Planning for Uncertainty
With
national debt crises in both Europe and the United States, a shaky
recovery from the deepest recession since World War II and volatile
currency markets, it’s not surprising that recent research conducted
by the Beyond Budgeting Round Table found that more than two-thirds
of corporate budgets are irrelevant before the end of the first
quarter. The problem is exacerbated by the inherent weaknesses of
the traditional budgeting process, according to Steve Player,
principal with Beyond EPS Advisors and program director of the
Beyond Budgeting Round Table.
Budget
targets are based on assumptions, and the facts on which those
assumptions are based can change even in a relatively stable
environment. In today’s environment it is almost impossible to
predict what will happen.
“Managers
spend far too much time explaining again and again why the
assumptions in the budget plan are no longer relevant,” Player said.
But
faulty assumptions are not the only problem with traditional
budgets, according to Player. The greatest problem is that budgets
are typically used as performance appraisal tools. “This provides an
incentive for managers to negotiate for the lowest acceptable
target,” said Player. “The result is that growth potential is left
on the table.”
So if
you don’t measure performance against budget targets, how do you
measure it? The answer, according to Player, is to look at
performance relative to peers who are experiencing the same market conditions.
Another
problem, on the spending side, is that employees often see budgeted
expenditures as an entitlement, which can lead to poor cost controls.
The
Beyond Budgeting Round Table, an international organization
dedicated to improving the financial planning process and whose
membership includes American Express, tw telecom and Unilever, says
companies that follow 12 principles can eliminate budgets entirely
and enhance performance in the process (see sidebar “12 Beyond
Budgeting Principles,” below).
Some
of the first principles CPAs in financial leadership positions
should consider, according to Player, are those dealing with
planning and controls via rolling forecasts rather than traditional budgets.
ROLLING FORECASTS
The
purpose of forecasting is to get the most realistic picture possible
of the future for as far out as a company’s management can look.
“If
you have a short-term operational plan and a long-term strategic
plan for what you want to become, the business forecast focuses on
the in-between part, how to move from where I am to where I want to
be,” said Player.
The
Beyond Budgeting Round Table recommends the rolling forecast go out
at least five quarters, but many span six quarters. “Really you want
to go out as far as people can see,” said Player. “For some, it
might be six months. If you go beyond what people can see, then it
just becomes a math exercise.”
UPDATE INTERVALS
The
intervals when a given item’s forecast is updated should reflect the
item’s variability and importance to your business (see Exhibit 1).
“If
it’s highly critical and highly volatile, you look at it very
frequently,” said Player. “If you have things that are high on one
measure and low on the other, you look at them with a medium
frequency. If they’re low on both, you can drop back to an
infrequent update only as necessary.”
For
example, Southwest Airlines, a member of the Beyond Budgeting Round
Table, updates its revenue forecast daily and its fuel forecast
weekly. But other items may be forecast bimonthly, monthly or
quarterly (see Exhibit 2). The updates only cover critical items
that are changing. Player noted “some organizations such as American
Express take an ad hoc approach with forecasts triggered by when
significant changes have occurred in their business.”
Player
compared managing a business to navigating a ship. “The ship
represents your organization’s cost structure. It is configured
based on thousands of decisions you’ve made in the past. You’re
sailing in this competitive sea, and over time you can change
everything, but you can’t do it overnight. The planning process is
about how to forecast ‘what do I need to do differently.’ ”
COMMON MISTAKES
But
many forecasting systems fail to achieve their objective, according
to Player, for a variety of reasons. Player identifies the following
common mistakes to avoid in forecasting:
Forecasting
to the wall.
Many
forecasts focus on the plan year. So each month or quarter into the
plan year, the forecast period diminishes by the elapsed time in the
plan year (see
Exhibit 3). The rolling forecast maintains a continually
updated horizon, usually five quarters out (see Exhibit 4).
Confusing
forecasts with targets.
The
purpose of forecasting is to show the most realistic picture of how
your organization is tracking toward its objectives, not the picture
you want to see. “When a management team allows a forecast and a
target to be equal, it becomes a ‘trust me’ forecast—‘Trust me I can
hit the plan target,’” said Player. “The problem with this approach
is that it eliminates any robust discussion of what actions are
needed to reach the target, what risks have to be managed and what
resources are required. It also obscures visibility into how to grow faster.”
Demanding
forecast accuracy.
Forecasting
requires assumptions, and conditions will change. Pressure to make
forecasts more accurate can provide an incentive for gamesmanship
where managers provide lowball forecasts and then stop when they are reached.
Relying
on Excel spreadsheets.
Unless
you are a small company with a single user, Player advises that
Excel should be avoided as a forecasting tool due to the high
likelihood for error and the inherent constraints of a desktop
spreadsheet environment. He recommends companies that are concerned
with systems expense look to cloud-based systems (for a list of
cloud-based forecasting system vendors, click here).
Excessive
detail.
The
rule of thumb, according to Player, is to limit the detail
forecasted to what can realistically be used by management. “You
want your managers spending more time using the data than collecting
it,” he said.
Relying
on “probability-based forecasting.”
Some
organizations manage uncertainty by estimating the probability that
an event will occur. They then plan using that percentage estimate
so an item with a 60% chance of occurring would result in a plan
that includes 60% of related revenue and expense. Player warns “to
be careful with this approach since many events are ‘yes or no.’”
For instance an acquisition or government approval to sell a new
drug is either yes or no. In those cases, that plan should reflect
two separate scenarios rather than a blended approach.
Immediately
assuming a growth forecast
.
Forecasts
frequently suffer from what Player calls the “hockey-stick effect”
where the forecast gets significantly better as it approaches the
end of the plan year. Make sure growth is based on underlying
physical factors rather than management’s hopes that things will get better.
Treating
forecasting as a “special event.”
Forecasting
should be an integral, ongoing part of monitoring the business.
Using
only one time horizon for all forecasts with the same interval.
Use
different time horizons for different decisions such as sales and
operations planning, financial planning and capital planning. But
integrate the system into a unified whole.
Failing
to learn from your forecast record.
Forecasting
should teach you things about your business that you didn’t know
before, and that information should be acted on. If you’re not
getting actionable data, there’s something wrong with what you’re
collecting. If you’re collecting actionable data but not using it to
manage your business, there’s a communication problem.
IMPLEMENTATION
The
annual budgeting process has long been described as one that takes
too long, costs too much and is out of date often before it is
printed. Companies such as American Express, tw telecom, Group
Health Cooperative, Park Nicollet Health Services and Unilever have
implemented rolling forecasts to overcome these problems. “The
frustrations of the current budgeting process provide a reason to
change. Many organizations have moved to rolling forecast as the
first step to more effective ways to plan and control their
organizations,” Player said.
12 Beyond Budgeting Principles
Governance
and Transparency
1.
Values. Bind people to a common cause, not a
central plan.
2.
Governance. Govern through shared values and sound
judgment, not detailed rules and regulations.
3.
Transparency. Make information open and
transparent; don’t restrict and control it.
Accountable Teams
4.
Teams. Organize around a seamless network of
accountable teams, not centralized functions.
5.
Trust. Trust teams to regulate their performance;
don’t micromanage them.
6.
Accountability. Base accountability on holistic
criteria and peer reviews, not on hierarchical relationships.
Goals
and Rewards
7.
Goals. Encourage teams to set ambitious goals;
don’t turn goals into fixed contracts.
8.
Rewards. Base rewards on relative performance, not
on fixed targets.
Planning and Controls
9.
Planning. Make planning a continual and inclusive
process, not a top-down annual event.
10.
Coordination. Coordinate interactions dynamically,
not through annual budgets.
11.
Resources. Make resources available just-in-time,
not just-in-case.
12.
Controls. Base controls on fast, frequent feedback,
not budget variances.
Source: Beyond Budgeting Round Table,
bbrt.org
.
Share your
budgeting experience and hear from other CPAs about their lessons
learned. Visit facebook.com/JournalofAccountancy
and click “Discussions” to participate.
Vendors that provide rolling forecast tools:
Source: Player Group/Beyond Budgeting Roundtable North
America
EXECUTIVE SUMMARY
The
facts on which budget assumptions are based change
even in
relatively stable environments. This makes most budget targets
obsolete shortly after they are prepared.
Traditional budgets, through ties to performance evaluation,
incentivize negotiating the lowest acceptable target.
This
leaves growth potential on the table. Budgets also can encourage
inappropriate spending and discourage appropriate
investment.
The
purpose of forecasting is to get the most realistic picture
possible of the future for as far out as a company’s management
can see.
The
business forecast should link short-term operational plans to
moving toward medium-term strategic goals.
Rolling forecasts typically go out five quarters.
But
you only want to go out as far as people can see. Otherwise, it
becomes a math exercise.
Common mistakes include:
Forecasting
for a plan year rather than in rolling forecasts; confusing
forecasts with targets; demanding forecast accuracy; relying on
Excel spreadsheets; providing excessive detail; relying on
probability-based forecasting; immediately assuming a growth
forecast; treating forecasting as a “special event”; making one
time horizon fit all forecasts with the same interval; and failing
to learn from your forecast record.
Successful implementation requires unified support from
management.
The
support typically comes from a high level of frustration with the
current process.
Matthew
G. Lamoreaux
(matt@mattlamoreaux.com)
is a freelance writer.
To
comment on this article or to suggest an idea for another
article, contact Kim Nilsen, executive editor, at knilsen@aicpa.org or
919-402-4048.
AICPA RESOURCES
JofA
article
“Scenario
Planning: Navigating Through Today’s Uncertain World,”
March 2011, page 22
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