A driver-based model is only as good as the relationship between the input and the outcome. More companies are adopting this approach in their forecasting and planning processes, as outlined in an upcoming AFP FP&A Guide, What’s Driver-Based Modeling and How Does it Work?, due out in January.
“Technically, the definition is building a model that has any kind of calculation that references some other variable, i.e., a driver,” said Mitch Max, CEO and president of BetterVu. In the case of financial planning and analysis (FP&A) specifically, according to Sholape Kolawole, EPM transformation associate principal at The Hackett Group, “driver-based modeling is a way to leverage operational metrics that have a mathematical relationship with financial outcomes, particularly revenue or expense items in the P&L or the balance sheet.” Thus, he said, “driver- based planning is the process of using those metrics to drive outcomes. It’s about what moves the needle and identifying the operational/financial relationships.”
It’s hard enough to identify the right drivers. The next step is to define how the drivers relate to the financial results that match the company’s key performance indicators (KPIs).
According to Philip Peck, vice president, finance transformation at consulting firm Peloton, there are various techniques that can be used to develop the driver-based model relationships. That applies to:
- The determination of the candidate operational drivers
- Testing the mathematical algorithms and drivers for the effectiveness and accuracy of their predictive value and
- Refining those drivers and related model relationships over time.
One way to start is by decomposing the end-to-end value chain of the underlying business. Essentially this is looking at the business and understanding all of the various activities and functions that contribute to making, packaging, selling, delivering, and supporting the goods and services generated by the organization. “The analysis helps one develop a horizontally integrated view of the organization and highlights the key integration points between various aspects of the business,” said Peck.
“To define and develop the actual driver models, the most common approach is to leverage “driver trees” or “predictive logic diagrams” to determine the driver model relationships and candidate drivers.” This involves looking at the outcome measure in question (dependent variable) and determine all of the contributing drivers (independent variables) that impact the outcome measure. Depending on the domain area in question, the number of levels or layers can be as simple as one or could continue into multiple levels. “Driver models can be quite simple, e.g., A X B = C. Alternatively, the driver models could be complex and incorporate a multitude of independent variables and potentially several levels of driver interdependencies,” Peck explained.
“Once the initial driver model relationships and candidate drivers have been established, statistical analysis with representative data can then be used to determine the best drivers and to refine the model relationships; the goal is to find the drivers that are highly correlated with the outcome measure, demonstrate clear causality via statistical analysis measures, and optimize the model’s predictive capabilities.”
Don’t go it alone
Developing that mathematical relationship cannot be done in isolation. This must be a joint effort between finance and operations. It’s critical that the finance function is part of the discussion, in collaboration with the business leadership, advised Jeff Wuest, president and CEO of consulting firm SynFiny and an ex-P&G FP&A practitioner. “The finance function has to be part of the discussion. You need the finance ownership of the business team so finance already has a good sense of the key drivers, and then engage other functional leaders to get their buy-in and explore the drivers and how to make business decisions about investments based on those drivers,” Wuest explained. In his experience, a lot of drivers can come from outside, e.g., macroeconomics like the price of oil, currency rates as well as marketing investments. “Those are drivers that truly impact your business,” he said. “A lot depends on the kind of business you’re in.”
The AFP FP&A Guide, What’s Driver-Based Modeling and how How does Does it Work?, will be published on January 22, 2016.