rates to your forecasts and measure the actual error rate after the forecasted horizon has passed? As the projected period lengthens, the larger the cumulative forecasting errors.

Despite evidence of enormous forecasting errors in the past, there is an ingrained tendency in us to ignore failure statistics and believe we are suddenly better at predicting the future compared to our uncomprehending predecessors.

Should we therefore discard predicting the future altogether? No, we first need to acknowledge that what we think we know about the future is not all there is. Our comprehension of the future is limited. From there on we can plan while bearing in mind such limitations.

In other words, we should stop overestimating our known knowledge about the future. We may be good at predicting the ordinary, but not the irregular, and this is where we ultimately fail.

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.

© 2019 ERPM Insights

Theme by Anders NorénUp ↑