Future imperfect

THE PROBLEM with making predictions is that when you get them wrong you are left looking ill-informed. And if one thing is certain, it is that the forecast number will rarely be exactly achieved.

For a football pundit to be found to be totally wrong when the results come in on a Saturday afternoon it can be a minor embarrassment, and economists seem to have a singular skill at side-stepping the flak when they are forced to revise their forecasts. But for a finance director working at investor-focused companies in an environment where forecasts have to be right all the time, such errors can put the entire business in jeopardy, not to mention the small matter of their careers.

But forecasting is an inexact science. An insurer once pointed out that no matter what action they took when forecasting loss reserves – the amount of capital an insurance company sets aside to protect the balance sheet against future claims – they could be sure the figure would be roughly right and precisely wrong.

Even economists, who probably sit at the zenith of this art, are known to get things woefully wrong. Speaking at a briefing to FDs last year, Mark Berrisford-Smith, HSBC’s senior economist, pointed out that economic forecasts should rarely be taken as stone-written fact, being as they are often revised upwards or downwards after the period to which they apply has long since passed.

So how can FDs predict with any degree of certainty how their business will perform three months, one year or five years down the line, when it is impossible to predict what the economy will be doing next week?

“You have markets that are unstable and they cease to grow. That is going to be the norm going forward. Finance directors need to change their approach to forecasting,” says Brian Hawkes, a former FD and founder of growth management and trajectory forecasting software company Foresite.

Long-term vision

One big change is a move away from traditional fixed-period forecasting. There is no panacea to reporting over a 12-month period, but the process is becoming more inclusive rather than being a top-down review.

“When budgets for the year come down from high, I don’t know of a quicker route for devaluing the business and putting the budget at risk,” says Simon Fowler, managing director at Advanced Business Solutions.

But there are as many pitfalls to taking a bottom-up approach as there are in taking a top-down view. Micro managing the budget creates a tendency to produce a host of detailed forecasts, regular updates and reconciliations from one forecast to another.

But does this really change anything? Neil Forster, chief financial officer and chief operating officer at Ingenious Media, says that without getting buy-in from the rest of the company, such an approach will struggle to succeed.

“In both extremes – whether bottom-up or top-down – you don’t have that engagement and that is the first challenge,” he says. “If you don’t get people engaged with the process and get buy-in and belief, it is already very difficult to hit the forecast before you have even started.”

The route Forster advocates is to try and aspirationally engage the business as to what can be achieved over a period of time, which can vary depending on the business’ time horizon.

Success is all about getting engagement and buy-in from every aspect of the business. To get that buy-in employees will need to be sold on the company’s long-term vision.

“You have got to start with the long term; where we want to be, what sort of company we want to be,” says Forster. “You have to have some form of consensus on that. You have got a prize then that can very clearly be defined over that period. We all need reminding sometimes of what the bigger picture looks like and where we are heading and why.”

Controllable risk

Once a clear direction for the business has been defined, Forster says the next key thing to focus on is the allocation of responsibilities within the business. In order for the business to achieve its long-term target there needs to be a clear breakdown of what needs to be achieved along the way in order to build momentum and who is responsible for what.

What that tries to address is the controllable risks of business forecasting. There is nothing FDs can do to influence the future of the eurozone, inflation, interest rates and the price of oil, but what they can control is the company’s vision, the end goal, staff engagement and the allocation of responsibilities.

“That’s the bit that can often go missing because people set a forecast,” Forster says. “Nothing really happens without it being pushed. Human nature requires people to circle back with people on a regular, if not continual, basis. Our job as managers of the business is to first of all identify as many challenges as possible, but then to work with our teams to make sure that everything is working as smoothly as it possibly can.”

But just because a business has got people engaged in the process does not make forecasting any more accurate. Without that buy-in the business will almost certainly struggle to create accurate forecasts but that in itself is not enough. That is just a solid foundation from which FDs can build.

Rolling, rolling, rolling

The combination of engagement and allocation of responsibilities must be backed up by an effective review process, which, in theory, should minimise the remaining aspect of controllable risk.

According to Paul Simpson, finance director at Kcom, that oversight and circling back needs to happen daily and weekly.

“We do formal forecasting on a quarterly basis but the one thing you know about forecasts is that they will be wrong,” Simpson says. “We look at sales on a rolling forecast basis. We are constantly looking at how long the average order takes and if things are taking longer we ask what that means and what we need to change.”

ABS’s Fowler adds that “the time has gone when you do a budget and monitor it. You have got to look at it all the time. You’ve got to be looking at rolling forecasts.”

The lower the level of responsibility that was originally assigned in the planning process, the easier it is to monitor the rolling performance of employees throughout the value chain of the organisation.

For example, if sales targets are set without really saying where it is coming from by person, by client, by business type and product, any form of follow up is incredible difficult.

“That oversight and that circling back needs to happen daily and weekly and that touches on rolling forecasts,” says Forster.

But all of this is of little consequence without the ability to take corrective action if financial performance starts to slip. If the business is on top of the detail and everybody knows what was supposed to happen, contingency plans can be put in place. That gives an immediate warning sign. You may still hit your forecast, but not necessarily in quite the way that had originally been envisaged.

“You have to know what the deviations will be before they happen,” says Foresight’s Hawkes. “You have to know what caused them and have the ability to redeem them.”

Hawkes points to an example of a Danish group that had about 20% of its turnover exposed to the US dollar. In the third quarter of 2001 the dollar crashed against the kroner and wiped 40% off the company’s top line.

“The company has an average lead conversion time of 18 months and it appeared a complete wipeout for the trading year,” Hawkes says. “By looking at how they could improve performance in the commercial pipeline, they were able to grab back some of that.”

In the event, the group was able to recover 90% of its loss in the fourth quarter. That is where scenario planning – because the worst has a habit of happening – and management information that provides instantaneous information and allows you to take daily, hourly decisions is so important. But you do not have to have state-of-the-art electronically generated information in order to identify what is most important in your business, says Forster.

“Getting information efficiently and effectively is really important, but you can do a lot of this without having immediate information where you press a button and get it out,” he says. “In the absence of something all singing and dancing, there is an enormous amount you can do working with the business to understand where it is up to. You can glean more from talking to people than management information systems.”

Knowledge and insight also has impact of managing communication and expectation of stakeholders. If the business is able to insightfully manage and communicate effectively, that will inspire confidence and belief which is fundamental to continued buy-in, ownership and engagement.

“If stakeholders can see that the process is encouraging behavioural change and delivering improved business performance, then that will inspire a reinforcement of the process you have undertaken,” Forster says. “It’s not fool proof but it takes you a long way down the path.” ?