The world of financial planning and analysis has observed changes of such magnitude that they cannot be described by our traditional statistical and analytical models. In this age of frequent Black Swan events, the traditional business approach to operating on an annual budget and forecast is no longer effective. In order to deliver a competitive advantage to a company, modern FP&A function needs to be flexible and dynamic, be based on sophisticated analytics, examine life-time values of the products and services and encourage business partnering. This significant change in the role of FP&A function requires big cultural shift and modern change management techniques.
Flexible and dynamic planning process
A flexible and dynamic planning process is easily adjustable for different risk and strategy scenarios. It is multidimensional, driver-based, events-driven and activity-based. It uses advanced analytics and is not limited to the accounting period. It encourages collaboration between business functions and allows both top-down and bottom-up approaches to be used in the process.
Following are popular techniques for the flexible and dynamic planning process:
- Risk-adjusted planning
- Scenario planning
- Rolling forecast
- Activity-based budgeting and planning.
The risks enterprises face can destroy or create value. Therefore, successful mitigation of risk is important for the survival of the company. In order to survive in times of extreme changes, organizations need to be very quick and flexible in analysis and planning.
Historically, risk management has been a separate process within the organization, not connected to FP&A function. Increasingly more companies are beginning to incorporate risk information into the planning, in order to evaluate and manage external and internal risk. A risk-adjusted plan is one that responds to changing circumstances, providing the financial capability to react to events in a planned and proactive manner. The time of one static scenario planning has gone forever. The identification of risk scenarios enables the organization to develop risk response plans applicable to many possible events, not just one specific scenario.
Scenario planning is an important technique for flexible and dynamic FP&A process. At the time of rapid change, the technique is used during the planning process to evaluate risks and viability of different strategic alternatives. It is also used for sensitivity analysis. The standard approach of “three scenarios” (best, average and worst) is replaced with multiple on-demand scenarios. To arrive at one summarized view, probabilistic and expected values approach could be used.
Rolling forecasts are a planning method that refers to a process of forecasting trends that may impact your business 4-8 quarters in the future. With rolling forecasts the number of periods in the forecast remains constant and visibility of the business does not stop at year-end.
For example, the idea is to do a new forecast every three months and add another three months to the end of your forecasting cycle on the rolling basis.
A rolling forecast is a better management approach since it gives management a view into the future. According to APQC, use of rolling forecasting can save a median of 25 days on an organization’s annual budgeting cycle. A rolling forecast expands planning horizons and challenges the traditional static budget. More and more companies are introducing RF into their processes, many of them use the process parallel to the traditional budgeting process. However, quite a few organizations have abandoned the old budgeting and planning process in favor of the more flexible rolling forecast.
Activity-based (flexible) budgeting
Activity-based budgeting is a very effective technique for cost management and in the time of global expense cutting this method has become very popular. However, this concept challenges the traditional view of a budget fixed for the year. In an activity-based budget, variable cost is adjusted for the activity level throughout a year and cost managers learn to adjust to the idea that their annual budget is not fixed or based on previous years’ spending. It varies with the level of activity and could be lower or higher depending on the activity level. Therefore, the budget is dynamic, not static. The concept needs to be communicated to departmental managers, and it needs to be controlled and analyzed by finance business partners before it becomes part of the business culture in the traditional budget organization.
Advanced Analytics and Driver-Based models
Oracle recently commissioned a global study investigating the level of management coherence and profit visibility in large companies. The research, undertaken by Dynamic Markets, surveyed 1,500 organizations and found that 82 percent lack a complete visibility of profits, with 40percent suffering impaired financial performance as a result. Oracle explained these figures by the fact that more than half of the study participants used spreadsheets for profitability models.
Many companies have recognized that spreadsheet-based planning methods are inefficient and have moved to specialized planning and forecasting systems. Modern FP&A should be based on a model with formulae tied to fundamental business drivers. Advanced predictive analytics in FP&A model is a source of strong competitive advantage. This is a driver-based model which invokes consistency and participative cooperation across functions in organizations.
Some basic principles of driver-based modeling:
- Concentrate on top 10-15 business drivers
- Analyze and manage the drivers
- Look at their interdependence
- Explain the variances through the drivers
- Update driver-based models on a regular basis
Harmonization of the planning processes
In addition, strategic, operating and financial plans should be harmonized through drivers and ideally reside in one system. They should allow cross-functional collaboration and use automated reports that can quickly generate scenarios and easy multidimensional capabilities. The system should also allow top-down and bottom-up approaches to be used during the planning and forecasting process.
It is extremely important to leverage both approaches in order to harmonize strategic and operational plans.
Expanding time horizons, lifetime value view
The accounting period is an artificial concept which does not show us the whole picture or lifetime value of the product/customer. Accounting treatments such as capitalizations and provisions deplete the real profitability view.
That is why the life-time value analysis technique and rolling forecasts are important methods as they expand the time horizons of the financial analysis. The rolling forecast is an important concept in breaking artificial accounting period views. Survival analysis techniques are becoming very popular in forecasting true future profitability of the business.
Participative planning is growing more important in the organizations in order to implement strategy and improve the level of analysis. An effective planning and forecasting process should involve all key staff to help everyone better understand the drivers and reduce office politics.
Participative planning process helps with the following:
- Risk identification
- Connecting strategy with the operational plan
- Improving communication and understanding business drivers
- Flexibility of the FP&A process: with top down and bottom up approaches.
Such collaborative planning can be accomplished through an iterative process that allows managers to forecast and share alternative scenarios, which are essential given today’s economic uncertainties. Finance also plays the key role in facilitating the coordination of plans across the company, which helps ensure that operational tactics are aligned with financial targets throughout the organization.