Despite all our advances into technological wizardry, nobody yet has been able to develop a program that can, with 100% accuracy, predict the future. But what if you could pre-program alternate views of the future into a plan, which could be modified and tweaked based on whichever view ended up being the closest to reality?
Scenario-based enterprise performance management (EPM) aims to do just that -- provide a way for companies to manage uncertainty by letting them test various scenarios -- strategies, tactics and budgets -- before they actually occur. It's risk management with a proactive layer of financial planning and analysis, wrapped into a program capable of running detailed "what if" scenarios.
In this Business Finance Q&A, we sat down with David Axson, executive director, finance and enterprise performance, with Accenture's Cleveland-based practice, to gain insight into the capabilities of scenario-based EPM.
Business Finance: Why has scenario-based EPM become such a hot topic for organizations?
David Axson: If you look back to the last three to five years, volatility has been unprecedented. Many organizations have found that their budgets and their financial plans are largely obsolete the day they're created because the assumptions underlying them change so quickly these days that the past has ceased to be an accurate predictor of the future.
If you look historically at the way organizations built plans and budgets, it was largely to take last year's actual, and start to extrapolate forward, and then lay on top strategic investments, and say, "How does that change our performance?" Well, for every one of the last five years, the previous year has been an absolutely horrible predictor of the future, so organizations have invested thousands of hours of management and finance staff time creating very detailed budgets that are essentially obsolete the day they're created. In fact, in many organizations, they spend more time creating the budget than they end up actually using the budget because it ceases to have value. And that's triggered a lot of angst and a lot of frustration, both within finance and within the business.
At Accenture we did some research at the tail end of last year on the high-performance finance organization, and one of the things that came out loud and clear is that CFOs expect volatility to be business as usual -- it is the new normal,. And they're saying, "How do we acknowledge that reality and change our management processes to adapt to this new world?" And that's where a lot of organizations have used scenario planning in the past, but it's historically been used more in the strategic planning or very long time horizon view.
Back in the late 1960s/early 1970s, Shell Oil started developing scenarios about what the future demand patterns were likely to be for oil. And if you go to Shell Oil's website today, they're talking about oil in 2050. So it's a scenario that's 38 years into the future. A lot of organizations have begun to realize that the ability to be able to test your resource allocation plans and your budgets under different scenarios has value in much shorter time horizons, be it a two- to three-year strategic planning horizon, be it a one-year budget, or in some cases even a 90-day rolling forecast view. Organizations are now asking: If the future looks a little different from what we currently expect, what actions are we going to take and how are we going to change our resource allocation? And that explains why now we're beginning to see a scenario-based view be applied to areas other than just strategic planning. So it actually feeds through the overall management and planning process within an organization.
BF: What are some best practices that companies can use to successfully incorporate a scenario capability into their EPM processes?
Axson: The key is to match the scenario time horizon to the decision making time horizon in the business. There are seven steps you go through to do this:
Step 1: Identify those things that are going to have a material impact on your business. Maybe it's it a regulatory change. The whole 401(k) industry, for example, was created by government regulations. As soon as tax deductibility of 401(k) contributions was created by Congress, a whole new industry was essentially created overnight. But it could be a volatile commodity price. It could be a change in the tax regulations. It could be a demographic change in a particular marketplace. So identify those key factors that could have a material impact on the organization and then start to craft different scenarios: What if a tax deductibility of a 401(k) contribution was removed? What would that do to the business? How would you reposition yourself if you were a pension service provider to an environment where the target customer base no longer gets a 30-40 percent break on their contributions? That could have a pretty significant effect on the industry.
Step 2: Define relevant scenarios. Once you define those scenarios, you basically pick one and say, "Okay, this is what our best case is. This is the one we think is most likely to play out."
Step 3: Then build your budget and your resource allocation plan under that baseline scenario.
Step 4: And then you develop strategic plans, targets, action plans and budgets using that baseline scenario.
Step 5. Once you've built that baseline plan, you then begin to create alternate views of how your behavior will change, and also how your performance will change under each of those scenarios. "How would that change if these other scenarios hadn't transpired and played out? Which projects suddenly become more attractive under each of these scenarios? Which projects should we kill? Which products should we invest in versus which products should we deemphasize?"
Step 6: You then need to define some metrics that will give you some early warning that the baseline scenario that you chose is no longer the right scenario on which to base your decisions.
Step 7: And then you adjust your tactics as necessary and create a new forecast.
The key here is, by having done the scenario planning at the front end, business managers already have a view of how their behavior will change because they've already thought about it. They're not thrown into reactive mode, throwing their hands up and saying, "Gosh, the world's changed. Now what the heck do I do?" They've already almost gone through a simulation or a practice of what that would look like, and that does a couple things: They're able to make decisions more confidently, and they're able to make decisions faster. Which when you're dealing with volatility, is absolutely essential because if you just procrastinate, all you're going to do is magnify the negative impact of an unexpected event changing your view of the future.
Now one point I want to add is, some people when they hear this, they say, "Wow, that sounds like a lot of work." Well, it would be if we continue to develop our budgets in the same excruciating level of detail that most organizations do today. So what tends to accompany a move to scenario-based EPM is a reduction in the level of detail. Instead of having a thousand-line-item budget that goes down to the level of saying how much you're going to spend on travel next November, you would actually budget 50 items but do three different views of what those 50 line items would look like under each of the three different scenarios. You begin to sacrifice depth for breadth so that you have a number of alternate views of the future that can help you accelerate your decision making.
BF: What is the role of the CFO in EPM?
Axson: The CFO is typically the facilitator and the steward of the process. The CFO is part of the executive team, and the way the cycle usually works is, there's a strategic planning process, and the CFO is a participant in that process. Typically coming out of the strategic planning process are some targets and they're often financial targets, such as revenue growth or earnings growth. Then those targets are handed down to the business managers, and what typically happens is, the VP of financial planning is then responsible for managing the process from those targets being issued all the way through to going back to the board of directors and getting a budget and a plan approved for execution for the next time period.
Now every strategy and tactic -- the strategy may be you want to differentiate by being the most innovative company, a tactic could be you want to launch your products through the direct channel in western Europe -- each of those strategies and tactics at some point gets translated into a financial impact: What's going to be the revenue uplift, what are the costs associated with that, what will be the impact on earnings, and what is going to be the impact on the balance sheet in terms of assets you create and liabilities you might generate. So a financial representation is created of the strategy and tactical plan that a business is going to execute. So between the CFO and the VP of financial planning, they are the custodians of that process.
And increasingly the finance executives are finding that they're in the situation today where actual-versus-budget calculations and variances are exploding because our ability to predict the future has actually gotten worse, not better, simply because of the uncertainty that exists out there. So they're beginning to ask, "What types of management tools can help us provide better insight into why performance is varying, and what actions should we in the finance organization be prompting the business to take to get us back on track?"
To put it very simply, there are three questions that a finance executive should always be able to answer when they sit down with a business leader:
- The first question is, what happened? We're pretty good at that in finance. We can calculate the actuals and say, "Sales are off 15%."
- The second question that always follows right on the heels of the first is: Why did that happen? We're not always so good at that one. We might have to go and do some more analysis to analyze the variance.
- And then the third question is, what should we do about it?
To me the definition of finance truly being a business partner and helping the business is being able to go into the discussion ready to answer those three questions. If you contemplated variability during your planning process, finance can say, "Okay, we're moving from scenario A to scenario B. And when we looked at scenario B we decided we would change our marketing mix in this way, we would change our product mix in this way, we would cancel these three projects and invest in these three other projects instead as a consequence of the likely future scenario changing." So EPM is a tool to help speed management decision making in times of uncertainty.
BF: What's the payoff that finance or companies can expect to see from the adoption of EPM? And what does it take to successfully implement EPM?
Axson: There are some investments that need to be made from a technology standpoint, primarily around reporting and analytics. Actually, the bigger challenge is more cultural and behavioral because a lot of people feel some comfort in having a very detailed budget, and they're very comfortable in saying, "It's okay, it's in my budget," even though the budget was created nine months ago and the world has changed three times since then." Because it's in their budget it's almost a crutch that they can rely upon so I wouldn't underestimate the behavioral and cultural change that's required to introduce this mindset and this decision making philosophy to an organization.
In terms of payoff, it's pretty easy. One of the things that scenario planning does is to identify when a business investment no longer makes sense. Generally speaking, if you have a scenario-based EPM approach, you will buy yourself somewhere between 60 and 180 days of time in terms of being able to identify projects that no longer make sense, but also to identify new projects that now make tremendous sense, far faster than you would have done in the old environment.
It's the ability to identify much more quickly things that are working and things that are not working, things that make sense and things that do not make sense. Your ability to buy anywhere from two to six months of time -- that's real cash and that's real money that you can better deploy. And it will manifest itself in an increased ROI because you cease to throw good money after bad in projects that don't make sense, and you continue to invest in projects that do make sense.
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