by Robert D. Kugel CFA |
7/25/2008 | Article ID: V08-29 | Article Type: VentanaView
Summary
A good deal of budgeting is based on naïve extrapolation (the expression on Wall Street is “the trend is your friend”). As a quick and dirty method, it can be an accurate predictor of the future – until it isn’t. There has been extreme volatility in most commodity and currency markets over the past 18 months. Managing any company that has significant exposure (direct or indirect) to these costs has been a challenge, especially when it comes to budgeting and planning. Ventana Research finds that most companies fall short of their potential when it comes to handling their forward-looking activities. Chief among these is planning and budgeting, since the annual budget is essentially a static document that organizations work around to accommodate change. The current volatile environment demonstrates the value of driver-based planning and, especially for companies with multiple lines of manufactured product, the need to integrate planning across these business lines. The goal in doing this integration is being able to assess the impact of the inevitable trade-offs in order to ensure these decisions are optimized for the entire company.
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Two important reasons for planning are optimization and anticipation. Organizations make an effort to look ahead in order to maximize something: profits, revenue, market share or another important factor. They also look ahead to anticipate what to do when results turn out differently than assumed. During periods of slight price volatility, naïve extrapolation usually works as well as any other planning approach for relatively simple businesses. It is attractive because small, incremental changes almost never require managers to rethink the assumptions they build into their business models or force executives to re-examine basic trade-offs they have made in structuring operations. Small shifts in input costs may cause them to change recipes or adjust production runs, but they are unlikely to have a significant enough impact to justify major changes (such as where to source production or whether to offer a product). However, when basic input prices change significantly, it becomes necessary to do fundamental rethinking and rebalancing of the business. This is especially true when cost swings affect product prices and therefore impact customer demand.
An obvious example of a major change is the recent decision by some United States airlines to idle aircraft and cut capacity, despite record demand, because of the spike in the price of fuel. Since the price swing has been so extreme and their business model is relatively simple, this is a straightforward case. Yet businesses often can benefit from understanding the implications of a broader, more complete set of trade-offs even when prices change by, say, 10 to 20 percent.
Our benchmark research has repeatedly identified major shortcomings in companies’ forward-looking processes such as financial planning and budgeting, sales and operations planning (S&OP), and sales forecasting and demand planning. One of the biggest issues is that most of the planning that businesses do is based on isolated silos of information. Only half of companies in North America do any sort of sales and operations planning, an effort that expressly integrates customer-facing intelligence with the outlook and preparation for production, logistics and other elements of business execution. Moreover, even when companies do have an S&OP process in place, most fail to include the input from people in key roles in the process.
While a lack of coordination does not necessarily mean that an organization’s actions are disjointed, our research shows it does reduce effectiveness and profitability. Silo-based planning efforts also lead to decision-making “inside the box.” Business units typically base decisions on what’s best for them, at best on the theory that this is also what’s best for the corporation. Yet this is not necessarily true, especially in the wake of major changes in market prices. For example, Product X made in Plant 3 may be profitable, but after a 20 percent swing in the price of a key input, it may make sense to shut down production of X in this plant, switch the capacity to making Product Y and shift X to another location.
This example points to a second major issue. Often, process options spanning multiple business units are not pursued because companies fail to do operational planning that expressly considers the full financial implications of a given plan. Or they base optimization on financial models that have become obsolete because of price volatility.
A third major planning issue is the reverse: The budget is too much focused on the financial numbers and is largely divorced from the operational view. We believe a driver-based planning and budgeting process is the best practice here because it explicitly links resources and activities to their financial impacts. Driver-based planning and budgeting is superior to financial budgeting in periods of volatility because it makes it possible to replan and rebudget in a detailed fashion during periods of price volatility.
Assessment
The recent increase in price volatility caused many companies’ annual budgets to become irrelevant sooner than had been the case in previous years. We suspect most senior managements are wishing they had a way of dealing with wide price swings in a way that would enable them to replan and rebudget faster and more accurately. Improving the forward-looking activities of a company almost always requires addressing a combination of issues related to people, processes, information and technology. Because of the need for cross-functional integration, these efforts must have senior executive sponsorship and be tied to appropriate incentives. Processes themselves – both the planning and the execution elements – must be altered. Information needed for planning, decision-making and review cycles must be collected and made readily available to those who need it. The right software is a critical component of driving and supporting change. But many companies rely on desktop spreadsheets, which are poorly suited to any collaborative enterprise planning efforts. Companies need dedicated applications to manage the process and appropriate data storage methods to ensure the right information is available on a timely basis. Moreover, to the extent that companies strive to optimize their plans, they need the right software to support these efforts. Here again, it is important to have an application designed to optimize enterprise decisions for the enterprise, not its individual business units.
Related Research Notes
Integrate Sales Forecasting and Demand Planning
Together, the Two Can Improve Performance
Sales Forecasting Remains A Challenge
Lack of sales and demand forecasts holds back good revenue planning
Upgrading Technology to Tackle S&OP
Innovative companies use more than dedicated software to support sales and operations planning
Supply Chain Performance Management Research Agenda for 2008
Focus Is on Planning, Outsourcing, Performance Measurement and Information Management
Benchmark Research Finds Companies Struggling with Product Information
Help available from product information management processes and technology
Supply Chain BI Struggles To Realize Full Potential
Multiple source systems create problems for business intelligence about the supply chain
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