Any FD or CFO will tell you that a host of factors can affect financial forecasts, sometimes changing the whole strategy or direction of a company. Despite every effort to predict a company’s financial future accurately, the fact is that everyone occasionally gets things wrong.
Just as the outcome of sports matches or elections depend on constantly changing circumstances, financial forecasts too are often based on assumptions, which for any number of reasons sometime do not go to plan.
For a growing startup, the speed of change in the business often makes forecasting even more complicated. Equally if you are forecasting variables for the first time, you’re unlikely to have strong points of reference to challenge or test your own assumptions. So how can finance teams of all sizes improve their chances of accuracy?
The golden rule comes down to this: control what you can and learn from what you can’t.
If you follow this formula, you’re sure to see the accuracy of your forecasts improve. Here’s how:u2028
Separate the two camps
What differentiates best-in-class companies from those that struggle with accuracy is how they root out (and learn from) forecasting errors. While finance teams can control and eliminate certain factors, others are simply uncontrollable. In those cases, teams should concentrate on learning from their mistakes.
u2028Controllable drivers can include anything from process errors, miscalculations or managerial biases that could make forecasts too conservative or optimistic. On the other side, uncontrollable factors can range from natural disasters to interest rate rises to a supplier suddenly raising his prices.
Finance teams that can separate these drivers will be in a much stronger position to increase accuracy over time and drive accountability.
Engage the business
The best (and simplest) way to identify these variables is often to ask the front line business leaders themselves.
One company we worked with interviewed c-suite executives to ask about the operational drivers that affect business performance. After identifying the most common causes of variance, the company published the findings in a summary designed to help inform and improve future iterations.
It’s a bit like isolating the biggest variables that affect sports results – whether penalties, injuries or red cards – and learning from experience about how to deal with them.
Discourage forecast “gaming”
Personal bias can play a huge role in financial forecasts. Poorly structured incentive schemes often lead managers to game forecasts in a way that artificially boost the payouts they receive.
This “gaming” of budgets (and the forecasts that inform them) can be hugely damaging. As a small finance team, you may be less able to have the time or resources to challenge business leaders on their assumptions or identify where these assumptions may be flawed.
Some companies tackle this by holding stakeholders directly accountable for their forecasts and encouraging better performance. Stanley Black & Decker, for example, evaluates forecasting success according to five metrics that account for both quantitative and qualitative performance.
Another option is linking compensation targets to overall profits, rather than forecast accuracy. One of the US’s largest airlines adopted this approach, which incentivises managers to provide neutral, forward-looking predictions.
Learn from the past
Being proactive about learning from past mistakes is also critical. Too many finance teams churn out reports and variance analyses each forecasting cycle without incorporating learnings from past reports.
The best companies will speak with business managers to identify and share the top variance drivers with forecasting stakeholders in an actual scorecard. This in turn is used to inform future forecast iterations.
The best thing any finance team can do is to implement both after-the-fact learning processes and pre-emptive procedures that limit inaccuracy as much as possible.
You need to accept that perfection is impossible: there is, after all, no crystal ball. After that, it will much be easier for your team to concentrate on areas that improve future forecasts and inform better decisions going forward.
Paul Dennis is a senior director in CEB‘s finance practice.
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