My past experience from over 20 financial and operational planning projects in Finland has shown that driver-based planning created by different business functions is rarely used to full extent. Most commonly, revenue is recognized from sales volume and sales price. Cost Centre personnel costs are often calculated from headcount and added with automated side costs. These are of course the main contributors to P&L, but it is still lacking connection to activities performed and the capacity required to fulfill the business targets.
Some recognized challenges with budgeting
With the target setting process, I’m referring to the annual budgeting process in which the high-level targets are usually set first. For example, the target for revenue may be + 12 % and for EBIT 10 % in comparison to previous year actuals. After this high level target setting (TOP), the allocation for the organization’s business units and departments budgets will be done (DOWN).
This does not mean that all the business units and departments should have the same targets, but the aggregate total should be. One reason why budgeting takes such a long time often – even 3 months (Sep-Dec) – is that departments first estimate all their revenue and cost details into P&L, and when rolled up to an aggregate e.g. Business Unit and Enterprise level, the figures don’t match with the set high-level targets. It may also be that high level targets do not yet exist, or they might change and another too-detailed budgeting round will start again.
Another reason is that there is no direct connection from financial targets to business targets – something that an Enterprise, Business Unit and department are trying to achieve. These business targets can be e.g. penetration to new markets, increasing market share, developing and launching new products and services, growing brands, or strengthening partnerships. Businesses should realize what activities and resources are needed in order to achieve the business targets.
Let’s take the above example, where new financial revenue target was set to +12% compared with the previous year actuals. In order to improve sales, some activities e.g. more sales visits have to be done.
With the current customer lead conversion rates, it can be estimated that the number of sales visits has to be increased by 50%. With the current capacity, a.k.a. available salespersons, this cannot be achieved. More salespersons need to be hired, and eventually their salary costs will land to P&L personnel costs.
This is a closed loop scenario, where business drivers (# Sales visits, lead conversion rate-%, # FTEs) determine how the targets can be achieved, how much resources it will require, and how much it will cost.
Another example presented from another angle: If the financial target is to cut e.g. ICT costs by 20% or by 2.000.000€, this will then set the target amount for ICT resources: Headcount (#FTE), personal computers (#PC), office space (#m2) etc. from which the costs are occurring.
Reducing the ICT capacity will finally impact ICT service levels e.g. how many incidents can be solved? Is there onsite support available due to lack of office spaces? This kind of a closed loop planning process brings better understanding compared to pure financial budgeting about what has to be done in order to achieve something and what is the impact on business processes.
With forecasting, the planning process and objective is different
While in budgeting, the focus is on top-down target setting for one fiscal year, forecasting aims to bottom-up predict if the targets can be achieved and also what are the possible future outcomes (e.g. best and worst scenarios) within the next 12-16 months or even in the longer term.
The latter is called scenario planning and it can be fit to a purely financial planning context, but it still requires input from Business Units about their business environment, external drivers impacting on it, and the possible impact on business operations’ internal drivers and financials. Examples of external events that a company has no control on, but which impact business performance: Legislation, taxation, currency exchange and interest rates, loan market, competitors, economic growth, inflation and political crises.
The main purpose of scenario planning is to be able to understand magnitude and direction of changes in the market and to react faster. The closed loop model, where both internal and external key performance drivers have been linked to financials, provides a quick and easy way of getting a holistic view of an enterprise from both business and financials perspectives.
Benefits of having driver-based planning in addition to financial planning
- Easier to understand, explain and plan – more accurate forecasts – better quality and better informed decisions
- Faster to update when changes in the business environment occur – helps to understand and react to external events
- Increases the awareness about what drives the revenues and costs – Key Drivers of the Business
- Enables Scenario and What-If planning
- Facilitates more collaboration between the functions and organizations and increases the responsibility for and ownership of results