It has been more than three years since the global economic crisis battered investors, consumers and businesses alike. While there are signs of stabilization, the environment continues to be full of surprises, as witnessed by the recent battles over the U.S. debt ceiling. The situation in Europe offers little relief, with a series of sovereign debt concerns casting doubt on the fate of the Euro and the ongoing solvency of the European Union’s weaker participants. With slow growth and high levels of employment in the United States, the outlook is for more uncertainty.
These volatile and challenging conditions make it difficult, if not impossible, for companies to adhere to traditional planning cycles. The old planning model was suitable for a more static environment, but given continuing turbulence and uncertainty around the globe, forecasts based on fixed assumptions are almost guaranteed to be wrong. Severe volatility greatly diminishes the accuracy of planning. Look at the wild swings in the price of oil, which affects everything from customer behavior to raw materials costs to distribution expenses.
Wrong assumptions lead to poor guidance for investors as well as poor business decisions. In an Accenture survey conducted in 2010, two-thirds of respondents said that planning accuracy decreased because of economic volatility, and only 11 percent of respondents said they were fully satisfied with their planning capabilities. That is hardly surprising when, at many companies, planning relies heavily upon guessing at percentage increases for various budget line items.
Fortunately, however, the financial planning process is itself evolving. Leading companies are now pursuing a more dynamic and effective approach to planning. In particular, new technologies, such as sophisticated analytics, are helping transform traditional planning from a one-time, once-a-year exercise to a fluid, ongoing process capable of absorbing information and making course corrections on an almost real-time basis. These companies are also working to broaden the planning perspective to include intangible investments, such as brand value, as well as investor expectations.
The key element in a faster and more flexible planning process is the ability to make rapid adjustments based on evolving external factors. The high-performing companies we surveyed use external information on customers, competitors, investor expectations, and regulatory changes and incorporate external benchmarks into their business targets.
Using external information, in turn, is essential to effective scenario planning. While scenario planning is a relatively new practice for many firms — with only 29 percent of organizations in our survey using it for five years or more — three out of four respondents that have scenario planning capability recently started using it more extensively in response to economic volatility.
Scenarios can help managers anticipate changes in the environment and, with proper links to business processes, can also help make decisions and course corrections more rapidly and effectively. Eli Lilly, as reported by The Conference Board Review, closely tracks such leading indicators as the incidence of chronic diseases. Every six months or so, it assembles its scenario planning team and looks at key questions tied to the future trends in healthcare and improving care for patients over the next 20 years, or how integrated the company should be in terms of research, development and distribution. Strategies are tested against current data and updated every year.
Once an evaluation of external factors is completed, a company can identify a series of actions that would be taken if certain scenario “triggers” are reached. For example, the emergence of new competitive threats or negative external economic factors might trigger postponement of discretionary or non-strategic initiatives, freeing up investment for higher-priority operational expenditures.
The most useful way to incorporate events is by monitoring a set of value drivers chosen for their volatility and material impact on the business, such as patent expirations for pharmaceutical firms or grain price fluctuations for food companies. Tolerance ranges can be defined for each value driver, and when the tolerance level has been reached, the organization should revise its plan and reallocate resources in order to close the expected gap.
Tesco, the U.K.’s largest grocery chain, has created its own weather team and uses proprietary software to better forecast temperatures and accompanying changes in consumer behavior. This helps reduce costs, avoid spoilage of food such as meat for barbecues, and manage inventories for spikes in demand. The system successfully predicted temperature drops during 2009 that led to a major increase in demand for soup, winter vegetables, and cold-weather puddings.
Involving Operations in Forecasting
At half of the companies we surveyed, the finance function assembles forecasts with limited participation from operational line managers. Accenture research shows that, when business environment volatility increases, those companies are more likely to report diminished forecast accuracy than their peers that involve operations in forecasting.
Scenario planning and the incorporation of events into forecasting will not succeed if restricted to a small, centralized team or exclusively to the finance function. Rapid, effective course corrections require the involvement of front-line operating staff, who are keenly attuned to shifts in customer priorities, competitor initiatives, and other changes in local market conditions. People on the front line are in the best position to provide the assumptions and insight for key value drivers. This typically starts with an accurate forecast of demand, since changes in demand affect sales, inventory levels, production volumes and staffing needs. Operating staff are also more attuned to relevant shifts in their businesses and are better situated to update forecast models.
Finance should still maintain the central role of building the planning model, challenging the assumptions of front line managers, and coordinating the overall planning effort. Finance must also make sure that senior management understands the impact of its plans, including the effect on investor expectations.
Collecting Better Data and Improving Analytics
Analytics – employing quantitative methods to derive actionable insights — can help companies make better business decisions and deliver better outcomes. Our research has confirmed that high-performance businesses — those that substantially outperform competitors over the long term, and across economic and industry cycles — are five times more likely to use analytics strategically, compared with lower performing companies. Superior analytics starts with good data. Poor quality of underlying data remains a major problem, and investing in analytics without data of proper quality is a waste of money.
For the purposes of strategic planning, companies must identify the highest priority data and then make sure it is validated, cleaned and consolidated. Companies must also determine what additional data is needed, especially external data, and where it can be obtained. Many firms have surprisingly little solid information on key factors such as the market share of competitors in their major product segments; customer repurchase intent; and brand equity data for their own and competing brands. When the data is obtained, it must be sorted and organized to get the data points most pertinent to various investment options.
With high-quality, comprehensive data, managers can employ advanced analytical techniques. For example, predictive analytics, based on statistical and data-mining techniques that analyze current and historical data, reveal hidden patterns within such data and make predictions that support business decisions.
Consensus methods, another analytical technique, use the opinions of experts and crowds, along with mechanical algorithms, to guide decisions about major investments. Prediction markets operate on the principle that a crowd, collectively, can often make better decisions than individual managers.
Building Stronger Frameworks for Capital Allocation
At many companies, the resource allocation process ignores the true cost of capital and its impact on shareholder value creation. Performance targets for individual departments or business lines may undermine the effectiveness of capital cost evaluation, because the metrics used to assess managers are based on accounting principles rather than on measures that favor value creation. Projects that do not meet the cost of capital, but appear to help meet revenue or profit targets, may proceed, despite the fact that they actually destroy value.
A more effective capital allocation framework rewards employees who act like owners, by ensuring that only projects with a return greater than the cost of capital get the go-ahead to move forward. Criteria for project selection should also include non-financial benefits, such as employee satisfaction, enhanced capabilities, or customer service improvements, as these are just as important as base-case financials.
A properly structured framework also explicitly links capital allocation with the strategic plan. When strategies are ambiguous and only qualitative — not based on analytics and external data — then senior management decisions are really gambles, not informed choices about value creation. Of course, capital allocation should be adjusted for risk. In the Accenture survey, companies that tie risk management to planning report higher satisfaction with their strategic and capital planning and are more confident in the ability of their planning capabilities to evaluate major investments.
Taking a Broader Perspective
When confronted by continuing economic volatility, many managers may focus on shorter-term planning sub-processes such as forecasting. Overreaction to short-term economic fluctuations, however, impairs long-term strategy and can compromise a company’s ability to create value in the future. A broader planning perspective strikes the right balance between short-term and long-term performance and takes into account both capital and investment activities that may fall into the selling, general and administrative (SG&A) category. These activities may nonetheless be crucial for future value creation.
Intangible assets such as brand equity, intellectual property, channel relationships, and human capital drive a growing proportion of business value. In 1980, 80 percent of the market value of an average S&P 500 stock could be directly tied to tangible assets such as factories and equipment, while 20 years later that proportion dropped to what we estimate as 25 percent, with the remaining 75 percent attributable to intangibles.
Traditional planning misses this new reality. One-third of the organizations we surveyed do not plan for intangibles in any form. While measurement of intangibles, and identifying direct links between intangibles and financial outcomes, can be difficult, it is nevertheless essential to take these factors into consideration in the planning process.
Companies that do not plan for intangibles risk under-managing some of their most important drivers of value. SG&A costs such as employee training, research, and customer management clearly create future benefits, but must be expensed as incurred rather than recognized on the balance sheet and amortized over time. This favors short-term market expectations over long-term value creation.
A broader perspective recognizes that certain SG&A costs should be managed strategically, especially for companies with a major portion of their enterprise value driven by intangibles. A company providing services, for example, might examine the links between employee engagement and such “hard” metrics as site profit, customer satisfaction, and the frequency of repeat business. When these connections are established, it is easier to move forward on strategic expenditures for intangibles.
A new approach to planning will encourage managers to pursue more long-term, value-creating investments, regardless of their short-term profitability. This type of change requires a significant effort in educating teams about planning and convincing them of the merits of this new approach. Senior management must communicate effectively to explain the new approach, why it matters, and what changes it will involve.
While the process starts with communication, it is also essential to enlist the active participation of operating business units as well as finance, starting with front-line staffs that are closest to customers. This allows companies to make adjustments necessary in the face of continuing uncertainty and ongoing economic volatility.
By Scott Brennan
Scott Brennan leads the Enterprise Performance Management practice within the Finance & Performance Management consulting group at Accenture, a global management consulting, technology services and outsourcing company. Robert Bergstrom is also an executive in Accenture’s Finance & Performance Management group.