In today’s increasingly turbulent markets, forecasts of future earnings have become less predictable. Customers are more fickle, competitors more aggressive and deals disappear overnight as clients cancel orders and postpone projects. If the earning forecasts are adrift, the analyst community will be ruthless in marking down the share price, destroying shareholder value at a stroke.
Speeding up monthly reporting for an even faster close is unlikely to help either. What financial directors need is better visibility into their future performance. That means having access to the latest information on what demands the business faces next month, next quarter and next year and what resources will be needed to satisfy those demands.
Currently, the main tool used for setting future performance goals, co-ordinating departmental resources and controlling spending is the budgeting process. The traditional budget is formulated, negotiated and agreed annually with extensive discussion to ensure alignment across departments. Typically, it is then fixed for the coming year. The shortcomings of this process can be briefly summarised: the process is too time consuming and costly; it is often divisive, creating barriers between departments; the resulting budgets are rarely strategically focused and the framework is rigid and restricts organisational responsiveness and flexibility. As the year progresses, it is rapidly obsolete.
But few organisations are reluctant to move away from the annual budgeting cycle completely. Most finance managers are now seeking incremental improvements to the process – to make it more flexible and responsive – by implementing more frequent or rolling re-forecasts. There is an obvious benefit in re-forecasting more frequently. It provides management with the opportunity to review future income and expenditure and realign resources across the business.
But delivering reliable re-forecasts more frequently is not without problems.
With traditional planning and budgeting applications, line managers spend much time and effort modelling the non-financial data that drives their line item costs off-line, typically in spreadsheets. Each time finance asks the organisation to submit a re-forecast, line managers refer back to these off-line models and update driver data to project their cost and revenue line items.
As well as adding significant time to the re-forecasting cycle, this offline modelling creates other problems for the organisation. Each model contains the underlying assumptions that drive the cost centre forecasts.
This intelligence is largely invisible to finance and the rest of the organisation. The result is that managers plan and forecast in isolation, disconnected from events in other cost centres that could impact upon their assumptions. Without a set of commonly agreed logic, each forecast becomes an opinion rather than a fact-based estimate of future performance.
Finance managers must then check, cross-reference and consolidate the cost centre forecasts to ensure all departments can deliver, before beginning the process of internal negotiation – a process that adds more time to the cycle. In order to manage and anticipate the future, organisations must become more forward-looking instead of backward-looking. Forward-looking companies understand and accept that it is the non-financial, operational metrics that ultimately drive the financial performance of the organisation. Instead of attempting to manage using financial measures, they focus on understanding the ’cause and effect’ relationships between business drivers and their impact on business performance over time.
As we have seen, this vital non-financial information is hidden in individual departments and needs to be brought into a company-wide picture. By integrating this information within the central performance management system, these drivers become visible to all levels of the organisation. Now, the organisation can create budgets and re-forecasts that are assumption rather than opinion-based and managers can simply update key metrics to submit a re-forecast. This has significant benefits.
Line managers can rapidly generate a re-forecast simply by updating the non-financial driver data. It reduces the time and effort required for finance to negotiate with line managers and understand their business logic prior to signing off a budget or re-forecast. It improves the accuracy of line manager forecasts by removing departmental barriers.
Integrating the operational perspective also adds a third dimension to finance’s ability to manage variances. Traditionally variance analysis is confined to examining ‘what?’ (i.e. which line item) and ‘Who?’ (i.e. which department) is out of line with original budget expectations.
The ‘why?’ is often the focus for the remaining time after month-end when financial analysts interrogate unsuspecting line managers to get explanations of negative variances. This activity in itself takes up a considerable amount of finance time, but with an operational perspective the reasons for both positive and negative variances are clear.
Once the organisation accepts that managers do not operate in isolation, it becomes logical that they should not budget or re-forecast in isolation.
Their actions impact other managers and departments on a daily basis, but unless each one is aware of the other, the resources in the individual cost centres will not be aligned.
To connect cost centres this way, the organisation must model the relationships between non-financial metrics and line items, not just within each individual cost centre, but between cost centres. Line managers can then see the impact of their forecasts on the rest of the organisation as well as their own cost centre. Likewise, line managers can be alerted when that changes in other cost centre forecasts impact their own resource requirements.
This encourages collaboration by forcing managers to recognise the interdependencies and to work to optimise their joint performance.
There are two benefits for the organisation: managers are no longer isolated from forecasts and assumptions in other cost centres that will impact their own performance and so can align their resources accordingly. Finance can simulate the impact of changing business assumptions and create new re-forecasts in real time with little manual intervention.
By reconnecting the operational and financial views of an organisation, the process of re-forecasting earnings and realigning cost centre targets can become part of everyday financial management. It is no longer a laborious process of manual data collection, reconciliation and co-ordination, but a living and dynamic process that reflects the latest intelligence from across the business.
- Richard Barrett is vice president marketing international of ALG Software.
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