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Companies struggle to produce reliable forecasts

Financial performances suffer as companies struggle to produce reliable forecasts

by Joost van Beek
July 19, 2013

Planning, budgeting and forecasting are processes that business executives rarely get very enthused about. Time-consuming, tiresome and just a tick in the box; very few see forecasting as a worthwhile process or one to which they look forward. They may argue that it doesn’t really matter – but it does. Weaker development of shareholder value, poor performance management and missed business opportunities are all symptomatic of poor forecasting. The really frustrating aspect is that it’s all so avoidable.

The symptoms
In case of listed companies, share prices suffer when there is a significant mismatch between outlook guidance (based on forecasts) and actual results. The reason for that is simple. Good forecasting correlates strongly to good performance management whereas poor forecasting can be symptomatic of a much wider malaise within a business and hints at very real business performance management shortcomings. This is not something which can be lightly disregarded.

For example: In February one company listed on the NZX issued its second profit warning in as many months, prompting its stock to plunge by nearly a third. An investment analyst noted that “the company had issued numerous profit warnings over the last few years, which results in a low level of confidence in the ability of the management team and board to see how the company is going”.

The slippery slope
Our practical experience shows that to improve the financial performance of a business, one of the first things that has to be addressed is the forecasting process.

This is because poor forecasts are often associated with poor management information in general. They lead to less-than-ideal resource allocation, which in turn can place stress on the company finances. It is quite easy to see this as the first step down the slippery slope towards severe under-performance. Poor forecasts can also make it difficult to identify which areas of the business are under-performing.

Many annual forecasts fail to be tested on the impact of significant price changes, costs increases, or make any sort of seasonal trend allowance. These kinds of developments can place a massive strain on the banking facilities in place. For this reason, forecasts should be undertaken on at least a monthly basis, no matter how difficult this may prove for larger, more complex businesses.

Some key failings

‘Garbage in is garbage out’
Any forecast is useless no matter how good the forecasting methodology and system is if it is based on unreliable information.

Rather than building forecasts solely around static, detailed, internal data that is relatively easy to predict, leading organisations focus on the key dynamic internal and external business drivers that concern management. These are critical issues such as customer demand, economic activity and economic conditions. These companies use external economic reports and market research or look at data on non-economic risks. Although more difficult to obtain and predict, these measures provide greater value into the business environment than purely internal data can.

The changing face of forecasting
Another issue forecasters have traditionally not been comfortable with is the conceptual problem in deciding how to address and quantify the impact of non-financial risks when creating a forecast.

Some consider scenario planning as the answer to enhance forecasts to take account of uncertainty. In particular they use multiple scenarios to prepare better for the vagaries of the future. By running numerous different scenarios, risks and opportunities can be more easily measured. The process also facilitates the development and - if necessary – the implementation of contingency plans for when those risks become a reality.

Furthermore an increasing number of forecasters are making use of rolling forecasts. It is seen as a way of helping to ensure that organisations keep pace with a rapidly changing business environment. Rolling forecasts are able to adapt to new information, giving their users a competitive advantage over those who persist with rigid, static forecasts.

The culture of forecasting
Human nature is a terribly difficult thing to change. Yet it is human nature that is mainly to blame for the fact that so many companies appear to underplay their forecasts. Sometimes called “sandbagging”, “low-balling” or “gaming”, there is a definite tendency to under-play forecasts in order to exceed them.

In general two problems arise from this. Firstly, investors/shareholders have become more aware and will quickly pick up on companies that are consistently falling into this pattern of under-forecasting; and will amend their view of that company accordingly. Secondly, poor forecasting can lead to poor decision making.

Traditionally, “making budget” has been a key measure of performance and therefore a key behavioural driver. Linking incentives to relative performance (e.g. market performance, external and internal peers or key economic conditions) rather than meeting a budget that was set months ago is a significant enabler to changing behaviour.

As well as addressing cultural issues, leading forecasters appear to treat forecasting as a discipline. They treat it as a key management process, involving the right people. They instil a culture that facilitates quality forecasting. They align incentives to relative performance rather than targets.

In doing so, they are able to change the perception of the forecasting process from something which is an inconvenient waste of time into something which is a means of generating data that is important for the successful management of the organisation.

Agility, vision and communication
If an organisation is able to master the modern day approach to forecasting, the potential benefits are numerous. Reliable financial and business projections are just one part of it. A company can benefit from greater agility; the ability to sense and respond to changes rapidly in a dynamic business environment.

There will be increased transparency around future business opportunities and an improved ability to manage uncertainty and risk.

There will be an improved basis for dialogue with external stakeholders, enhancing trust and increasing confidence. Finally – perhaps most importantly – there will be the chance to grow a sustainable business.

How is your organisation currently dealing with forecasting? Does your company apply the best practices available to drive the business forecasting processes? It may be worthwhile getting a fresh “outside view” from a specialist to bring your organisation’s forecasting capabilities to the next level.

About Joost
Joost van Beek is a director at KPMG and has extensive experience in project finance, mergers & acquisitions, financial & business modelling and valuations in a number of industry sectors. Joost has worked for KPMG member firms in Europe and South America before joining KPMG New Zealand.

About KPMG New Zealand
KPMG is focused on fuelling New Zealand’s prosperity. We believe by helping New Zealand’s enterprises succeed, the public sector do better and our communities grow, that our country will succeed and prosper.

KPMG is one of New Zealand’s leading professional services firms, specialising in Audit, Tax and Advisory services. We have 825 professionals who work with a wide range of New Zealand enterprises – from privately owned businesses, to publicly listed companies, government organisations, and not-for-profit bodies. We have offices in Auckland, Wellington, Christchurch, Hamilton and Tauranga.

Globally, KPMG operates in 156 countries; employing 152,000 people in member firms around the world. The independent member firms of the KPMG network are affiliated with KPMG International Cooperative (”KPMG International”), a Swiss entity.

ENDS

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