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INFLUENCE: Principles to healthy forecasting

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The objective of business forecasting should be to become ‘future ready’. Companies can do this by systematically and rationally assembling information that gives managers forward visibility regarding likely outcomes as well as risks so that they can execute strategy. Greg Bogiages explains

Achieving robust performance over the long term requires businesses to develop healthy forecasting processes. But budgeting and forecasting frequently fall short of improving performance, and often actually contribute to performance woes. Let’s look at why.

Traditional budgeting, a longstanding part of forecasting, simply confuses targets and forecasts. The process is also hamstrung by the financial year-end. Traditional budgeting is incompatible with the use of rolling horizons built around decision-making lead times because its reach stops at the fiscal year-end, to which every activity is linked. In addition, budgeting constrains adaptability.

Most importantly, the traditional budgeting process constrains an organisation’s ability to respond, which undermines the value of forecasting. Appropriate, timeous action cannot be taken because the department involved ‘has not got the budget’ to respond to changing conditions that arise in the marketplace.

OLD INFORMATION CAN BE CRIPPLING

When making decisions to support the achievement of strategic objectives, finance managers cannot rely solely on information about what has happened. Instead, companies also need information about what managers believe might happen – information that is generated through the process of forecasting. However, the bulk of business forecasting practices have ranged from ineffective to downright crippling.

By adhering to the following principles, companies can strengthen their business performance over the long term.

Understand the characteristics of a healthy forecasting process

Business forecasting can improve an organisation’s health by identifying the actions necessary to move from reality to a better future – the achievement of a strategic objective. Although it makes sense to plan, the original plan – traditionally defined as the budget – quickly becomes outdated because of changes in business conditions.

This is why it makes more sense to forecast where performance is going. By doing so, organisations can use that information to identify the corrective actions necessary to have a greater chance of ensuring that future performance achieves strategic objectives.

Recognise the impact of reaction times

If a business had perfect information and could react instantly, forecasting would be unnecessary. Because this is not the case, two questions must be asked: First, how far ahead does the company need to forecast? Second, how frequently should the forecast be conducted? With regard to the forecast horizon, the answer depends on how long it takes to enact a decision. A company’s unique structure, decision-making processes and responsiveness, among other factors, all should influence the type of forecasting that is required.

Choose the right model

Any forecast requires a model, which is a set of assumptions about the way the company’s world works. If the future is like the past, these kinds of models can be effective. However, business frequently changes too fast for highly structured approaches to provide much accuracy. That’s why business forecasting frequently relies on judgement: where the ‘model’ resides in the head of an expert or a group. But human judgement is prone to error and bias. With forecasting models, the objective should be to understand the range of methodologies available, choose appropriately and take steps to mitigate weaknesses.

Take vital signs

Few businesses take steps to monitor their forecasting processes for evidence of bias so that they can quickly eliminate any when they are detected, or they measure the wrong things at the wrong time.

Forecasting errors need to be identified quickly before decisions informed by the forecast have taken effect because the act of forecasting has the power to change future results. Using the usual quarterly forecasts to steer toward an annual target makes it impossible for managers to identify and correct a biased forecast before their company’s performance hits a wall.

Understand variations

One of the only certainties about the future is that any forecast is likely to be incorrect. The debate should therefore not focus on whether or not a projection is correct; rather, discussions should focus on how components of the forecast might turn out to be inaccurate, and how the company might respond. Specifically, it is important to distinguish between risk, which can be defined as variations around a trend, and uncertainty, which is caused by discontinuities.

A risk would, for example, be the likelihood that a forecast of a 5% economic growth turns out to be lower or higher. An uncertainty indicates a much more drastic and, usually, unforeseen outcome: the possibility of credit markets freezing up for even the most financially sound companies during early 2009 is an example of uncertainty. Frequently, the discontinuity is brought about by an external factor such as a change in the market or the actions of a competitor. Uncertainty is important because it can invalidate the forecast.

Therefore we need different strategies for managing uncertainty.

Companies that understand potential uncertainties can take advantage of opportunities they present. It is thus important to develop the capability to spot and diagnose deviations from forecasts quickly, and to create a set of potential responses that help the company to adapt to these variations without unnecessary pain.

Forecasting is neither art nor complex science

The process consists of applying modest amounts of knowledge, in a disciplined and organised fashion. Building a good process involves taking the right steps in the correct and consistent manner. Elements responsible for bias should be designed out of the process, the results of the process continuously monitored, and minor flaws corrected as they become evident.

CHANGE DELIVERS RESULTS

Blaming people for failures when the process is at fault is a sure way of encouraging unhealthy, even dishonest, forecasting practices. By focusing on forecasting improvement, finance managers can help drive a shift in their enterprise’s understanding of business forecasting as well as the changes in perspectives, practices, politics and processes required to replace traditional approaches to budgeting with a rolling forecast – and ultimately achieve hardy performance into the future.

Author: Greg Bogiages CA(SA) is a director at Cortell Intelligent Business Solutions

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