Most sizable companies around the world engage in some form of forecasting. Forecasting of sales, production, inventory, cash, and financial statements may be among those activities companies seek to track. However, most companies subscribe to outdated thinking and practices when it comes to forecasting. This article will address some of the traditional practices that were once true but now border on myth. This includes the importance of budgeting, the time required to build a rolling forecast, the importance of always-improving accuracy, and the relevance of traditional spreadsheet software.
A core aspect of financial planning & analysis (FP&A) is forecasting and budgeting. To plan effectively and envision the future, businesses must contemplate company-specific, competitive, and macro considerations. The better the intelligence, arguably, the better the forecast and budget. However, many businesses attempt to drive their businesses forward based upon flawed assumptions that waste time and capital. Effective financial planning requires a practical approach to forecasting and budgeting, implementing approaches that make sense rather than reinforce outdated norms.
In this article, exposed are some of the more common myths so frequently accepted as truth within FP&A groups around the globe.
Myth: The aim of a forecast is to be as accurate as possible.
Truth: The aim of a forecast is to be as accurate as needed to effect business decisions with a heightened level of confidence. Many forecasters believe they should aspire to continuously minimize variances between forecast figures and actuals. Certainly, this would indicate that forecast accuracy is high. However, the degree of resource commitment, diligence, and reforecasting needed to reach extremely high forecast accuracy is often unrealistic.
Think about what is the purpose and use of a forecast. Oftentimes, business decisions can move forward with a high level of confidence without needing to be categorically accurate.
Myth: Budgets are necessary for running a business.
Truth: Budgets can be helpful for running a business but aren’t essential. The budget is a tool that has been used by companies around the globe, small and large, for decades. They’re used to translate strategic plans into financial plans, deploy resources, and compensate professionals for hitting future targets. Although it’s hard to argue against these benefits, the issue many companies encounter is the inaccuracy of budgets once the fiscal year begins. In a matter of just a few short months, budgeted figures can become completely out-of-date and impractical for planning purposes. A new phase in the evolution of FP&A is arising where companies seek to maintain an up-to-date forecast that reflects the most current company-specific and macroeconomic intelligence. These live financial models can serve the company well, allowing decisions to be made in real-time based upon current information.
Myth: Budgets should be used to set targets upon which compensation is based.
Truth: Many company departments are all too familiar with the unfair consequences of breaking and beating the budget. On one hand, when a department breaks the budget, financial performance falls below target and the department is often shamed for the disappointment. On the contrary, when a department beats the budget, it’s often not reasonably rewarded for the success; instead, the savings are frequently reallocated to other groups. As a result, many departments find themselves between a rock and a hard place. In order to hedge these outcomes, many professionals find themselves intentionally sandbagging their numbers, ensuring they’ve baked enough fat into the budget so that they can more comfortably hit their numbers as they need.
Just as earnings expectations influence the executive office’s performance motivations, so do budgeted targets influence professionals’ daily behavior. If budgets are how compensation is guided, professionals are more likely to bake in bias to increase the likelihood of hitting targets. Of course, not all professionals are motivated by compensation but it tends to be a dominant factor. If compensation is tied to the budget, the budget is likely to be biased. Instead, companies should segment variable compensation into various categories, each of which is tied to different types of performance. For example, a company may tie part of an individual’s variable compensation to the company’s overall performance, tie part to departmental performance, and tie part to individual performance. Note that the key factor here is performance, not an achievement of a pre-determined target as is the case with most budgeting.
In summary, FP&A should be tasked with helping companies make better business decisions. Companies should encourage FP&A to drive the business from the numbers, rather than set arbitrary budgetary targets and superficially back into them. To minimize or even eliminate sandbagging, it’s imperative to do away with outdated practices that disincentivize people from doing the right thing. Leadership has the unique capacity to spearhead common-sense approaches to building an excellent financial culture – a culture that behaves in-line with facts, not myths.
The article was first published in Unit 4 Prevero Blog