Introduction
Driver based modelling is becoming a function of the current economic uncertainty (aka the ‘new normal’.)
Traditionally, forecasts and models have been prepared along the lines of last year’s actuals plus a control /expectation margin either to increase sales revenue by x % or to decrease certain costs by y%. Throw in a measure of cost control around HR and IT and most businesses would get by. If there were capital projects or new ideas in the forecast then these would be added as appropriate with certain sensitivities. The problem with that approach is that it assumed a steady state economy with reasonably predictive markets.
Latterly we have been also talking about going back to ‘zero based drivers’ and looking at reducing costs to fund growth, the problem we have with that approach is knowing what costs to reduce which will free up working capital to invest in other areas.
The benefits of this approach is that it may lead to more visibility on the cost base, almost like starting with a blank canvas.
CEOs and FDs acknowledge this is not a precise science because of the laws of unintended consequences and the fact that such a strategy is a bit of a gamble.
Certainly over the recent past, businesses have been instrumental in eliminating long term and fixed costs and trying to align all costs in direct proportion to output, i.e. ‘variabalise ‘ their cost base so that any reduction of increase in Revenue is merely trickled down to the appropriate cost and that margins are more easily managed (at least that is the theory)
This, in turn has led to a further conceptual debate about what is ‘ driving the business’ hopefully this is a revenue led initiative and not one where the primary objective is to cover a fixed cost base ( usually salaries)
This inevitably means that if we are freeing up resources because of a cost reduction exercise, where does this spare resource end up? This means concentrating on the Drivers of the business (which should be aligned with the overall strategy) and ensuring that there is an appropriate cost base to support the growth area.
Focusing on the key drivers helps re-align management to key priorities, sources for growth and obtain better odds on their gamble.
Timing is also worth mentioning, because basing your cost expectations on costs that existed twelve months ago may be the wrong focus. Circumstances change, and indeed last quarter’s costs may not be appropriate as FDs struggle with variances in deciding whether they are a blip or a longer term trend.
One of the issues with ‘ Big Data’ is sometimes too much data creates an analytical paralysis of simply having too much information.
The trouble with Driver based planning is that an FDs perspective can be different from a CEOs and that is sales ratios may not be appropriate but rather sales per sales person and performance related criteria may be what is required.
The short answer is it all depends on what you want to achieve by using driver based forecasting as one of your levers of control
What are the advantages and disadvantages of using driver-based planning and rolling forecasting?
The primary advantage is focus and re alignment, turning a business culture at all levels into looking at what really matters and what costs are required to support the growth. Many SMEs have this instinct, especially start ups, and there comes a time in a business life cycle that admin functions start to take a disproportionate amount of costs for their value. Driver based planning re focuses the resources of the business into what creates wealth.
Rolling forecasts are equally a useful tool because they focus on the more recent past rather than what happened a year ago ( in different circumstances) and so this rolling ( or more real time) affect means that resources and capabilities can be more quickly and easily identified to support the driver.
This also depends on the broader response times of the Management Information system and what KPIs are used by the senior management team to measure success ( or at least adherence to plan).
As in most cases the main disadvantage is pinning your colours to inappropriate drivers because they were the wrong choice in the first place or circumstances have changed which makes them obsolete.
Again, it is a question of how responsive and flexible the reporting functions are in the Finance team.
How should a business go about setting appropriate forecasting horizons?
Most traditional budgets start creaking after the second quarter, appropriate time horizons are KPI or driver dependent.
What is required is a trend analysis and a time horizon that says there is enough data for the predictive modelling to be supported as accurate and robust or requires changing. This is always situation ally specific.
It all depends what the business agenda is (shareholder dividends / reinvestment in capital plant etc,) and what time horizon are these short term and long term strategies allowed before they themselves are changed.
The choice of driver will dictate the time horizon. A key driver may be the number of widgets produced, in which case data should be provided on a timely basis about machine throughput, this may indeed be monthly or even hourly. The rationale behind the provision of this data on a ‘timely’ basis is actually , if the number of widgets is less that you thought it was going to be on an hourly basis, what are you going to do with this information?, wait until a longer period is examined?. The thinking behind this (and the provision of ‘Big Data’) is that it increases corporate anxiety.
So you end up throwing more resource at monitoring the data and the pendulum swings back to an administrative culture rather than a fast paced slicker growth mentality.
Getting the timing right is therefore a matter of what you want your response to be and why you chose that driver in the first place. .
Conclusion
Focussing on drivers for planning purposes turns the firm into a wealth creator rather than a cost administrator and that we should not be too concerned about budgets per se, but rather the sensitivities of the cost structure to changes in the business drivers,- the ‘what if ‘ scenarios.
AT an SME level senior managers/owners know the business instinctively, they don’t need a driver based forecast to tell them the firm is heading in the wrong direction. In a larger business there is still this instinct but the driver based plans are used as a method of controlling behaviour at individual or departmental level.
The Language the Board may use ( and possibly the CEO) is different from an FD, instead of talking about zero based budgeting, it may be best to ask the question ‘ if we had a blank sheet of paper what resources would we need to run this size of business?’ This in itself takes the debate away from pure numbers but also looks at the people and processes (including IT capabilities). In more established businesses their will inevitably be ‘ job description creep’ where original roles have changed into something different due to the longevity of employment/ seniority of staff and changes in the external environment, so a ‘ fresh pair of eyes’ is probably what is required, as well as a deeper look at actually what drives the business. The bottom line on this approach is a values based organisation that is run on principles aligned with their values. Overtime these principles get transformed into rules as organisations get larger so a review of the employee handbook and the principles on which the business is run is also part of this zero based driver approach.
