Important FP&A techniques and processes
Financial planning and analysis (FP&A) as a function has come a long way from the days of traditional static annual budgets. Today's intelligent FP&A structure embodies a dynamic and strategic toolkit, held in the back pocket of an organisation, that enables it to respond to changes in business dynamics and optimize performance.
Modern FP&A teams support better decision making through dynamic planning systems and timely analytics-driven inputs. The integration of FP&A into the decision-making process and its resulting positive impact have been guided by the implementation of modern FP&A techniques. Let's take a look at these:
1. Rolling forecasts:
Rolling forecasts are probably the most significant and universal change to have been made to the FP&A planning process. A rolling forecast is a tool that enables organisations to make planning a continuous process. Instead of a static plan that lasts for a calendar year, a rolling 12-month forecast, by quarter or by month, enables an organisation to see trends and expect changes in the external environment so that it can adapt accordingly.
The most critical step in building a system of rolling forecasts is determining the length of the forecast period. The longer the period, the less accurate the forecast is likely to be. Conversely, the shorter the period, the more frequently the forecasts need updated.
To choose the right period, the FP&A team must consider the nature of the business, the volatility of the external environment and the resources available for organisational. There is no one-size-fits-all solution. For a young tech start-up, a week may be a sufficient forecast horizon whereas a large consumer multinational may need a 12-month rolling forecast.
2. Driver-based planning:
A traditional planning process builds financial forecasts by using actual historical numbers as a base and then adding a target growth percentage based on top-down strategic guidance. This approach misses the real ‘story behind the numbers’. A financial statement reflects the interplay of a multitude of factors that affect a business. While forecasting, it is critical to identify the key drivers of your business. While infinite factors do influence every business, there are a few key ones that have the most influence on a company’s results. One can use the Pareto principle (80/20 rule) to identify the top twenty percent of factors which influence eighty percent of the outcome. Any forecasting exercise needs to be based upon these driving factors and the uncertainties around them. For example, in an airline company, the prices of crude oil will be the most significant driver for its financial results. Other key drivers may be labour costs and the expected level of demand for air travel.
3. Scenario planning:
The fluctuation of the global environment has made planning a complex exercise. While static long-range budgets have no utility in these times, forecasting for shorter horizons with reasonable certainty is also near impossible.
The current pandemic situation is the best example of uncertain times. Currently, all planning teams across the world are struggling to build reasonable forecasts even for the next month or quarter. There seems to be no clear consensus on how long complete lockdowns will last or indeed whether normal or intermittent activity will resume once lockdowns are lifted. In such environments, it becomes important to plan for multiple scenarios without allowing bias.
4) Zero-based budgeting:
One of the most common errors in a budgeting process is the anchoring effect. This is the technique of using a historical number as an ‘anchor’ while building forecasts and budgets. It can have serious implications. For example, the most important factor when allocating cost budgets to different business units is their potential to deliver future results, not their past performance. If past performance is continually used to allocate budgets, a business may end up investing excessively in a business unit that has already reached saturation. Similarly, they may under-invest in a unit with high-growth potential. The solution to overcome this anchoring bias is zero-based budgeting (ZBB). In ZBB, every business unit needs to justify its budget allocation from the first penny. This is in contrast to traditional budgeting where the negotiation would be for a percentage increase or decrease in budget compared to the previous period. Zero-based budgeted therefore enables the most optimum allocation of resources.
By leveraging such modern techniques, FP&A can add incremental value to the organisation.