Executive Summary
of the January 14, 2004
SDG Executive eBriefing
Embracing Uncertainty
in Forecasts and Budgets
Featuring: Carl Spetzler and Adrian Lall
Moderated by: Jim Lang
Following is a summary of the Executive eBriefing covering:
•
The shortcomings of the budgeting and forecasting processes commonly used today.
•
What it means to embrace uncertainty.
•
Practically how to go about embracing uncertainty at both a business unit and a
corporate level.
•
The benefits and implications of embracing uncertainty.
©2004 Strategic Decisions Group. All rights reserved.
Created for SDG (www.sdg.com) by BullsEye Resources, Inc.
Executive eBriefing
Embracing Uncertainty in
Forecasts and Budgets
January 14, 2004
Embracing Uncertainty in Forecasts and Budgets
Speakers: Carl Spetzler, SDG Chairman and Adrian Lall, SDG Partner
Moderator: Jim Lang, SDG COO
Overview
Embracing uncertainty starts with recognizing that the expectation
of the budgeting process to yield a specific and accurate forecast is
unrealistic, demonstrated by the frequency with which companies
and business units miss their numbers. The consequences for
inaccurate forecasts are significant, as a company’s credibility is
diminished, and investors punish companies that fail to deliver on
their estimates.
Embracing uncertainty leads a company to adopt a probabilistic
budgeting and forecasting model. This model entails determining
the probabilities of all potential outcomes (i.e. a 10% chance of
outcome “x,” a 25% chance of outcome “y,” etc.) and yields an
expected forecast value. Developing the probabilistic forecast
requires undertaking an assessment process to understand the key
drivers and areas of risk that impact uncertainty at both the
business unit and corporate levels, and deeply analyzing each risk
variable to thoroughly understand it and its interdependencies.
Through this assessment process, managers better understand the
key risks of their business, can better manage their business and
take actions to mitigate uncertainties, and can more accurately and
confidently communicate the likely forecast results.
Context
SDG’s Chairman, its COO, and a partner with expertise in decisionmaking under uncertainty discussed the drawbacks of the
budgeting processes used today by most organizations, the benefits
of embracing uncertainty, and a specific process for doing so. A
case study illustrated this process and its benefits.
Key Learnings
• For most, the current budgeting and forecasting process
yields a false sense of accuracy and is time consuming.
In most organizations, a considerable amount of time and effort
goes into the detailed creation and endless refining of the budget.
As part of this laborious process, the “number” is negotiated
through ritualistic “corporate arm wrestling” to determine
forecasts, stretch targets, and serve as the anchor for incentives.
The time consuming budgeting process leads the participants to
perceive the forecast as accurate and in control.
However, this sense of accuracy is an illusion evidenced by the
frequency with which organizations fail to achieve their expected
results. Investors find such patterns troubling as they judge
companies and their management not only on their performance,
but also on their ability to accurately predict results, speak
credibly, and manage variance. Surprising Wall Street, even with
surprises on the upside, indicates a lack of budgetary control.
The conclusion: despite the considerable time invested today in
budgeting and forecasting, the results generated through
currently used processes are often unsatisfactory, leading CEOs
and CFOs to seek solutions to better manage their organizations
and improve their predictability and credibility with external
stakeholders.
© 2004 Strategic Decisions Group
www.sdg.com
• The concept of embracing uncertainty requires a shift in
culture and process.
The first step in embracing uncertainty is acknowledging that
certainty, control, and accuracy are an illusion. The belief that if
certainty is demanded (especially with regard to near-term
results), and that if someone’s feet are held to the fire it will then
be delivered, leads to gaming the system, dysfunctionality, and
blame. Only with acceptance that perfect certainty does not exist
can an organization move forward with implementing a probabilistic framework that involves assessing potential outcomes
based on their probabilities, understanding the key underlying
drivers, and making more informed, more realistic decisions.
“Doubt is not a pleasant condition, but
certainty is an absurd one.”
- Voltaire
Future performance is usually expressed using a specific “point
estimate” (used by 64% of eBriefing participants) – for example,
quarterly earnings per share of $.52 cents. Some (28% of
participants) go further and provide a best case/worst case range.
SDG advocates adopting a probabilistic forecast framework that
provides a distribution of the potential outcomes based on their
probability, leading to an expected forecast value (used today by
8% of participants). The true value of a probabilistic forecast is
not just that it is a more realistic and credible way to think about
the likely results, but that the process of creating a probabilistic
forecast requires that an organization understand the key drivers
impacting the uncertainty or variance of the forecast.
• Embracing uncertainty involves a revised budgeting and
forecasting process, with the primary building block being a
business risk assessment at the business unit level.
This individual BU assessment involves six steps:
1. Extend existing budget models and connect to risk analysis
tools. This means shifting from a standard valuation model to
a probabilistic model that focuses on the effects of the
uncertain variables (such as market price) and takes
dependencies into account.
2. Develop estimates on the 10 to 20 inputs in the budget process
that people believe might be the key uncertainty drivers.
3. Perform initial “tornado analysis” to identify the key drivers.
The tornado analysis takes each key driver of uncertainty and
shows the impact of that driver on total uncertainty.
“You quickly find that a very few variables
capture the vast majority of the uncertainty.”
- Carl Spetzler
4. Conduct rigorous assessment and verification of the
uncertainty in the key drivers. Quality is assured through use
of systematic processes that are designed to remove biases and
provide verification. The numbers must be accurate and
trusted, as winning credibility is crucial to success.
5. Fully analyze the uncertainty by combining all of the inputs to
understand the probabilities of risk in the forecast. SDG
Created for SDG by BullsEye Resources, Inc.
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Executive eBriefing
January 14, 2004
generates a business unit assessment template that facilitates
data collection and shows the interdependencies. The result
creates a distribution of the probabilities that is not a guessing
game, and develops credibility and consistency. The value of
the probabilistic model can be seen by comparing the results to
the original budget to identify differences.
6. Create ownership through review of results with business unit
leadership.
• After the assessment of the individual BUs, the process
involves integrating the analysis of all BUs, and considering
corporate level risks and “surprises.”
Six more steps are required to complete the corporate picture.
The first two deal with surprises not captured at the B.U. level.
unit, some of which may have been too optimistic in their
forecasts, and some of which will have sandbagged. An
outcome of better forecasts is the recalibration of bonus and
incentive plans, with each company having to decide at what
probability to set incentives – at a level that is achieved 80% of
the time? 50%? 20%? (eBriefing participants were most likely
to set budgets that would be achieved 50% of the time.)
- Corporate level: This includes the corporate relationship to
the Board and to the Street as well as the corporate functions
serving the business units.
At first, results showing that the original budgets are overly
optimistic are difficult for management to accept, but this
assessment process confirms their existing worries. Boards are
often receptive to this information that dimensionalizes
uncertainty by factor and business unit based on probabilities
and expected value. However, there is often a challenge in
recalibrating the expectations of analysts. In planning for
these conversations, the new forecasting process can help
management decide “how often are you willing to have your
results fall short of your annual guidance range?” If the answer
is never or once every twenty years, the guidance given will be
different than if the answer is once every three years, (Among
participants, the majority were comfortable with the idea of
missing their forecast to Wall Street only once every five years.)
1. Identify potential surprises by looking back over many years at
low-probability disruptive events. To each business unit these
potential surprises may not appear significant, but across the
portfolio these risks can add up to be significant.
2. Evaluate the likelihood and severity of surprises by looking at
relevant information from outside of the company.
3. Combine business unit results with the surprise analysis to
generate an integrated total operating portfolio uncertainty.
4. Generate a corporate picture by considering other corporatelevel factors that are outside the control of the BUs, such as
corporate development initiatives, financing, and global
uncertainties such as price volatility in commodity prices.
5. Identify quality and risk mitigation initiatives that might get
built into the budget. This is a short performance improvement cycle at both the business unit and corporate level based
on the risks identified.
6. Package the final results for communication with different
constituencies. Risk can be broken down and presented by risk
factor or by business unit, enabling management to better
understand the key risks in achieving the forecast.
• Undertaking the process described to embrace uncertainty
affects an organization at the business unit level, operating
group level, and corporate level.
- Business Unit level: This level is often skeptical of corporate
initiatives and needs to be convinced based on a credible
assessment of the key drivers and verification. One of the
benefits is that the expanded budgeting process takes out some
of the drudgery by focusing all attention on the key drivers of
forecast uncertainty. Business Unit managers see the identification of the key risk variables as valuable in establishing a set
of metrics and tracking tools providing better forecast information, identifying abnormal variations, and eliminating gaming
based on one number. Also, once the key risks are identified,
good ideas may be generated about risk mitigation that can
lead to practical risk reduction initiatives.
- Operating Group level: Managers initially do not like answers
that show a high probability that they will miss their forecast.
But, once they accept the true risks in their business and face
them head on, they can focus squarely on the key drivers of
uncertainty across their group. This focus leads to greater
efficiency in the budgeting process. It also provides a set of
tools to better understand the performance of each business
© 2004 Strategic Decisions Group
www.sdg.com
Embracing Uncertainty in
Forecasts and Budgets
• Changing an organization’s culture and processes to
embrace uncertainty yields four key benefits:
1.
Better forecasts: These improved forecasts will provide
greater confidence and enable giving better guidance. Better
forecasts mean giving up an expectation of knowing a correct
number, but instead focus on understanding the true
uncertainties and their underlying drivers. The processes
used by SDG reduce assessment biases and bring correct
probabilistic accounting rules to some critical areas,
including dependencies and surprises.
2.
Better management control, dialogue, and reward systems:
This involves careful effort to understand and separate
aspects of the business that are controllable by management
in the short term from those that are not, to understand
normal and abnormal deviations, to reduce gaming, and to
provide fairer incentives through better calibration of
incentives and budgets.
3.
More value from less effort: This is an efficiency improvement resulting from using a common language for discussion
of uncertainty, focusing on the key drivers and not being
distracted by minutiae, and avoiding the illusory pursuit of
perfect certainty and the endless circle of refinement.
4. Generates important six sigma and risk management
initiatives: This goes beyond the confines of budgeting but
uses the information learned about the drivers of uncertainty
and risk to help identify initiatives that can be undertaken to
reduce risk.
Created for SDG by BullsEye Resources, Inc.
www.bullseyeresources.com
Executive eBriefing
Embracing Uncertainty in
Forecasts and Budgets
January 14, 2004
Case Study: GloPro
(a NYSE listed Global Processing Company)
-
Situation: GloPro’s budgeting and forecasting process is
typical of SDG engagements in this area. SDG was brought
in by the CEO and CFO after twice missing their forecasts,
knowing they could not do so a third time.
-
Need: GloPro needed better forecasting and greater
confidence in providing external guidance, and to do so,
needed to better understand its risks.
-
Organization: Six business units (BUs), a corporate
development group (M&A), and a risk management function.
-
Culture: GloPro had a hard-nosed budgeting culture that
used point estimates.
-
SDG Recommendations: Augment the existing budget
process by conducting individual risk assessments at the
business unit level and integrating this analysis at the
corporate level. The process included consideration of
additional corporate risk factors such as surprises.
-
Business Unit Assessments: The BU assessments followed
the steps defined above. For the BU discussed in the case
study, the tornado analysis identified that 95% of the budget
variance was related to six budget variables. The profit
forecast using the probabilistic model was significantly lower
than the original forecast; in fact, the probabilistic model
showed that there was a 75% chance that the business unit
would fall short of its original budget.
© 2004 Strategic Decisions Group
www.sdg.com
-
Corporate Integration: When the business unit results were
combined at the corporate level, the probabilistic model
showed that the entire company had about a 70% chance of
missing its forecast. Additionally, when surprises and other
corporate risks were factored in, the likelihood of the
company missing its budget rose to 82%.
-
Leadership Reaction: While BU and group management
initially found this data difficult to accept, the credibility of
the analysis converted them. They realized that the new
budgeting process focused on the key risk drivers, was a
more efficient process, and was harder to game. A set of
metrics and tracking tools was developed and used to
monitor the key risk areas, with attention devoted to
abnormal variations.
-
Actions taken: GloPro used the output of this process to:
1.
Create a new baseline with the Board.
2.
Communicate new guidance to the Street, which was a
difficult process because analysts were expecting higher
results than the new process indicated were likely, and
expectations had to be managed downwards. GloPro
choose to provide the Street with a range that would
miss the estimate only once every five years.
3.
Pursue specific initiatives to reduce risk.
4.
Redefine the components of incentive compensation
including thresholds and “stretch” objectives so that
stretch targets could be achieved one out of three years.
5.
Help the finance group plan for future cash needs.
Created for SDG by BullsEye Resources, Inc.
www.bullseyeresources.com
Executive eBriefing
January 14, 2004
Embracing Uncertainty in
Forecasts and Budgets
Biographies
Carl Spetzler
Chairman
Specializing in strategy development, business innovation, and strategic change management, Dr. Spetzler has developed
creative business strategies for major financial institutions, capital-intensive companies, high-technology manufacturers, and
systems businesses. Over the past 15 years, he has been a leader in designing an innovative strategy development process
that helps corporate leaders cope with the lack of explicit strategic alternatives, deal with the complexities of uncertainty and
risk over long time horizons, and achieve lasting change. In addition to serving as the chairman of the board for SDG, Dr.
Spetzler leads strategy assignments to redirect and restructure major US corporations and to create revolutionary new
products and strategic alliances. Before founding SDG, he was the director of the Financial Industries and Strategic
Methodologies Center at SRI International. He received an MBA and a PhD in economics and business administration and a
BS in chemical engineering from the Illinois Institute of Technology.
Adrian Lall
Partner
Dr. Lall has over 15 years of experience in leading corporate strategy and new product initiatives across a broad range of
industries including telecommunications, pharmaceuticals, biotechnology, consumer goods, financial services, and resources.
He has helped senior management teams address major challenges in portfolio management, competitive strategy, R&D
optimization, eBusiness, risk management and achieving growth objectives. Dr. Lall has previously worked for Bain & Co.,
Unisys, and a start-up company providing a capital financing solution to Fortune 1000 companies. He has spoken at many
public events and has published articles on new product development and risk management. Dr. Lall received a PhD in
Economics from the University of Auckland. His thesis examines decision making under uncertainty in new product
development. He also holds an MS in engineering-economic systems from Stanford University.
Jim Lang (Moderator)
Chief Operating Officer
Mr. Lang, a founder of SDG's Boston and Houston offices, specializes in strategy development, capital investment decisionmaking, and organizational capability development. He has worked in a variety of industries worldwide, including energy,
telecommunications, high technology, defense, finance, and automotive. His value-creating work over the past few years has
led to new investments by his clients in excess of US $20 billion. Mr. Lang has also conducted hundreds of seminars in
strategy development, decision quality, and R&D in Europe, Asia, and North America. Before joining SDG, Mr. Lang held
planning and engineering positions at Analog Devices, Data General Corporation, and AT&T. He received an MBA from the
Amos Tuck School of Business Administration at Dartmouth College and a BS in electrical and computer engineering at the
University of New Hampshire.
THE INFORMATION CONTAINED IN THIS SUMMARY REFLECTS BULLSEYE RESOURCES’ SUBJECTIVE CONDENSED PARAPHRASE OF THE APPLICABLE EXECUTIVE
EBRIEFING. THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE SESSION. IN NO WAY DOES
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© 2004 Strategic Decisions Group
www.sdg.com
Created for SDG by BullsEye Resources, Inc.
www.bullseyeresources.com