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It’s time to think about the business forecasting process in a new way. If you believe that forecasts deal with the future, and in particular, the future expectations of people, then forecasting is not a mathematical process; it is a matter of humanities.
Those aspects have to be carefully considered in shaping the forecasting processes. Additionally, there are three key elements to put in place.
- Transparency: Forecast results and expectations (business objectives) have to be communicated to the organization and to all stakeholders.
- Ownership of the forecast: Any stakeholder has to understand his own objective and feel empowered to get it.
- Clarity and fairness in the calculation: The way in which objectives are calculated have to be clearly understood and accepted by all the stakeholders; the calculation methodology should not make any preference for anybody.
So the recipe for a good forecast is: provide transparency and clarity in the calculation methodology, with simple math anybody can understand. But the most important thing is to establish trust and collaboration among all parties.
But how do we accomplish all that?
Forecasting and game theory
The very simple model of the prisoner’s dilemma can be used to describe the relationship between the finance department and the operative manager. In order to apply the scheme, we must consider that each of them has two possible behaviors. They will either collaborate or not collaborate with the other in the preparation of the forecasting document.
Like in the prisoner’s dilemma, the selfish behavior of not collaborating with the other pays more than collaborating for both parties:
- If business does not collaborate, it will benefit from a forecast with lower or wrong targets, thus increasing its bonus payout, while reducing its effort.
- If finance does not collaborate, it will benefit because of a reduced effort, reduced time to prepare reports, no need for negotiations and reduced time in forecast preparation. If the forecast is not accurate, business is to blame.
The two are called dominant strategies as, in each of them, it is better to not collaborate, regardless of the strategy used by the counterpart.
Forecasting is a repeated game
To change the rules of the game and move towards a collaborative scenario, the forecasting exercise must be run multiple times between the same actors. Each stage is a part of a repeated game in which the decisions (strategies) taken in a previous run impact the future outcome as the counterpart will react to the strategy applied. In this scenario, collaboration is more convenient in the long run. Repeating the same exercise over and over, creates a social norm in which the players decide to collaborate because they know that the punishment will be high due to the non-forgiving reaction applied by the other player in the case of non-collaboration. The non-forgiving reaction is crucial to keep the other party stuck on the collaboration scenario.
So in a repeated forecasting game, the rules change dramatically; the reputation of the people involved is put on the table.
- The business side is pressured to tell the truth and be transparent, in order to avoid risking its reputation.
- The finance department has a clear pressure to listen to and accommodate the business side.
Negotiation and continuous adjustment of each side’s own strategies based on past behaviors are necessary for both parties to create equilibrium and a win-win situation.
Recommendations to improve forecasting accuracy
To summarize, the point is to create a collaborative and trustful scenario among players:
- Forecasting is not a recipe cooked in the headquarters office with a top-down approach. Forecasting is an organizational process to capture the contribution of all stakeholders.
- Ownership of each single KPI should be clear. The owner has to be empowered in reaching the target.
- Transparency about the complete set of objectives and their attainments should be provided. Reporting is a key aspect in the forecasting process. It builds the reputation of each stakeholder.
- Fairness has to be demonstrated by the finance department in order to keep the conflict at a low level and develop the trust among parties.
- Do not blame for business owners that miss an objective. This will reduce conflict among stakeholders and allow collaboration to emerge.
- A clear non-forgiving strategy has to be declared at the beginning of the game from both sides.
- Run the forecast game between the players as often as possible. For example, implement a rolling forecast approach with monthly reviews to enhance cooperation and communication among parties.
Andrea Terzaghi is FP&A associate director at Vertex (Switzerland).