Forecasting: Come rain or shine

Managing City expectations is never easy. Get it wrong, and it can have a significant impact on a company’s cost of capital and its ability to raise money cost effectively. The result can be a depleted share price that not only reflects the market’s lack of confidence, but may affect its ability to issue paper for acquisitions.

Historically, the focus has tended to be on how accurately companies report historic information. But the emphasis is shifting to how companies forecast what will happen in the future, with the mandatory operating and financial review of all UK-quoted companies likely to be the first step in this direction.

Budgeting and performance management have been on the minds of many organisations recently, due to the commercial realties of the market forcing companies to be more efficient in the way that they manage their professional affairs.

Some companies have abolished budgets, while many more have introduced scorecards and key performance indicators in an attempt to create business performance management (BPM) frameworks and ensure a realistic means of providing accurate forecasting.

The problem with the annual planning cycle is that it invariably sets a floor for expenditure and a ceiling on performance. In effect this drives a business down a predetermined path, with no flexibility to switch resource allocation until the next year.

Some companies confuse the role of a budget with that of a forecast, which can have serious consequences. To create a budget is to set the aspired or targeted outturn, together with the planned events, activities and interventions required.

To create a forecast is to articulate an objective and realistic assessment of the organisation’s likely outturn on the basis of actual trends, current assumptions, and plans and budgets, in the absence of additional management interventions.

A company’s ability to forecast accurately is a critical component of its overall financial control and BPM framework. Indeed, it is now re-emerging as an essential part of financial management and control by CEOs and CFOs, particularly those who have suffered profit warnings or ‘surprise’ results. By improving the quality and the accuracy of their forecasts, organisations can more easily see what interventions are required.

Regulatory regimes in the US and UK are putting companies under pressure to improve the speed, quality and accuracy of their forecasting – but there are also sound business drivers. The ability to forecast accurately brings with it significant financial benefits, as it enables operations to run more smoothly and profitably, as well as allowing better communication with financial markets.

But a quick look at the results of UK plc suggests that few have got the process down to a fine art. Parson Consulting recently researched the performance of FTSE100 companies against analyst consensus earnings per share (EPS) forecasts. Nearly half missed consensus EPS forecasts by more than 10%. Even more worryingly, 38% underperformed by more than 10%, while 11% overperformed by the same margin.

In most cases, the problem is that UK companies have difficulty developing adequate forecasting capabilities and they do not fail to communicate their expectations.

In our view, it is essential to build this capability in order to integrate forecasting into the company’s BPM framework. Accurate forecasting then becomes a fundamental part of a company’s management processes, enabling it to identify key value and cost drivers, develop appropriate performance measures, and plan and budget its performance effectively by articulating its aspirations in terms of key performance measures.

If management is to make timely and effective interventions, it must have sight of where its business is heading. If business units submit ‘aspirational’ forecasts, management will not have an accurate line of sight until, perhaps, it is too late.

By the same token, management should not encourage business units to treat forecasts as budgets or order business units to ‘increase’ their forecasts without the assurance that the new predictions will be achieved.

The forecast a company should release externally should be the aggregate of the objective and accurate internal forecasts, plus the probable incremental value of the interventions management will now take.

Discussions about reforming forecasting and planning processes often revolve around reducing the time spent on such activities. Accurate forecasting will rarely result from the implementation of a new system, however. A more successful approach will focus first on changing people’s behaviours and making the process itself more effective.

Once forecasting has been made more effective, the next step is to review its efficiency by equipping finance with enabling technology. Automating the forecasting process through the use of a dedicated forecasting application will release the finance function from its scorekeeper role and enable finance managers to become evaluators and challengers, helping the business to optimise performance.

CEOs and CFOs are increasingly being held accountable by investors for the accuracy of their forecasts. Identifying and addressing the root causes of inaccuracy results in more than just better forecasts; it cuts to the core of how well companies are run.

The key is to invest in improving the effectiveness of forecasting first before addressing efficiency. This will not only help organisations increase their forecast accuracy, but will help finance fulfil its role as a proactive business partner.

BEST PRACTICE

• Forecasting is not an afterthought to be tacked on to the end of the period-end reporting process, but is a critical process in its own right
• It should be carried out frequently, at least on a monthly basis
• Forecasts should ‘roll’ by articulating an objective and realistic assessment of performance up to 15-18 months ahead
• Start with the main business drivers, which in most businesses revolve around sales
• Forecasts should be articulated in terms of the company’s complete BPM framework, including both leading indicators and lagging financials
• Accuracy must be measured and should become one of the key indicators for which business unit general managers are held accountable
• The mid-year 18-month forecast should form the basis for building the following year’s budget. It shows the gap between the current trend and the aspiration of management for next year’s budget, and therefore gives management forewarning of the level of intervention needed during the budget process to bridge the gap.

Tony Vadasz is practice director in Parson Consulting’s European region.