30 January 2023
The conventional approaches for creating forecasts have been rendered obsolete by the combined effects of COVID-19, global supply chain disruptions, the war in Ukraine, and skyrocketing inflation.
Forecasting financial success is a difficult task especially with the past several years having seen extraordinary risk and volatility. The conventional approaches for creating forecasts have been rendered obsolete by the combined effects of COVID-19, global supply chain disruptions, the war in Ukraine, and skyrocketing inflation. At a time when understanding potential future performance has never been more crucial, techniques including trend analysis, variation to budget, and rolling projections have been found to be insufficient.
The most valuable forward-looking duty for a management accountant is essentially creating reliable predictions of future financial performance. Forecasts are used by chief financial officers (CFOs) to create plans, select the best resource allocations, inform stakeholders of expectations, and define internal performance and pay goals. It is disheartening that forecast quality and accuracy have not increased proportionately despite recent significant investments in technology, data, and analytics.
There are numerous justifications or even excuses offered for the difficulty to produce precise forecasts. However it is an obvious fact that that the future is simply unknown. Explanations include unusual market conditions, quicker or slower adjustments in important indicators, or shifts in consumer behavior. All of them make sense, but they are not the only causes of forecast errors. Other elements that may reduce forecast accuracy are:
- Forecasting to budget: Organizations spend a lot of time creating extremely precise budgets, which are frequently used as the foundation for determining compensation structures. Budget deviations are recorded and examined each period. Managers are under stress to make necessary changes so that the organization can later on in the year “come back on budget.” This can result in a forecast model that artificially manipulates statistics to produce a conclusion that closes any budgetary variation, regardless of whether such changes are feasible or realistic.
- Failure to comprehend the forecast’s goal: For a prediction to be meaningful, it must be an unbiased assessment of how the organization anticipates the future will pan out, based on the greatest knowledge at the moment. Forecasts, unfortunately, frequently reflect business leaders’ idealized vision of the future rather than what they truly believe it will look like. Plans and budgets may be aspirational, but for forecasts to be believed, they must be logical.
- Corporate Bias: Often, accurate projections are made utilizing the best data and analysis available, only for management to make a few “top line” tweaks that are not based on data or analysis but rather serve to depict the desired conclusion.
- Ignoring risk and uncertainty: Since it is impossible to predict the future with accuracy, it is useless to create a forecast that offers a single perspective on it. However, a disproportionate number of projections are based on a single set of assumptions that exclude alternative hypotheses and well-known risk factors.
Looking ahead to 2023, it is wise to consider how forecasting might be strengthened to produce results that are appropriate for the situation. Following that, the following are some essential steps in a successful budgeting and forecasting process:
Assessing Current Year-to-Date Performance
Companies need to comprehend the present in order to precisely predict the future. Business leaders need to assess their say:do ratio, operational strategies, and KPIs and metrics for the first half of the year to determine whether they are being reached. Were the objectives over or under-achieved? Businesses will require this context to properly inform their upcoming financial projections and goals. Recall that the forecast and budget are merely expressions of the company’s operational and strategic intentions. The budget will be guided by determining the who, what, where, when, and why of the business activities.
Re-examining The Business’ Long-Range Plan
Long-term planning is a crucial tool for outlining not only the future vision, but also the associated goals and plans to achieve those goals. As a result, businesses should work with their CFO and CEO to utilize their long-range plan (LRP), also known as a target operating model (TOM), in order to give direction to the rest of the executive team. Verify that the business plan has not fundamentally changed and that this high-level guidance accurately depicts the company’s growth rates and matching investment levels. The long-range plan’s implementers must comprehend not only the aims, outlooks, and financial implications it includes, but also how everything will be executed.
Explicitly addressing risk and uncertainty
To convey the effect of uncertainty and variability on important variables, business leaders should look into using sensitivity analysis and scenario planning. Four important variables (inflation in raw material prices, exchange rates, shipping costs, and rival pricing) that might significantly affect future financial performance should be developed into projections so that companies can determine through time that one of these four variables is the primary cause of roughly 90% of forecast variations. The range of potential future financial outcomes under various conditions can be understood by the company by producing alternative forecast views under various assumptions for these four factors.
Communicating confidence levels
Not all forecasting data is created equal. Some figures, like costs that are quantified in long-term contracts, can be predicted with a high degree of reliability. Others are exceedingly challenging to forecast accurately, and they are often regrettably highly substantial things like sales. Many organizations share their degree of confidence for each forecasting component so management is aware of potential areas of uncertainty. There are several ways to accomplish this: Use ranges, with a wider range denoting lesser confidence and a narrower range denoting greater confidence, to express confidence, for example, green for high and red for low.
Planning For Multiple Scenarios
Instead of trying to get things perfect, “scenario planning” should be the main focus. Business executives must identify and challenge the underlying presumptions underlying their business model, market, regulatory framework, and consumer behavior. To create the organization’s response to the shifting conditions, pose hypothetical questions. Be very cautious when considering dogma or anecdote to be the final authority, and be sure to inquire even about what are actually accepted as industry best practices. Create a healthy mistrust of the fundamentals since they might be moving under our feet.
The crucial elements for preserving, growing, and accelerating the health and well-being of the company are what are defined, assessed, and developed in the plans based on the scenarios. Therefore, businesses should begin by considering the value chain for their organization and the crucial dependencies across all aspects of the business, including external relationships, customers, suppliers, regulatory agencies, and more. The value chain is defined as all the activities required to develop a product or service. Business leaders might want to consider a wide range of factors that go into the scenario that depicts a circumstance.
While some scenario planning variables will take macroeconomics into account, others will be regional and sector-specific. Include both long-term viewpoints for the following three to five years as well as both short-term perspectives for the upcoming year. The best case scenario planning should be coordinated with a company’s capital allocation strategy. Examining the balance sheet and the profit and loss statement should be done while forecasting. Capital allocation strategies will aid businesses in prospering after a period of turbulence in addition to managing liquidity.