Jeremy Gray – Show 10 Season 4. Improving FP&A Forecast Accuracy
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Last week I introduced you to the concept that FP&A should be a profit generator for your business.
The challenge in many companies is that FP&A delivers little more than a budget that quickly grows stale. That is unacceptable.
The best-performing organizations use FP&A to drive business outcomes, not just to budget spending or forecast sales and expenses.
They do more than predict desirable results; they develop rigorous, well-conceived plans to deliver those results.
One of the keys to that is linking operational and financial planning. To use a simple example, a best practice FP&A company will recognize the relationship between productivity and cost of goods sold (COGS). If the company establishes a target of increasing earnings by a specific dollar amount, it will assess the required productivity gain necessary to reduce COGS and increase profitability.
This underscores that financial projections aren’t divorced from operational planning. In fact, it’s just the opposite: Financial projections are seen as worthless without an operational plan to achieve them.
In modern thinking FP&A now sits between the financial leader and the operations leader. The CFO and COO in lager organizations. FP&A should support the entire organization. Helping sales in pricing strategies, R&D in goal setting and the management team in decision making.
To be effective FP&A needs to build models that provide a solid basis for making business decisions. Note that I use the word solid rather than accurate. It is almost impossible to be 100% accurate in a forecast. There are just too many variables and external influences to achieve that level of accuracy. What is required are models that are accurate enough to enable the best business decisions to be made using the facts available and your understanding of the business environment.
Show Objectives - The Why
As your business grows the more complex it becomes and the investments required to move forward become larger both in $ terms and resources needed. Also decisions acquire more momentum and to make changes when needed become more difficult.
Your FP&A team therefore needs to be able to provide you with the best forecast they can, which includes the resources required and form the ROI on your investment.
ROI should be the return you require above your hurdle rate – that is what it costs you to borrow money from all sources. Shareholders expected returns, bank interest rates, factoring costs – whatever it is costing you to raise funds.
Key Issues - Owner Perspective:
As the owner of the business what level of accuracy is acceptable? You need to avoid the well recognized challenge of paralysis by analysis. Where no decision is made as executives ask for one more what if scenario, the inclusion of one more variable into the model. As Voltaire said best is the enemy of good. You have to achieve the right balance between practicality and optimization. The law of diminishing returns applies to financial modeling too.
Strange as it might sound many executives are afraid to make decisions. Making a decision invites consequences so it is tempting to spend hours analyzing a problem. Asking for more analysis can be seen as taking action when in reality it is inaction, As time passes options become fewer until if you wait long enough there is only one option open to you and the decision is made. Likely this is not the optimal decision.
So as an owner alarm bells should ring when one of your management teams says I have asked the FP&A team to run one more scenario.
What You Need to Know - The What
What level of accuracy is acceptable? It may be surprising but in the field of forecasting there is a model called the naïve forecast. At its simplest the naïve forecast assumes that tomorrow is going to be very much like today. That the status quo will continue and nothing much will change. This might seem simplistic or naïve but over the short term it may be an acceptable forecasting technique. If the industry you operate in is relatively stable and change comes slowly the naïve forecast may be all that is required. It is a case of effort over reward, or cost versus benefit. Will a more detailed model deliver a forecast that enables an much better decision and thus outcome?
The level of accuracy required depends on circumstances. In supermarkets the demand forecast accuracy for short shelf life products needs to be more accurate than demand forecast accuracy for products with a longer shelf life. If a can of baked beans sits on a shelf for a couple of weeks there is little harm done much beyond using a little bit more working capital than needed. If a head of lettuce sits in the chiller for a couple of days it is either going to have to thrown away or marked down significantly to get it sold.
In this example and many others the balance is between needing accurate forecasts versus adjusting your supply chain to tolerate inaccuracy in forecasts. The ability to respond to variances in forecast accuracy is another factor. If you can quickly respond to an inaccurate forecast at minimal cost the less accurate your forecasting needs to be. Note this does not need to be handled by you if you can pass this challenge on to your supplier.
The challenge to you as the business owner is to strike the right balance between accuracy and resources needed to produce the forecast.
What You Need to Do - The How
1. Keep Budgeting and Forecasting Flexible
Rigid forecasts and budgets aren't very useful. Things change as the time progresses, and you need to be able to factor in those changes and how they will affect your business. Continuing to base decisions on the best guesses made months prior can lead to faulty and costly decisions. Keep in mind the inertia basis we have talked about in the past. In addition, holding employees to metrics based on out-of-date information is counterproductive and frustrating. Building flexibility into your budgeting and forecasting will allow for more accuracy and better results in your business. This can be achieved by point 2
2. Implement Rolling Forecasts and Budgets
You can update rolling forecasts and budgets based on present results, not on what a manager thought may happen several months ago. You can use this process to shorten the projection period for example only predict one or two quarters ahead or as I prefer use the latest information to update the predictions for the entire project.
3. Budget to Your Plan
Spending should reflect actual results not planned results. If you do not do this it is easy for spending to get ahead of earnings with disastrous results to you cash flow and eventually your profitability.
4. Communicate Early and Often
As the forecasting and budgeting affects all aspects of the business, you want to keep an open line of communication with all departments throughout the entire process to help minimize issues and to ensure alignment between your company's operational and organizational strategies.
5. Involve Your Entire Team
Budgeting and forecasting should be a team effort so that departments and units have a clearer understanding of their needs. As well as the people in your finance department, having people with their pulse on the various departments can give you the data you need to make accurate predictions and set realistic budgets. Moreover, using your entire team allows you to have multiple perspectives on where your business is now and where it could be in the future.
6. Be Clear About Your Goals
The purpose of forecasting is to predict your company's financial future. Forecasting aids in the making of business decisions and in understanding their impact before you implement them. If you aren't clear on the overall goals of the company, then your ability to accurately forecast your business's financial future falters. Therefore, you should have a clear understanding of what's driving your forecasting predictions; otherwise, they are just random guesses not grounded in the goals of your company.
7. Plan for Various Scenarios
You can't plan for everything, but you can have an idea of some of the obstacles that could affect your initial forecast and budget. Review external market and economic trends that may negatively or positively impact your company. A rolling forecast is helpful for staying on top of any changes that could impact your business. Rolling forecasts also allow you to pivot as needed based on any new data presented so all decisions are based on what's happening now and not on what happened the previous year.
8. Track Everything
Everything needs to be accounted for when budgeting and forecasting for the upcoming fiscal year, whether it's the potential buyout of a competitor or just the office supplies. Don't underestimate the importance of seemingly minor details and their ability to affect the company's financial health. Once a budget is in place, allow for forecasting that looks at the many potential scenarios that may occur. Keep eyes and ears on market trends, client behaviors, and what the competition is up to as the business forecast is being finalized.
9. Include Profit and Cash Flow Goals
Gene Siciliano a respected author says "Every budget should have profit targets and cash flow targets because the two bottom line measures are very different, and they require different kinds of attention to control them." If you're not keeping track of these two important metrics of your business, how useful and accurate will your budget be? To keep your company from missing its financial goals, set realistic targets for both your cash and profit flow.
10. Let Excel Go
Don't rely on Excel or other spreadsheet software to do your budgets and forecasts. Planning software can go a long way in making the process easier and less time consuming. If you have the right FP&A team they will be pressing you to implement such software.
How to calculate your cost of capital. The link below provides a clear explanation of how to calculate your cost of capital without using complex formulas.
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