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FINANCIAL MODELLING AND FORECASTING

FEATURES

MASTERING
FORECASTS

Accurate results forecasting is the leading internal concern for those heading up
finance functions. Below Steve Morlidge and Steve Player explain how to improve
the quality of your business forecasting.

Steve Morlidge and Steve Player are the authors of the


recently published book Future Ready: How to Master
Business Forecasting, John Wiley and Sons ISBN 978-0470-74705-6
Steve Morlidge works as an independent
consultant. Previously of Unilever, he is
also a former chairman of the European
Beyond Budgeting Round Table.
steve.morlidge@satoripartners.co.uk
Steve Player is managing director of The
Player Group. He is also programme
director for the Beyond Budgeting Round
Table in North America.
steve@theplayergroup.com

The poor quality of business forecasting is a major


headache for managers all over the world. The scale
and nature of the problem is highlighted in the
quarterly analysis by Ernst & Young of profit warnings
issued by UK quoted companies such warnings
totalled 282 for the whole of 2009, following a record
449 in 2008, with an average for each of the past
eight years of over 300. These companies' share prices
have fallen on the day of the warning by an average of
between 10% and 20%.
Clearly, then, increased economic turbulence, such
as that experienced recently, makes anticipating the
future more problematic. Yet it also makes it more
important. Few businesses can afford to wait and see
what happens before taking action.
It is no surprise, therefore, that in a survey last year
by CFO Europe magazine the ability to forecast results
is the number one internal concern for chief financial
officers worldwide, ahead of such issues as attracting
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scouring the academic and management literature, we


think we have an answer to improved forecasting.
Interestingly, during this research it became apparent
that the key to successful forecasting lies not only in
what you need to start doing, but also in what you
need to stop. In particular, traditional budgeting
practice, and the mindset associated with it, is part of
the problem and one of the habits that needs to be let
go.
Below, organised around six principles of forecasting
mastery, are some ideas, and some related questions
(plus answers).

and retaining qualified employees, balance sheet


weakness, counterparty risk, managing IT systems
and supply chain risk.
Producing reliable forecasts has never been easy, but
the situation has become critical in recent years as
other previously tried and trusted techniques
historically relied upon have bent and buckled under
the stresses of the current economic environment.
For instance, even in normal times most budgets
are out of date within two quarters, and in 2008 and
2009 the majority were rendered redundant within
three months.
So we have a major problem. What is the solution?
Unfortunately, the professional literature focuses
almost exclusively on forecasting technique the
application of complex mathematical solutions to the
relatively simple problem of how to forecast the value
of a single variable in the near future. What we really
need, however, is a simple solution to the complex
problem of how to forecast the value of a set of
interrelated variables into the medium term.
A PRACTICAL SET OF WELL-GROUNDED PRINCIPLES
Happily, after five years of plundering the knowledge of
many practitioners in a range of disciplines, and
FINANCE & MANAGEMENT June 2010

1. Mastering purpose
The purpose of forecasting is not to predict the future.
The purpose is to anticipate what might happen, given
a reasonable set of assumptions about the world. Armed
with this information, managements take decisions,
either to help bring that future about, or to change it to
one that is more desirable. To achieve this you should:
stop using budgeting processes and chart of
accounts to produce forecasts; and
start recognising the crucial distinction between a
target (what we would like to happen) and a forecast
(what we think will happen) as well as the necessary
and inevitable existence of gaps between the two. In
addition, you should design forecast processes
around the decisions that they support. This requires
that they be:
timely: in good time for decisions to be made
(which might not coincide with accounting
periods);
actionable: using less but different detail from
that used for budgeting;
reliable: unbiased, with acceptable variation
rather than absolutely accuracy;
aligned: complementing other sources of
forecast information rather than in competition
with them; and
cost effective: rather than low cost.

QUESTIONS (1)
What decisions will be made with the aid of your
forecast? This usually involves starting, stopping,
rescheduling, changing or creating some form of
activity.
What information do you need to make these
decisions and is it provided as part of the forecast
process? Usually this involves understanding the
incremental impact of any changes you might want
to make to the portfolio of activities. Often this
information is not readily accessible to decision
makers.
Can you eliminate information that is not relevant for
decision making purposes? If you can it will
streamline the forecast process and help improve
forecast accuracy.

Forecasts are necessary only because we


cannot react fast enough to events as
they happen

An analogy
We find that sailing provides a useful analogy for helping
people think about forecasting (Figure 1). Before setting
out to sail from point A to point B (your target), it is
important to prepare a plan. In our line of business we
normally call this a budget. But we may soon find
ourselves in an unexpected place (C), because the
assumptions we made about the world when we prepared
our budget (tides and wind or market conditions and
competitors actions) have proven to be false. At this point
it is often not sensible to try and get back on plan.
Instead, we need to forecast where we are heading so that
we can take action if it is not where we want to go (eg
hitting the rocks, poor business performance). If our
forecast shows us heading towards trouble (D), we need to
change our action plans (move the rudder, tack or perhaps
change price and promotional activity) to steer back
towards our goal.
2. Mastering time
Forecasts are necessary only because we cannot react fast
enough to events as they happen. That is why super
tankers need radar but speedboats do not. Forecast
processes therefore need to be designed around decision
making lead times and the nature and rate of change in
the environment. As a result you need to:
stop producing forecasts that extend no further than year
end, according to accounting timetables; and
start producing rolling forecasts (ie with a consistent
horizon), as and when needed.

FIGURE 1

QUESTIONS (2)
How long does it take to enact a decision? The
decision making lead time will determine how
long your forecast horizon should be.
Are there many potential decisions with shorter
lead times? If there are, you may need subhorizons that contain more detail.
How frequently do elements of your forecast
change in a way that impacts decision making?
This will determine the frequency at which you
need to refresh your forecast and is likely to
involve updating some forecast elements more
frequently than others.

3. Mastering models
Forecasts are the output of some form of a model of
the world. These models may be explicit and
quantitative, but they are often held in the heads of
forecasters: judgemental models. There is no
mathematical silver bullet; forecasts will always
involve the use of judgement in some way, but this
always carries a high risk of bias. Model choice needs
to take account of the relative strengths and
weaknesses of the different approaches, so:
stop relying exclusively on one approach to
forecasting; and
start using different types of models in combination,
exploiting their relative strengths and mitigating
their weaknesses.

QUESTIONS (3)
Which forecast variables tend to follow a clear
historical trend? These may best be forecast using
statistical extrapolation techniques. Research has
shown that simple techniques usually give more
accurate results than complex ones.
If forecast variables do not follow a simple historical
pattern do you have a good grasp of drivers of
performance? If so, it may be appropriate to use a
driver based model to produce your forecast.
Which variables are best forecast using judgment?
This will most likely include most of the variables
impacted by decision making. Wherever judgement
is used you need to take steps to reduce the risk of
forecast bias.

4. Mastering measurement
Given that businesses are seldom stable for long, the
performance of even the best forecast will deteriorate
unpredictably unless there is some form of feedback
on its performance. Continuous measurement of
forecast error is needed to calibrate forecast models to
take account of shifts in behaviour, and to improve
them through a process of learning. In business,
forecast performance is often not measured at all, and
when it is, usually the wrong techniques and processes
are used. You need to:
stop relying on informal approaches to the
assessment of forecast quality; and
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FEATURES
start routine and frequent measurement of forecast
error over short time horizons. Focus on detecting bias,
rather than attempting to measure forecast accuracy.

QUESTIONS (4)
Do you have a clear, well communicated forecast
policy? Most businesses do not, so it is not
surprising that forecast quality is poor. As a
minimum, this should state that forecasts should
be unbiased with no systematic error and
subject to acceptable levels of variation.
Unsystematic error should be at a level that does
not compromise decision making.
Is forecast error routinely measured and
appropriately followed up? If not, it should be.
Ensure that you eliminate bias as soon as it is
spotted, but take care not to react where there is
insufficient evidence of bias.
Are forecasts ever overridden or adjusted? Avoid
this wherever possible. If they are altered,
maintain records to ensure that any adjustments
made consistently reduce bias.

5. Mastering risk
Perfect prediction is impossible, so forecast processes
should include the generation of alternative potential
outcomes, to promote situational awareness and to
help generate an appropriate range of responses. It is
important to differentiate between risk (unavoidable
variation around a forecast) and uncertainty
(discontinuities). To accomplish this:
stop exclusively forecasting single point outcomes;
and
start incorporating the assessment of alternative
potential outcomes into the routine forecast process.
Post lookouts and build contingency plans so that
your organisation is able to respond quickly and
effectively should circumstances change.

6. Mastering process
Reliable forecasts are the result of the conscious design and
disciplined operation of a routine process, not intuition or
ad hoc analyses, so:
stop treating forecasting as an optional exercise; and
start building forecasting into the fabric of your
management processes.

QUESTIONS (6)
What process do you use to produce forecasts? If
forecasts are to be relied upon, you need a
standardised process that is consistently applied
and constantly improved.
What other business processes feed, or are fed by,
the forecast process? It is important that
appropriate linkages are built into your forecast
process. In particular, there should be a close
linkage between forecasting and the resource
allocation process, since money and other forms of
resource are required to enact decisions.
Who is responsible for what? There is no one right
way to allocate responsibility for forecasting. Good
forecasting requires a mix of technical aptitude,
domain knowledge and objectivity; attributes that
are unlikely to be found in a single individual or
function.

CONCLUSION
In many businesses, the forecasting process is badly
broken. As a result, managers are flying blind or, worse,
they are using instruments that provide misleading signals.
The remedy is at hand: a set of simple principles, which if
they are rigorously applied, guarantee a reliable and cost
effective process. All that is needed is a structured
approach to implementing them, the courage to dispense
with some legacy processes and mindsets and the
collective will and discipline to stick to the principles,
especially when (as will need to happen at some stage) the
forecast produces an unwelcome message.

QUESTIONS (5)
Does your organisation only produce single point
forecasts? If so, start producing range forecasts.
Be careful to distinguish between routine
variation around a forecast and the potential
discontinuities changes in the pattern of
behaviour.
Does your organisation produce multiple,
competing forecasts? If so, stop immediately. If
there are genuine, potentially valuable,
differences of opinion, capture these in your
range forecast process.
How quickly can you respond to unexpected
changes? For a range forecast to be useful you
need to know how you would react to a range of
potential outcomes. This may simply involve
minor changes to your portfolio of activities, but
contingency plans are required to deal with
potential discontinuities, particularly if they
threaten the survival of the organisation.

REFERENCES
Analysis of profit warnings, Ernst and Young,
www.ey.com/UK/en/issues/Transactions/
Restructuring/Profit-Warnings
Top ten concerns of CFOs, CFO Europe,
www.cfo.com/article.cfm/13606188/c_3805465/
?f=archives

FINANCE & MANAGEMENT FACULTY


This article was first published in Finance &
Management, the monthly magazine of ICAEWs
Finance & Management Faculty. The faculty helps
members in business to perform at their best. For
more information on the benefits of membership
see icaew.com/fmjoin

Copyright ICAEW 2010


FINANCE & MANAGEMENT June 2010