When is Driver-Based Modeling Applicable?

Nov 23, 2015

Nilly Essaides, Director & Practice Lead, Financial Planning & Analysis, AFP

More companies are looking to put science in their forecasting and planning processes. To this end, they’re basing more and more of their forecasting models on key business drivers – those factors that can really move the needle and affect enterprise performance.

“Driver-based modeling and planning use operational drivers to predict financial results,” said Philip Peck, Vice President, Financial Transformation at consulting firm Peloton Group.

These models are essentially equations that represent mathematical relationship between key operational drivers (e.g. volume, rates, conversion ratios, brand awareness, etc.) and anticipated financial outcomes.

The driver-based models have several key advantages: they’re more accurate, more efficient, can be run on the fly and enable FP&A to come up with actionable information more quickly, at a time when senior management is facing an increasingly complex and uncertain business environment. They also help balance the inherent bias managers have in producing forecasting data -- a combination of human error, politics and over-optimism. Of course, to do this they have to be correct.

When does it work?
According to Mitch Max, CEO and President of BetterVu, forecasting is one of the first areas where driver-based models can be applied. “As a basic example, if I’m forecasting a product or series of products, and have a price, the driver is typically volume; it’s a simple metric calculation of rate X volume. It’s applicable in many volume-sensitive calculations. But it can also be used for non-volume-sensitive items, for example, you can apply a driver-based calculation to payroll and multiply by average salary,” Max said.

“What’s important is the level of detail. Even drivers have different levels of detail,” said Sholape Kolawole, EPM Transformation Associate Principle at The Hackett Group. The level of detail should be aligned with the applicability to each planning cycle. For example, a quick monthly forecast or the strategic plan would call for a less detailed driver approach.

According to Vic Datta, CEO of Resilicore: “The models enable the company to move away from allocation-based budgeting to a more anticipatory approach, with an “activity-based” costing approach as the precursor. “Driver-based models are outcome based, rather than the more traditional inward-looking models,” Datta explained.

But driver-based models may not work everywhere.

Craig Schiff, Owner of consultancy BPM Partners Schiff said that he thinks driver-based modeling is very applicable in the forecasting and long-range planning processes in FP&A but less so in the detailed budgeting process. “When you look at budgeting it’s not ideal,” he noted. “The budget includes a very detailed expenses and revenue lines for the year,” he said, “whereas driver-based models are better suited to higher-level, quicker and more frequent forecast and planning processes.” Budgeting often involves mapping expenses by area, by month. A true driver-based model won’t produce these results.

Another area where driver-based models don't work is in fixed costs, for example rent, or charitable donations.

In addition, according to Curtis Gratz, Director at Huron Consulting Group, driver-based modeling is not applicable where there are only very loose relationships between drivers and outputs, or if these items are not material or actionable.