SWTCH by Pigment
Three days of predictions, insights, and advice from leaders in finance, sales, HR, supply chain and more
Register now here
SWTCH by Pigment
Three days of predictions, insights, and advice from leaders in finance, sales, HR, supply chain and more
Register now here
By Alan Dybvig, Managing Partner at Dybvig Consulting
Alan Dybvig
Alan Dybvig is the managing partner of Dybvig Consulting. His intellectual property was implemented to create the operational budget (OB). His business experience includes 32+ years with IBM as a director and senior manager, primarily in supply chain and sales/marketing assignments, and then four years with a Warburg Pincus-financed supply chain startup where the idea for the OB germinated. He has had five articles published in the Journal of Corporate Accounting and Finance, two articles in the Institute of Management Accountants’ Strategic Finance and one each in the Institute for Business Forecasting's blog and INFORMS’ magazine, "OR/MS Today".
Alan Dybvig's LinkedIn profile: https://www.linkedin.com/in/alan-dybvig-0a374ois/
In this article, we will look at how driver-based advanced analytics has overcome the problems with the current budgeting process.
This is the first article in a series that is devoted to next generation budgeting; specifically, the operational income statement (OIS) and its associated operational budget (OB). This article will review the analytics that makes the OIS possible. NOTE: If this analytics is not well-understood, the benefits described in subsequent articles may not be fully appreciated. In fact, the interested reader is urged to contact the author if, for any reason, this first article is not clear.
This article has 3 sections: i) What is OIS; ii) the OIS structure and its associated analytics and iii) Conclusion. It describes how easy it is to demonstrate one of OIS’s most important benefits - more profit. It does so by determining how much profit last year’s p/l left on the table. In fact, an OIS test case demonstrated the firm had left an excess of 50% profit.
OIS is a totally new answer to the major problems with the current budgeting process. These are well summarized in Steve Morlidge’s FP&A Trends article “Why Budget?” Quoting from the article:
More offhandedly, the problems with the current budget’s process were summarized nicely by the former GE CEO, Jack Welch. Paraphrasing: ’The budget process should never have existed; it is the bane of corporate America.’
Importantly, OIS is developed first and then the OB from it. Today it’s the opposite; the budget is developed first and then the income statement is developed from it.
Also, OIS is a particular kind of a driver-based model. Specifically, all the drivers are the same; i.e. activities (aka, operations, processes, production lines).
Some of the most important benefits of OIS’s activity-based model are:
Thus, OIS confirms that FP&A Trends Group Managing Director, Larysa Melnychuk, was prescient when, in a recent email, she observed: “…S&OP is one side of FP&A.” (NOTE: As references, these WSJ and Forbes financial trade articles provide additional confirmation of OIS’s operational and advanced analytics approaches.)
The OIS model is created with a node/link structure and is costed with predictive analytics. It is then solved with prescriptive analytics; in this case, a mix of integer and linear math programming techniques is applied. As such, OIS represents leading state 4 and 5 analytics in London’s FP&A Board’s analytics maturity model. See Figure 1, below.
Figure 1. FP&A Analytics Maturity Model
Each term in this definition will be discussed in turn.
Figure 2. Supply chain
The nodes are facilities and are connected by links. Inside the facilities are activities (aka, processes, production lines) and products.
All four of these structural elements (i.e., links, facilities, activities and products) are capacitated and, where possible, one or more capacity relief alternatives are included in the model. For example, build ahead, overtime, outsourcing, second shift, additional capital equipment, etc.
The relationship between facility, activity/production line and product cost functions are modeled with a cost function tree structure. See Figure 4, below
Figure 4. Cost function tree structure
Second, response functions describe how quantity varies as a function of total sales and marketing fixed and variable costs (i.e., the S of SG&A). See Figure 5 below.
Prescriptive analytics: The prescriptive technique used by OIS is a mixture of integer and linear math programming techniques (MILP). While the specifics of the techniques are beyond the scope of this article, other examples of MILP applications were cited above and include supply chain network design and marketing mix modeling. These have been commercially successful for decades.
There are two reasons why the OIS model cannot be solved by scenario analysis; i.e., by enumerating the possible solutions:
The results of the OIS model include:
As illustrated in Figure 4, all fixed costs associated with variable costs are included in OIS. Thus, all that’s required to create an OB is to add those costs that are completely fixed; e.g., elements of R&D, elements of corporate headquarters, etc. NOTE: These completely fixed costs have no impact on the OIS results.
Given the promise of next generation budgeting, it is important to know how easily the OB’s value proposition for any given firm can very be determined. Specifically, how much profit did last year’s p/l leave on the table?
The first step in creating an OIS is to create a baseline model of last year's p/l results. This baseline model ensures the OIS model has structural integrity, typically modeling last year’s results to within 1-2%.
Then, all that's required are the following three steps to update the baseline model:
1. Response functions added to the model
2. Where possible, all constraints must be relaxed since there is no way of determining what the new forecast’s volumes will be. Further, when there is more than one option (e.g., second shift, outsource, build ahead, over time), they all should be included so the best one can be chosen. Example of the constraints include:
3. Updated baseline model is configured, creating the new, superior income statement. It includes the new forecast and the associated supply chain required to make and fulfill it. The difference between the profit of the new income statement and last year’s actual profit is the profit that was left on the table. It serves as a compelling "proof of concept" of the OIS’s value proposition.
As I walk around various offices or even in social gatherings, I find many conversations about artificial...
We will regularly update you on the latest trends and developments in FP&A. Take the opportunity to have articles written by finance thought leaders delivered directly to your inbox; watch compelling webinars; connect with like-minded professionals; and become a part of our global community.