FSN White Paper
“How To Prosper In A Downturn”
Contents
LESSONS FROM THE CREDIT CRUNCH
Are we measuring the right things?
The need for external market focus
The role of strategy in volatile markets
The need to improve forecast accuracy
THE STRATEGIC RESPONSE TO A DOWNTURN
The need for an agile strategy in the credit crunch
The need for a robust performance management cycle
Organisational alignment is crucial
THE OPERATIONAL RESPONSE TO A DOWNTURN
By all accounts the breadth and depth of the “Credit Crunch” has been more pronounced and pervasive than most respected commentators imagined. Given the scale of the calamity, how is it that the early warning signs were not picked up? Why did Boards of Management, resplendent with elaborate governance, risk management and compliance processes fail to identify the concerns in time? Why have sophisticated performance management and ERP systems failed to furnish management with the information needed to take evasive action?
“Britain is on the verge of a recession. More than a million homeowners could be at risk and repossessions are due to increase by about 50 percent”, says John Moulton, Managing Partner of Alchemy, a UK-based private equity firm.
Complacency has understandably played a part against the backcloth of an economy that that has grown unabated for 18 years. Many managers now in influential positions have never experienced a marked downturn and are not necessarily familiar with the telltale signs of a slowdown in their industry. It should also be remembered that many of the causative factors have been uncontrollable and on a global scale, for example, reckless lending practices in the US, the interdependencies of global capital markets and rampant rises in oil prices spurred on by a range of geo-political considerations, burgeoning growth in developing economies and speculative trade practices.
Although these factors and many other economic drivers remain uncontrollable from a corporate perspective they are definitely on view. So who in your company is surveying the horizon for problems and opportunities, how far forward can you predict earnings and revenue performance, and what can you do in the short and medium term to defray the impact of a downturn?
In other words what lessons can be gleaned from the credit crunch, what strategic and tactical responses are appropriate and how do you imbue an organisation with the competencies, culture and processes not only to ride out the storm but to flourish in such challenging conditions? This white paper seeks to demonstrate practical measures around systems and processes that can transform a downturn in to an opportunity, to exploit competitor weakness and gain market share.
LESSONS FROM THE CREDIT CRUNCH
Are we measuring the right things?
Well before the Credit Crunch gained a hold, doubts were expressed about whether companies were measuring the right things in order to assess their performance and prospects for success. In particular, a 2007 survey issued by the global CEO of Deloitte1 charged that many board members and senior executives are still in the dark about the overall health of their organisations because they lack high-quality non-financial information.
The survey also revealed a critical disconnect between rhetoric and reality in the boardrooms of some of the world's leading companies with many acknowledging the crucial nature of non-financial indicators but failing to act. The majority of companies said they are under increasing pressure to measure these indicators, but the quality of non-financial performance information they receive is inadequate to meet their needs. But why are non-financial indicators so important?
For most companies the focus of financial measurement is deeply rooted in traditional accounting techniques and it only in recent years that preparers and readers of financial statements have begun to question the value of accounts prepared using a technique developed for businesses more than five centuries ago. At the heart of the debate is the realisation that strict financial measures merely provide information about past performance and do not necessarily provide a sound basis for extrapolating performance into the future. Traditional financial measures such as “profit”, “cash generated from operations”, and “revenues booked” so called, lagging indicators, provide little insight into future prospects and are of little value in a downturn.
In the search for more reliable harbingers of enterprise performance, business managers are turning to so called non-financial indicators or KPIs (Key Performance Indicators) that provide better insights into the factors which drive business success. Non-financial indicators are often tightly correlated with future financial performance. For example, measures of customer satisfaction are often linked with a propensity to buy goods and services in the future. Similarly, measures around innovation, such as the percentage of sales derived from new products inform a company’s medium to longer term prospects for success. Likewise, measures of employee commitment gives insights into future workforce attrition and, by implication, the ability to earn revenues in the future.
The notion that non-financial measures are important in assessing company health is not new. Since the early nineties various methodologies such as Ernst & Young’s “Measures that Matter”, Kaplan and Norton’s Balanced Scorecard (BSC) and Stewart & Stern’s Market Value Added (MVA) and Economic Value Added have enjoyed faddish periods of success. All of the techniques have contributed to the thinking on the subject but it is only now that the importance of non-financial metrics is gaining traction in the Boardroom.
What the credit crunch illustrates is the crucial importance of promoting a more balanced approach to performance, with equal attention being focused on financial and non-financial measures, lagging and leading indicators.
“Directors of major UK banks seemed to have no understanding of the products they were trading or the risks they were facing”, says John Moulton, in a 2007 “Despatches” documentary about the Credit Crunch and the Northern Rock crisis.
The need for external market focus
One key to survival in any environment but especially a downturn is having a clear view of external influences impacting the business. But, according to Gregory P. Hackett, Goodyear Executive Professor, Kent State University, companies today have too much of what the father of modern management, Alfred P. Sloan, would consider “good management.” Large businesses are run by professional managers who excel at creating and executing a business plan and measuring vast numbers of ‘key’ performance indicators but the focus is on “controlling the controllable” with insufficient attention being directed to what is going on around them.
Companies need to look outside the organisation and recapture intuition as a factor in decision-making. Hackett’s research, conducted in 2007 indicates that companies are failing at an unprecedented rate. The founder of the Hackett group analysed the performance of the 1,000 largest U.S. companies over the past 40 years, and found that about 80 percent of companies are stagnating or are in decline. Only 21 percent are growing. Furthermore, companies are failing at a rate three times faster than 30 years ago.
Hackett concludes that companies stagnate, decline or die because they minimize or miss profound changes, for example, the impact of Amazon on book publishers or the effect of digital photography on producers of photographic film.
Perhaps the impact of the credit crunch could have been better understood and managed if companies had been looking at key economic indicators, such as interest rates and growth in lending, rather than focusing exclusively on internal benchmarks. Unfortunately, for the majority of companies there is no single department or function that has over-arching responsibility for observing external risk factors and to assess their implications on the health of the company. Without such processes there is little reason to be confident that companies will not succumb to a downturn.
The role of strategy in volatile markets
Responding to change in volatile markets is extremely challenging and when revenues are under pressure it is tempting to make sweeping changes and cuts across the board. Some would argue that strategy has little merit when the market is changing so rapidly – indeed many companies are precluded from taking appropriate decisions because their strategies and plans simply cannot be revised and refreshed in the shortened timescales that a downturn demands.
However, it is at times of heightened pressure that it is particularly important that actions are aligned with strategy so that short term decision making and the temporary allocation of resources is not allowed to damage long prospects when normal market conditions eventually return. The key to responding confidently to a challenging economic environment is to ensure that strategy is inextricably linked with operational plans and that these are communicated effectively across the organisation so that management at all levels of the reporting hierarchy can make decisions safe in the knowledge that they are strategically aligned.
The need to improve forecast accuracy
When it comes to forecasting accuracy, commerce generally does not cover itself with glory. All recent surveys point in the same direction, namely that the majority of companies do not get anywhere near the mark. According to one study2, over the last three years only 1 percent of firms have hit forecast exactly and just 22 percent have come within five percent either way. On average, forecasts have been out by 13 percent (calculated as the mean absolute deviation from actual results).
A separate survey3 says that two out of every three companies are unable to accurately forecast earnings for the next quarter, missing the mark by anywhere between 6 percent and over 30 percent. It appears that companies do only slightly better when forecasting sales according to the same study. More than 50 percent of companies are unable to accurately forecast sales for the next quarter (accurate being defined as being within plus or minus 5 percent of actual results).
One reason that that forecasts fail to live up to expectation is that current business practice fails to formally recognise risk and probability. This is in marked contrast to other fields of scientific endeavour such as meteorology, epidemiology and quantum physics where future projections are always expressed in terms of probability. For example, a weather forecast may say that it will rain with a “60 percent chance of precipitation”. Contrast this with the typical business approach that loosely couches an earnings forecast in terms of ‘upside’ and ‘downside’ risks without any quantification of probability. Developing forecasts with a more rigorous approach, for example using Monte Carlo simulation to assess a wide range of outcomes rather than the usual spreadsheet based ‘best’ and ‘worst’ case scenarios is going to be critical to improving forecast accuracy.
Lack of forecasting precision in a downturn is a worry. Accurate forecasts provide an essential window on future trading performance, allowing management to refine strategies, change direction and re-allocate resources as needed. Without robust forecasts an organisation is effectively rudderless and unable to proactively manage change. The downturn will severely test those companies for whom forecasting is a challenge.
THE STRATEGIC RESPONSE A DOWNTURN
The need for an agile strategy in the credit crunch
A strategy is by definition the starting point for corporate behaviour. It expresses an organisation's ambitions, sets out its chosen direction and describes the principal initiatives and projects necessary to achieve its mission. It is overwhelmingly important in setting the tone of an organisation and its prospects for success.
The inherent agility of a strategy is important since strategy development can no longer be viewed as a standalone activity. In the uncertain climate of a downturn, the strategy has to be accessible and constantly fine tuned in response to market conditions. In other words the strategy has to be an inextricable part of a broader performance management regime which constantly tests and refines the strategy as new information comes to light.
The need for a robust performance management cycle
The performance management cycle depicted in the diagram above is a continuous process made up of a series of iterative steps. The strategy establishes the goals and performance measures for the organisation which are built into business plans, budgets and forecasts which are monitored continuously against actuals, analysed and reported upon. The results of these analyses are then used to inform and refine the strategy which is adjusted as appropriate before the whole performance cycle starts again – which is why performance management is sometimes referred to as a closed loop process.
In this process, strategy is inextricably linked to the performance management cycle and forms a key part of continuous performance improvement. Actual results continuously inform the strategy allowing management to alter course as circumstances dictate. It is this agility that is so vital in a downturn.
Organisational alignment is crucial
Strategy development is a curious mixture of science and art, fact and insight, knowledge, experience and creativity. In addition, in today's complex multinationals it draws on the skills of management from across the enterprise and in all functional areas. After all, strategy has implications for the development of human capital, information technology, product development and financial management to name a few, as well as the use of all other assets and resources owned by a company. This in turn means that if strategy is to be delivered successfully by an organisation it must be clearly articulated and communicated throughout the business. In other words, the strategy must be widely understood at all management levels so that operational plans and day-to-day activities are aligned with corporate goals and objectives.
Yet organisational alignment remains one of the most neglected areas of management practice. For example, research has shown that 85% of executive teams spend less than 1 hour per month discussing strategy and only 5% of the workforce understands strategy.
In recent years information systems have played an increasingly important role in enabling 'downstream' strategy activities, such as budgeting and forecasting and communicating the strategic message utilising scorecarding and dashboard techniques to percolate key objectives and measures through the organisation. The advent of web-based systems has allowed organisations to implement these applications very cost effectively. In parallel, centralised planning tools have allowed organisations to model different scenarios once the strategy has been set but often this activity has been conducted in a vacuum. The plans have neither been coupled with the strategy in one direction nor linked with operational budgets and plans in the other. It seems that systems have not allowed management to close the so-called, 'strategy gap' i.e. the disconnect in communications between strategy development and operational plans.
The key challenge when facing challenging business conditions is integrating the performance management regime, so that information flows fluidly from one financial process to another and that managers have access to consistent and accurate information on tap.
THE OPERATIONAL RESPONSE TO THE CREDIT CRUNCH
There are also more pragmatic steps that can be considered in a downturn in addition to the more lofty strategic approaches described above. These include extracting more value from existing systems, and using applications more comprehensively to increase productivity, enhance competitiveness and improve profitability.
In common with DVD recorders most business applications are used for only a fraction of their capability. When business conditions are buoyant there is less incentive to look inwardly but in more challenging times a review may reveal some useful short-term gains. Reviewing management reporting is one of the most fruitful areas to commence the search. For example, can you answer, “How many customers account for 50 percent of profit?” Similarly, “How many of products and services account for 50 percent of profit?” Which customers and products are profitable?
In a downturn attention needs to be focussed on these vital management reports as well as cash flow forecasts, cash generation from operations, working capital management, overheads and bank covenants. If current systems cannot provide this information on demand then remedying this should be a high priority.
Productivity comes from a wide range of sources but integrated business systems with a consistent look and feel come high on the list. Microsoft Outlook style user interfaces in business systems promote a familiar look and feel, reduce training effort and assist users to move from one application area to another. Integration allows users to do more work from one area and helps to break down functional barriers that create inefficiencies. In recent years the tighter integration of Microsoft Office with mainstream accounting products allows users to take advantage of a wide range of familiar Office applications, such as Excel, Word and Email to reduce clerical effort and delays in for example, sending invoices, generating debt chasing letters and analysing profitability.
Workflow management and specialised document management systems are also transforming technologies that allow businesses to grow without necessarily adding to headcount. Digitally captured supplier invoices can have a profound effect on end user productivity and automating the ‘purchase to pay’ cycle is demonstrably one of the quickest and easiest ways of delivering a payback from a modest system investment.
A wide range of systems-inspired measures can increase competitiveness such as the ability to furnish a sales quote by email automatically out of a business system. High up on the list should be an integrated CRM (Customer Relationship Management) system that allows prospect and customer data to be merged and which enables a more proactive approach to managing the sales quote and sales order pipeline. Tight integration between CRM and Sales Order Processing brings a range of productivity benefits as well as financial benefits derived from accelerating the ‘’Quote to Cash” cycle.
Activity Based Costing (ABC) and Activity Based Management (ABM) systems have been available for around 15 years and yet, very few organisations in the UK (probably only between 10 and 12%) have embraced these techniques. Instead the majority of businesses rely upon traditional line item posting and tracking of costs, usually at a cost centre level in their accounting and budgetary processes. Whilst this allows organisations to understand the nature of costs being incurred and where organisationally they lie, it does not tell them how or why those costs are consumed.
Even though indirect costs can account for upwards of 70 or 80 percent of total costs most organisations persist in using standard and absorption costing techniques for their product or service costing. Whilst being simple to understand, apply and operate, this method fails to apportion or allocate business costs on a realistic basis often resulting in a very misleading view of profitability. It is not uncommon for companies to find that products and customers previously regarded as profitable using absorption techniques are in fact loss making when taking a more realistic activity based approach.
In a downturn it is vital to have a realistic view of, for example, product, channel and service profitability and ABC/M systems are the key to delivering a more rigorous approach.
The credit crunch has exposed the need to have a robust approach to cultural change which threads it way through all of the systems and process issues identified earlier in this white paper. Embracing non-financial measures more comprehensively requires a shift in mind-set from comfortable financial ratios and KPIs to less familiar measures around employee and customer satisfaction or innovation. Unfortunately, whilst senior directors acknowledge the importance of non-financial KPIs they are still clinging to financial measures and show little willingness to change.
One of the challenges of non-financial metrics is that responsibility for gathering, monitoring and reporting is not regarded as a top priority by Boards of Management. Whilst most acknowledge the crucial importance of non-financials in driving business success this is not matched by reporting practices. In the main, responsibility for managing non-financial information is usually delegated to senior managers. In sharp contrast financial metrics usually enjoy full Board sponsorship.
The same lack of Board commitment is reflected in the way that businesses typically manage the roll out of performance management projects. Another recent survey4 reports that only 47 percent of performance management projects (designed to capture and report key performance measures) attract Board level or “C” level sponsorship. This adds weight to the view that there are considerable cultural obstacles to the widespread adoption of non-financial KPIs and that there is a significant gap between what Boards say is important and what they do in practice.
Encouraging greater forecasting accuracy also requires a step-change in culture. Few organisations measure and monitor forecast accuracy yet setting benchmarks is a vital tool in the context of continuous process improvement. Furthermore corporate culture generally celebrates and remunerates over-achievement of budget rather than forecast accuracy.
“In the lead up to the credit crisis Bankers were rewarded for making reckless lending decisions. Bankers knew what they were doing but the more money they lent the bigger the bonuses they were awarded. No wonder nobody wanted to stop the party”, says John Moulton.
An honest appraisal of market conditions (positive and negative) affecting performance is absolutely critical if forecasting is to become reliable. The wide spread practice of “sandbagging” which focuses on setting soft targets which are easily exceeded simply promotes an inefficient allocation of resources. Recent research backs up this view and suggests that the best performing organisations (i.e. with actual results within 5 percent of forecast) incentivise their managers for forecast accuracy.
Perhaps the biggest single cultural challenge relates to how an organisation communicates its strategy and imbues its workforce with the knowledge it needs to confidently take decisions knowing they are strategy compliant? How do you transfer the strategy from the Board table to each employee and embed it in the organisation?
Technology is not a ‘magic bullet’ that will instantly transform an organisation and remedy all cultural impediments to change. There is no substitute for traditional forms of communication such as briefings, conferences, webcasts, seminars, workshops and other forms of meeting (both formal and informal) in order to communicate the strategy and make it relevant for a particular part of the organisation. Employees and their managers need to know how the strategy affects them, what they might be doing differently and how they will be measured and rewarded. Failure to recognise and embrace the cultural aspects of performance management is courting disaster – especially in the tough conditions of the downturn.
In a strong economy even weak companies can survive, buoyed along by exuberant demand and confident consumers, but in a downturn attention needs to be directed towards strong management and enabling technologies. When under pressure it is tempting to focus inwardly yet research shows this is precisely where companies go wrong. In a downturn, management should be scanning the horizon for opportunities and risks, supported by forecasting applications that allow them to predict performance accurately, alter course as necessary and stay on track.
The response to a downturn can be viewed at two levels, namely; a strategic response based on timely insights gained from an agile performance management platform and an operational response grounded in more effective use of existing systems coupled with systems enhancements and additions which increase productivity, competitiveness and profitability.
As always, business and process change cannot take place in a vacuum. More testing conditions require a shift in mindset as well as systems and processes. Senior management engagement is vital to imbuing an organisation with the skills and confidence it needs to respond to heightened risks and opportunities.
Experience shows that those organisations that are measuring the right things, communicating their strategy to their employees and honing their processes are well placed to fend off the challenges of a downturn or even flourish.
Note1 Deloitte Survey, “In the Dark II: What many boards and executives still don't know about the health of their businesses,” developed in conjunction with the Economist Intelligence Unit (2007)
Note 2 Report: Forecasting with Confidence; Economist Intelligence Unit/KPMG 2007
Note 3 Hackett’s 2008 Finance Book of Numbers™ research 2008; The Hackett Group
Note 4 Survey: The Truth about Performance Management SAS 2007
About FSN
FSN Publishing Limited is an independent research, news and publishing organisation catering for the needs of the finance function. The report is written by Gary Simon, Group Publisher of FSN and Managing Editor of FSN Newswire. He is a graduate of London University, a Chartered Accountant and a Fellow of the British Computer Society with more than 23 years experience of implementing management and financial reporting systems. Formerly a partner in Deloitte for more than 16 years, he has led some of the most complex information management assignments for global enterprises in the private and public sector.
Whilst every attempt has been made to ensure that the information in this document is accurate and complete some typographical errors or technical inaccuracies may exist. This report is of a general nature and not intended to be specific to a particular set of circumstances. FSN Publishing Limited and the author do not accept responsibility for any kind of loss resulting from the use of information contained in this document.
