Good forecasting is more science than art*

Relatively few firms know how to make accurate projections. How do the best differ from the rest?

By Stephen Spooner

*This is an expanded version of a summary that originally appeared in the April 2008 issue of CAmagazine.

Shareholders, boards of directors and other stakeholders are paying more attention than ever to financial results of public companies. Firms can no longer shrug off a bad forecast by deeming the process to be more of an art than a science.

Nevertheless, many firms significantly miss their forecasts, according to a recent global study conducted by the Economist Intelligence Unit on behalf of KMPG International. KPMG’s recently released report, Forecasting with Confidence: Insights from Leading Finance Functions, says the firms of only 22% of 544 participating senior executives came within 5% of their forecast figures over each of the past three years.

The study found the respondents –59% of whom represented organizations with more than US$1 billion in annual revenue – missed their targets by an average of 13% over three years. The participating executives (30% of whom are chief financial officers) estimated that negative investor reaction subsequently reduced their overall share price by 6%. Participating firms that came within 5% of their target saw their share prices increase by an average of 46% over that three year period, compared to only 34% by other participants.

To improve their accuracy with forecasting, the study says participants should consider implementing the practices that the more successful respondent firms illustrated.

What do these firms do differently?

First, to make the process more of a science than an art, the best forecasters get the basics right. This is akin to laying a solid foundation before construction. Without such a base it is virtually impossible to build on top of it. The good forecasters then enhance the quality of the forecast, confident in the underlying data and the people who produced it.

The more successful firms rely on a wide range of internal sources within the firm, including operational managers closest to where the business is taking place, in order to get numbers that are as reliable, timely and relevant as possible. They obtain input from independent external sources, such as market reports and competitive data.

Acquiring input from a wide range of internal and external sources increases the chances of attaining a more secure foundation of accurate information upon which to plan with confidence.

Successful firms also seem to take forecasting more seriously than those whose numbers are further off the mark. They demonstrate this by holding managers more accountable for the forecasts produced, providing more incentives for managers to forecast accurately and making greater use of such forecasts for ongoing performance management.

An important theme emerging from such practices is, therefore, the importance for financial professionals to get other senior officials from across the firm interested in and actively engaged in the forecasting exercise. Accurate forecasts depend on generating the best available numbers, of course; but strong people management skills are a necessary element of securing those figures. The finance department’s job is to use its professional expertise to turn that information into cogent reports upon which stakeholders can rely.

In the more successful firms, senior management doesn’t just produce an initial set of numbers and set them in stone. It engages in a greater degree of scenario planning and sensitivity analysis to validate its forecasts. Senior managers are not afraid to test different underlying assumptions to determine which scenarios are most accurate and realistic, or make adjustments as necessary to improve accuracy.

That’s important because in a fast-paced global business environment, data must be both accurate and timely for decision-makers to respond quickly to events, take advantage of opportunities and manage risk. It is not sufficient to rely on figures that are accurate today when they may be outdated tomorrow.

Successful firms also use advanced accounting software to produce forecast data (unlike a significant 40% of study participants who continue to rely solely on spreadsheets, which can be a time-consuming and higher-risk process).

Clearly, to be successful at forecasting companies need to establish a solid foundation by treating forecasting as a science, not an art. By understanding and implementing the practices of the best forecasters around the world, CFOs can enhance their own company’s forecasting – and reap the same benefits.

This report follows two recent studies by KPMG. The first, Striking the Balance, a Canadian study, assessed what CEOs wanted and needed from their finance operations. It was published in July 2006. The second study, Being the Best: Insights from Leading Finance Functions, published in December 2006, was conducted globally. One of its key findings was the importance of the forecasting function to CFOs. For an article on this second study, visit www.camagazine.com/financefunction07.

To download a copy of Forecasting with Confidence: Insights from Leading Finance Functions, go to www.kpmg.ca/forecasting.

Stephen Spooner is a partner and western practice leader, operations improvement, for KPMG Advisory Services. He is based in Calgary