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The Power of What If: Why Predictive Modeling is a Business Necessity

  Article published in DM Direct Newsletter
February 28, 2003 Issue
 
  By Anthony L. Politano

One of the most challenging tasks for parents is planning for and funding a college education for their children. What were considered normal college costs even ten years ago cannot even be considered a low estimate today. Assuming that parents have some foresight and start saving at an early age, they need to make some key assumptions based on future scenarios. What if college costs double every seven years? What if levels of available financial aid do not change as the mean family income does? What if we pick a private college as opposed to a public one? What if the child chooses commuting rather than on- campus housing? Answers to each of these what-if questions will likely yield a different savings strategy.

Surprising enough, most organizations do not factor even this relatively rudimentary level of  "what if" into their budgeting and planning process. Imagine trying to save for college costs based on the assumption that the current cost of living and costs for college will not change.

The Current State of Budgeting and Planning

Many organizations have a strategic plan in the form of mission statements and goals. Usually, quite lofty, such as relentless pursuit of customer satisfaction or market leadership, these strategic plans many times do not reach the level of tactical implementation. When it comes time for the tactical plan, most organizations still rely on the annual budgeting and planning cycle. This process, which in some larger organizations can take up to six months, usually plans on a twelve-month time horizon. Organizations will start budgeting and planning for the following year in the third or fourth quarter and will use this budget to guide their expenditures and expectations throughout the next year.

This process, even in medium- size organizations, is typically one of the most bureaucratic activities of the year. Oftentimes, whole departments will be dedicated to the budget and nothing but the budget for months. Forward-reaching projects are put on hold to complete budgets, endless meetings are scheduled, e-mails are circulated to large distribution groups. During this process, many cost center managers are very concerned with protecting their individual budgets. So, although there is considerable time expended on this budgeting and planning process, much of it is not directed toward achieving the end result.

The centralized finance organization, ultimately responsible for the budget to the CFO, faces other collaboration issues. With the trend toward globalization, there are increased challenges with geographies and time zone differences. The managers who provide the data may be spread throughout the globe. Anyone who has done business where international collaboration and communication are required in real-time, fully understand the challenge of having very early morning or very late evening meetings and conference calls.

Many organizations also face increased technical challenges. Most budgeting systems are built on spreadsheet technology and have grown more complex as the years have passed. What began as a simple spreadsheet may have turned into a set of 50 sheets with intra- and inter-sheet links. Often, the origin of the sheets and the associated formulas may not be known. Organizations stay with this process as creatures of habit. Another technical challenge is the existence of multiple technical platforms. Many times, companies will have one division using a particular platform for their financial systems, while another division may be using a second platform that is incompatible.

In the current budgeting and planning process, there is also a significant amount of effort spent on correcting quality problems in the data. For example, a cost center may have used one formula to determine gross profit, while the corporate organization uses another. The central finance organization is now forced to change the data, many times causing reentry of data. This reentry is also susceptible to errors, as is any data entry process. Improperly entered data may not even be detected until all the spreadsheets are consolidated. By then, it may be too late to recollect the original figures from the cost centers and a best guess may have to be used.

Due to this bureaucratic process and the vast amount of manual data entry and rework, many organizations have little or no time to concentrate on anything more than a twelve-month planning horizon. Focusing beyond the next year would require even more data entry and consolidation and risk not having the budget completed on time. The main focus is on getting the figures and making sure they balance.

Moving to the What If

Similar to the college planning exercise, organizations need to take advantage of the power of what if. If the budgeting cycle can be streamlined, more time can be spent on performing what-if analysis. This enables organizations to model possible outcomes based on major, or even minor changes, and understand the ultimate possible impact on the business. Organizations are able to understand the impact of something as major as adding or closing a plant to minor adjustments such as changing list price on one product. Although the latter may seem quite minor in the large scheme, ultimate impacts could be extensive.

When evaluating what-if scenarios, changes are magnified by time and quantity. Using the parents saving for college as a real example: if the parents are planning on an average annual return of five percent and have planned this for the next 10 years, but the return averages to three percent the end result could be funding difference between Ivy League and State U.

When examining major changes in organizations, impacts may actually be easier to understand, since there is usually some known cause-and-effect pattern. Closing plants will usually result in cost savings. Introducing new products will usually create revenue but will also incur new marketing or research costs.

Understanding the minor changes and their ultimate impact often proves more difficult. Assume that a company has 1,000 distinct products or SKUs and they are sold through 25 different sales offices. Next assume the product manager of one of the SKUs decides to decrease the list price by one percent along with a host of other pricing changes. What the product manager may not know is that particular SKU is responsible for 60 percent of the sales for the two most profitable sales offices. Instead of a minor product pricing change, major impacts will be seen in the bottom line. The impact of this change may not be noticed until it is too late and the profits from the two sales offices have dwindled. It is this combination of the time and quantity, which have turned the minor change into a major business impact.

The Scenario-Based Planning Environment

To address the problem of minor adjustments becoming major business impacts through time and quantity, organizations must embrace a scenario-based planning environment (SBPE). In the SBPE, impacts of minor changes are seen before actual capital or resources are expended. SBPE dictates that modeling and understanding the impact can be done without having to commit business resources and money. Through a model-based environment, iterations of changes can be tested and their impact can be seen immediately. Organizations can avoid costly entrances into new business models that may ultimately fail.

In a SBPE, more effort is spent in modeling and understanding the impact, instead using the majority of effort in creating a single budget through gathered information. There are four enablers of SBPE: change adaptable environment, metrics-based decision making, collaboration and technology.

First, and foremost, is that an organization must be change adaptable. If upper management will not accept any change to their process, any changes will fail. Upper management must be open to changing such core processes as budgeting and planning. Many times this is not an issue. Pose the question, "What do you think of your budgeting process?" to many organizations and the answers will range from a rolling of eyes to "adequate." It is very rare for an organization to brag that they have the best budget process. Management recognizes that there is usually room for improvement.

Organizations that use metrics-based decision making embrace measurements, historical data and metrics for supporting decisions. This is the second enabler of SBPE. They have evolved beyond making business decisions based on hunches. They also realize that if there are metrics and measurements for past decisions, the organization can use this information to support better, more informed decisions. Metrics-based decision making many times does not require sophisticated and overburdened information systems. In many cases, information can be delivered through familiar interfaces such as spreadsheets.

Metrics must reach well beyond the traditional top-line measurements, such as aggregated gross revenue or earnings per share. The metrics required for supporting decisions must be available at mid and high levels of detail. For example, profit contribution can be measured at a product- line or cost-center level.

The third enabler of SBPE is collaboration. Collaboration is a term often misused by technologists. Webster Collegiate dictionary defines collaboration as: to work jointly with others or together especially in an intellectual endeavor. Although technology can be an enabler of collaboration, technology should not be a driver of collaboration. The SBPE organization will understand and leverage the process of collaboration and pick the appropriate technologies to support the process. If the organization needs to perform scenario-based planning across disparate geographic regions, they may opt for more Web-based collaborative environment. If all people are located centrally, the introduction of Web-based collaboration may be overkill. Instead, the organization could implement a centralized shared budget application and use the local area network (LAN) for enabling the collaboration.

Collaboration enables organizations to take advantage of a SBPE in real time. As product managers are forecasting at brand or product levels, the cost center managers are evaluating and adjusting the impact on the bottom line. Without collaboration, there would be delays in understanding impact and there would also be increased manual coordination between different departments.

The fourth enabler is technology. As previously described, different drivers, such as geography and organization design, will help guide the type of technology used. The most important factor in technology is the ability to support both centralized and decentralized processes within one environment. If the technology requires managers to enter data in one system for products and another for costs, the manual process will lead to lost productivity and increased errors.

The technical platform should also be based on existing or emerging standards. This will guard against proprietary obsolescence. By making investment in standards-based technologies, an organization will extend the longevity of the systems and increase the overall return on investment.

The technical platform should also provide built-in functionality that is common to modeling and planning scenarios. Functions that relate to financial modeling, allocation, time-series analysis and exception reporting should be included since these are common functions regardless of industry or sector. Organizations may use the built-in functionality in unique combinations and iterations, but the basic functions that form the building blocks remain common.

Becoming an SBPE Organization

There is a three-phase methodology for organization to follow to become an SBPE organization. The trio of phases - model the as-is process, model the to-be process and implement the technical environment - must be performed in sequence.

Model the As-Is Process

The current state of business process must be understood and analyzed. This will provide a starting point for moving forward. More important, understanding the current state will point out shortcomings in the current process.

An organization must be able to understand and model how they are currently performing planning. Most likely, this involves multiple departments and groups. In modeling the as is, an organization will need to understand the data that is used, how that data is shared, when decision points are reach and what is the conflict resolution strategy.

Data Selection. Selecting the data to use is the cornerstone of the current process. The granularity, or detailed level, of the data is important. The further the level of detail, the greater the possibility for performing more detailed planning. Besides granularity, the functional applicability of the data is also important. With functional applicability, data is examined for the number of business functions, such as marketing, research, sales, represented in this data. In many organizations, each function has its own data points, which can hinder creation of true business scenarios. Organizations must pay particular attention to the adaptability of the data points to other parts of the organization.

This sharing of the data across functions is a result of both organization design and technical considerations. Many organizations have unknowingly built up islands of responsibility within their own organization, with little or no view toward a holistic view of the data. In addition, many older technologies prescribe to proprietary formats and storage mechanisms. Even if the organization was redesigned to promote sharing, there may still be a technical undertaking.

Decision Points. As this data flows throughout an organization, the decision points need to be modeled. Ultimately, the planning process is a chain of decision points with expanding realm of control for each decision. The current process may have departmental managers preparing plans and then passing this on to divisional management. Once divisional management has agreed and passed the plan on to the central finance organization, the control of the decision is out of the realm of the departmental manager. Understanding and modeling this decision tree is key to understanding the as-is process.

Conflict Resolution. Just as important, though, is the conflict resolution strategy. As the centralized organization is consolidating plans from each division, there will be adjustments. Funds may have to be moved from R&D; to sales or from one product line to another. This may ultimately create an internal conflict. It is key for an organization to understand and document the conflict resolution strategy for plans.

Model the To-Be Process

Not every organization will have the same desired SBPE process. There are a number of factors that will impact their choice of to-be including: industry velocity of change, technical adaptability and management span of control.

Velocity of Change. Velocity of change is defined as the speed at which business models must adjust to changing business environments. Depending on the specific industry, velocity of change can be quite different. Generally, there is a relationship between dependence on technology and velocity of change. The more an industry is dependent on newer technology, the higher the velocity of change. For example, the biotech industry revolves around introduction of new technologies and has a high velocity of change - changes happen very often and very quickly. The real estate industry uses technology but is generally not very dependent on newer technologies to remain viable. Thus, the velocity of change is low - changes do not happen very often and not very quickly.

In modeling the to-be SBPE process, understanding the impact of velocity of change will impact the overall process. In high velocity of change environments, organizations must design a SBPE process that enables on-the-fly modeling with an emphasis on quick turnaround of scenarios. The SBPE process must enable rapid modeling of what-if upon what-if scenarios. This may mean that less detailed data is used in the interest of timeliness of creating scenarios. It also may mean a more centralized control of the planning process, in the interest of speeding up the on-the-fly modeling capabilities.

Lower velocity of change industries, will have the ability to create more thorough and detailed what-if models. Also, because the technology is changing at a slower pace for this industry, a fewer number of iterations of the what-if scenarios may be required.

Understanding and using the velocity of change is key in modeling the to-be process.

Technical Adaptability. Technical adaptability applies to the organization's ability to absorb and assimilate to new technologies in the planning process. If the organization is using the same circa-1990 mainframe programs for planning and have not embraced newer technologies without great resistance, they will have a lower technical adaptability. Organizations, though, which have implemented newer technologies, such as databases and intranets, without negative business or productivity impact, have a much higher technical adaptability. Technical adaptability must be understood and built in the new SBPE process.

Management Span of Control. The to-be SBPE process must fit within the management span of control. If a single division of a company plans to implement a SBPE process, it is not realistic to expect other division to also automatically adopt SBPE. Management must recognize this in building the to-be SBPE process. The process can take into account, but should not expect to change, processes outside the span of control of management. This is also true for business partners and vendors. If an organization is dependent on data from business partners to create business scenarios, they may request this data from their partners. There should, though, be realistic expectations of what requests will be honored. Many times, business partners do not have the level of detail or requested timeliness of data required for the optimal SBPE process.

Each of these factors: velocity of change, technical adaptability and management span of control will contribute to the design of the to-be SBPE process.

Implement the Technical Environment

With an understanding of the as-is process and modeled to-be process, the proper technology must be implemented to support the transition to the new process. This technology must be able to support the level of detailed data, turnaround time for scenarios and online collaboration.

Different systems allow varying levels of detail in the data that can be captured and managed. One of the shortcomings of many traditional budgeting computer systems is that they can not support both the low level detail, such as SKU, project or cost level and highly aggregated data, such as division or legal entity, in the same computer application. Key technology platform selection criteria for organizations moving to SBPE must be the ability of to support detailed and aggregated data in the same application.

With this level of detail, the computer system must also have the ability to provide acceptable turnaround time for scenarios. In a rapidly moving environment, it is often unacceptable to wait for overnight processing to evaluate new scenarios. Many times, on-the-fly, real-time scenario generation and evaluation are required. This can often be difficult for many monolithic systems that were not designed for quick turnaround.

The fast turnaround of detailed and aggregated data, should not sacrifice the advantages of online collaboration. Although spreadsheets can provide much of the detailed data in a timely fashion, collaboration is limited to sharing or e-mailing files. An optimal technical environment would combine the speed and ease of use of spreadsheets with an industrial strength database integrated with the spreadsheets for sharing and collaboration.

These three criteria, data detail, quick turnaround time and online collaboration are the building blocks for selecting an implementing the technical environment to support the SBPE.

SBPE offers significant advances in the way organizations perform planning and budgeting. By moving from the "what happened" to the "what-if" mind-set, organizations can take advantage of their existing planning process while better preparing for future business changes. They can also take advantage of the velocity of change. SBPE requires an up- front understanding of the current process, the to-be process and the technology to enable the new environment. Following a process-centric approach in order to drive the new technical environment will allow organizations to build new planning process which, in turn, can enable greater competitive advantage.

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For more information on related topics visit the following related portals...
Data Analysis and Data Modeling.

Anthony L. Politano is chief executive officer of MIS AG’s United States division. His expertise includes more than 14 years in the IT industry, specializing in delivering business intelligence, data warehousing, and large-scale application development solutions. He can be reached at tony@politano.com.

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