Walgreen Co. responded to a defamation suit filed by former Chief Financial Officer Wade Miquelon, asserting he was responsible for the company’s forecasting process and the ensuing $1 billion forecasting mistake that led to his departure. According to a Wall Street Journal article, Walgreen lawyers claimed Miquelon’s forecasts were often overly optimistic and he resisted revisiting them.
Walgreen’s claims point to what appears to be a breakdown in the pharmacy chain’s forecasting process, and one of the most typical problems with traditional forecasting. Forecasts are made on a quarterly basis and are not updated to changing monthly conditions. Those changes that are made often are through a less-than-scientific process. Managers have incentives to game the system and the assumptions are not tested for risk and updated as conditions warrant.
There are ways companies can future-proof their forecasts, not only by switching to rolling forecasts that adjust to changes in market assumptions, but also by risk-adjusting their forecasts to events that may affect the outcome. The result is a range of probable outcomes that give management the chance to come up with a more agile response and prepare a playbook to adjust to changing conditions quickly.
According to Ken Hooper, director-advisor at PwC, a risk-adjusted forecast incorporates a range of assumptions and forecast outputs to provide a greater understanding of risk factors and potential mitigating strategies. While most companies have not yet adopted such sophisticated models, many have adopted some form of adjustment for multiple scenarios.
Changing to a risk-adjusted forecast is not easy so it’s best to start with a single business unit or a capex project that act as proof of concept and build capability overtime.
Keep in mind the following:
- Describe each risk from a probability and an impact perspective.
- Avoid trying to incorporate too many different risks. After the first 10 or 15, the marginal benefit of adding more is reduced.
- Put these 10-15 relationships into a simulation model to derive some cash flow or earnings distributions and start looking at a couple of different aspects—the base plan and the risk-adjusted plan.
- Ask the right questions: How realistic is the resulting budget? What are the key downside drivers?
- What would be the impact on the balance sheet if the company experiences a worst-case scenario?