Wayne SlaterWhen I was young, my father always used to remind me to look forward and plan for a rainy day. Like when I bought my first car, I planned to make sure I would be able to cover my car loan and insurance payments. However, Dad was saying, you’ve planned for the things you know will happen, but life isn’t like a weather forecast, so you need to plan and be ready or the things you can’t control like car repairs, insurance deductibles and more. As life would illustrate continually after that, there really isn’t that much in life that is predictable, but if you can plan for it and are able to make necessary adjustments along the way, things would be just fine. I remember making rudimentary budgets on my old trusty Apple II computer, then I would make adjustments as my bills changed, or my income fluctuated, but this resulted in a plan to save and plan for the future – was I forecasting?
Fast forward a few years, well a lot of years, and I now work at Prophix and guess what, we specialize in helping organizations streamline their budgeting, planning, and forecasting. In business, when it comes to business planning, budgeting and forecasting are the primary means to an end. Budgets are a key management tool for setting baseline annual expectations against strategic goals and anticipated demand. But many finance professionals argue that the budgeting process is time-consuming, rigid, and prone to obsoletion.
Sure, budgets are important because they help businesses map out where they want to be in the future, but this can be an idealistic practice. For example, can sales really boost product A revenue by 50%? To help validate this assumption and bring us back to reality – enter forecasting.
Why Forecasting?
Forecasting allows you to account for variables that affect your goals and profits and that change over time. Forecasting serves as a reality check that aligns budgets with actuals. If things aren’t panning out the way they should, then forecasting helps management to realign by taking immediate action.
Forecasting becomes especially important during uncertain times. The more frequently you can do it, the easier it is to adapt, be agile, and make better decisions. Most of us can agree that forecasting adds tremendous value to the business.
However, the challenge for many finance departments is that forecasting usually adds more work to an already heavy workload. But this is important to point out because forecasting does require a degree of process discipline – a discipline that scales with the type of forecasting technique you employ. Next, let’s discuss the different types of forecasting methods that exist.
Types of Forecasting
When it comes to financial forecasting, there are three main types: qualitative, quantitative, and causal1; and they are all important to consider.
Qualitative
Qualitative forecasting is more judgmental is nature. When I was in school, we were reminded time and time again to make decisions based on evidence, but that’s not always possible. For example, no amount of historical data could project the current pandemic.
While your data may not indicate the best way forward, your intuition might. However, it’s important to be aware of any personal biases. Use this type of forecasting when data is limited by expanding market research, and you plan to involve cross-functional leaders and experts in the planning process. But, as always, you should create multiple scenarios to consider the problem from all angles and to capture overarching potential realities.
Quantitative
Quantitative forecasting is, as the name suggests, a numbers-driven approach where you can leverage past data to find trends. You can use data analytics tools to find patterns like seasonality and translate this into evidence-based decisions and projections for the future. This approach is more bias conscious but relies solely on having good data that spans multiple years. Then, you can combine your data with your adept judgment to map out the future.
This type of forecasting can be further broken down into two main categories – traditional and dynamic. Traditional forecasting is your 3 + 9, 6 + 6, or 9 + 3, where the first number represents the number of actual months on hand, and the latter represents your planned periods. So, a 3 + 9 traditional forecast has three months of actuals and nine months of plan data. It’s traditional because this sort of forecasting is usually done every quarter. Assuming four quarters, you should be forecasting three times over the course of your fiscal year. Traditional forecasts are often tied closely to budgets. This means that there is a short-term emphasis on the planning horizon, such that quarterly or year-end objectives are a higher priority than long-term goals.2
To combat some of the challenges with traditional forecasts, many companies have adopted a more dynamic form of forecasting – rolling forecasts. Rolling forecasts are a way for FP&A professionals to continuously and dynamically plan for a certain number of future periods. These forecasts are agile in nature because they force the business to always forecast X number of months or Y number of quarters into the future.
For example, a monthly rolling forecasting could follow a 1 + 12, 2 + 12, or 6 + 12 format. So, as you close a period, you add another period to your forecast. In contrast to traditional forecasting, there’s no “end date” to rolling forecasts, which gives companies a better long-term outlook. Rolling forecasts are more accurate than traditional forecasts since you’re constantly tweaking projections along the way. They’re also more agile because they let you capture trends faster, as you can update your outlook with real-time data on new drivers, changes, and patterns.
However, it’s important to keep in mind that if you don’t have the right tools, such as CPM software, you could end up creating a lot more work for your employees. Finance can no longer rely on slow and error-prone spreadsheets in today’s fast-moving globalized business world.
Causal
The last type of forecasting is the causal method, also referred to as cause and effect forecasting. This is the most elaborate type of forecasting since it’s very mathematical in nature. Causal forecasting is regression-based and statistically derived – your forecast is a function of multiple variables and constants. Imagine you not only have a plethora of data on hand, but you also have deep analysis behind the numbers. For example, data on consumers, suppliers, products, and interest rates, such that you could measure the cause and effect behind independent and dependent variables. This would allow you to model supply and demand predictions at a detailed, numerical level. One use case for causal forecasting is if you wanted to see the impact on sales from a short-term promotion and use these insights in your planning process.3 Causal forecasting is not often used in business environments because it requires a lot of resources and maintenance.3
Conclusion
I guess in the end; Dad was right when he said, “There really isn’t that much in life that is predictable, but if you can plan for it and are able to make necessary adjustments along the way, things would be just fine.” As we know, business is just as unpredictable as life. So, if you’re facing increasing risks and having trouble making decisions, it might be time to consider the benefits of forecasting.
Regardless of the type of forecasting you use, you can leverage the insights to validate if you’re on the right trajectory and adjust your decisions accordingly. Forecasting helps mitigate risk and uncertainty when combined with scenario planning.
Forecasting can also serve as a feedback loop that allows you to incorporate new data into your agile planning process. I would recommend a combination of quantitative and qualitative forecasting because data is paramount, and judgment comes from experience and leadership.
Planning is iterative in nature and technology like Prophix’s Corporate Performance Management (CPM) software can help manage these repetitive tasks by automating key processes. Quickly get information, consolidate up to a plan, and determine drivers in an environment that is secure and convenient, giving you time to focus on strategic initiatives.
1 – https://hbr.org/1971/07/how-to-choose-the-right-forecasting-technique
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