FSN: Why Forecasting is coming of age

Why Forecasting is coming of age

26th March 2007
Not every journey proceeds according to plan - frequent, timely updates of what lies ahead are needed to avoid the obstacles that lay in wait. The emphasis here is on timeliness, rather than frequency. It would have been useful, for example, if somebody on the Titanic had shouted “Iceberg!” some minutes, rather than seconds, before the fateful collision, says Mark Simpson, senior FSN writer, as he continues his popular series of articles on budgeting planning and forecasting.

Back on dry land, the compilation of revised forecasts – the Forecasting process in a Performance Management context - maintains alertness to threats and opportunities emerging in the business landscape. Executed effectively, Forecasting is arguably the single-most powerful tool for managing performance, since it acts as a management radar system, highlighting events as they unfold and identifying their likely impact. Ideally, unlike the warnings issued on that ‘unsinkable' liner, the forecast provides sufficiently early indications of likely future performance that management has an opportunity to take corrective action where appropriate. In some businesses, particularly those that are capital-intensive, this may require taking a long-term view.

Budgeting was originally viewed as a process which essentially overlapped with Forecasting – but as we have seen in previous articles in this series, Budgeting has evolved into a control process, committing participants to achieving specific targets and hence is focused on what people want to happen. As such, Budgeting is not an entirely reliable predictor of future business performance and as budget processes can take months to complete, their projections are often out-of-date before they are published. In the same way that the invention of the motor car was swiftly followed by the first road accidents, the early Budgeting processes, no doubt, quickly spawned the first budget variances and before long, the need for effective Forecasting – regularly collating an outlook based on what people really believed was going to happen, irrespective of any targets that had been set.

At first, revised forecasts were seen as an adjunct to the Budgeting process, usually a revamp of the budget figures, part way through the financial year. This meant that as the end of the year approached, until the Budget for the next year was prepared, the visible horizon of future business performance might be limited to only a few weeks ahead. Inevitably, in order to avoid the dangers of this myopic outlook, organisations have sought to supplement their annual budget with some form of rolling forecast – one that always covers a specific period – say 12, 18 or even 24 months ahead.

Given the significant role that Forecasting plays in Performance Management armoury, it is no surprise that Finance places a high priority on effective systems to support the process. As the CEO of Clarity Systems, Frank Pizzolato, commented in a previous FSN article, “Once the budget cycle has been optimised, CFO's start to focus on the value of Actual v Budget comparisons and capturing forecasts and re-forecasts.” Richard Buettner of Infor confirmed this view - he told FSN, “Forecasting is playing an increasingly important role - most people start with Budgeting, but want to know that their Performance Management system can cope with Forecasting - so that they know whether they can keep on track.”

However, the nature of Forecasting makes different demands on IT to those posed by Budgeting. For example, the continually moving window on the forecast challenges systems designed to manage data covering a fixed timescale. This factor also presents difficulties to participants in Forecasting - even if it only takes a few weeks to complete an Annual Budget, there is no way to sustain this level of effort every month without bringing the organisation to a grinding halt. It is therefore critical that the Forecasting process is significantly less time consuming than Budgeting. “One key way to save time in Forecasting is to avoid iterations,” Andy Nelmes of Cognos told FSN. “It's important, of course, to monitor the gap between top-down targets and bottom-up forecasts – but don't waste time trying to make the numbers agree. All you are trying to do is collect the latest intelligence from around the business and build an up-to-date picture of how your business is likely to perform in the coming months.”

In addition to eliminating unnecessary cycles, you can make your Forecasting process more efficient by reducing the amount of detail you require participants to provide. Distilling your forecast requirements down to a small subset – say 20 line items - of key measures is the only way you can reasonably expect busy managers to contribute forecasts on a regular and frequent basis. In addition to the more obvious variables, such as revenue, staff costs and travel expenses, it can pay dividends to include ‘leading indicators' in your Forecast. Just as current and (recently) historical views of leading indicators, such as the number of sales enquiries, or approved job vacancies provide valuable insights, so forecasts as to how these measures are likely to behave can provide even earlier warnings of that looming iceberg. The key to effective Forecasting is having the ability to combine historical and current Actuals with the latest predictions from around the business. Ready access to summary data from operational systems such as ERP and ledger, is much more important in Forecasting than in Planning or Budgeting. “When it comes to Forecasting, we see many customers seeking flexibility in modelling both history and forward-looking measures,” says Nelmes, “so they can obtain as precise a picture as possible within tight time constraints.”

Despite the critical role of Forecasting, however, Finance often prioritises it below Budgeting when implementing a Performance Management system. “It's very unusual for an organization to address forecasting from the get-go,” Clarity Systems' Pizzolato told FSN, “– simply because of the change-management involved and the more obvious pains of the budgeting process.” And it's because Forecasting is typically a less well defined, more fluid process that implementing an effective Forecasting system has inherent difficulties. Flexibility and process-efficiency are critical. But perhaps the most important factor to remember when implementing a Forecasting system is that none of the managers involved in the process is likely to have a Crystal Ball. The pace with which organisations evolve and people move between jobs means that many lack the relevant experience to make cast-iron predictions. The fewer figures they need to forecast and the greater the control they have over the measures they are predicting, the better.

The Canadian-born economist, J K Galbraith , once said, “The only function of economic forecasting is to make astrology look respectable.” An effective approach to Performance Management will ensure this sentiment is not applied to business forecasting.

Related FSN articles:

Budgeting: Is there Method in the Madness?
What tools are you planning on?
Are you Planning, Budgeting or Forecasting?

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