We all know the forecast is never exactly right. Regardless of how sophisticated the methodology, whether we use predictive analytics tools and revise it on a rolling basis, there are always things outside our control that can impact it one way or the other. It’s what we think may happen; it’s our best guess.
But there’s a concept out there that experts call “risk-adjusted forecasting.” It’s a marriage of enterprise risk management and forecasting—a way to stress-test the forecast for the major risks facing the company, based on risks identified by the risk group. It can help FP&A come up with more realistic views of the future, or at least a range of scenarios of what might happen. But it’s not widespread, which is largely because:
- Forecasting is still not done on a very dynamic basis at many organizations (although results of the recent 2016 AFP FP&A Benchmarking Survey show more companies are moving to a quarterly rolling forecast)
- Both FP&A and risk management are viewed as cost centers, so it’s hard for finance professionals to demonstrate a positive ROI for investing in processes and tools that make more sophisticated stress testing possible; and
- Basic forecasting and budgeting processes in many companies have not changed in in decades.
However, integrating a risk management approach into your planning process can provide the foundation for managing, monitoring, and reporting business decisions with “eyes wide open,” according to Ken Hooper, a director with PwC. Hooper defines risk-adjusted forecasting as an approach that incorporates ranges of assumptions and forecast outputs that provide a greater understanding of risk factors and potential mitigating strategies.
Historically, budgeting, forecasting and enterprise risk management existed as very separate functions. Because they operated in silos, the budget and forecast did not take into account what risk management identified as the major risks to the business plan. If you do a risk-adjusted forecast, you can begin having the management intervention discussion: i.e., how do you react if one or more of those risks or opportunities crystallize? The objective is not to produce a fancy report but to “improve the strategic performance of the business,” said Mark Pellerin, principal at Oliver Wyman.
How risk-adjusted forecasting can work
Of course, a lot depends on the maturity of the company’s risk management function. But even where there isn’t a formal methodology for cataloging risks, management can often list the top five to10 risks to the business. To integrate the risks and the forecast, the best approach is to start small. Ideally, that means implementing a risk-adjusted approach to a one-off project (e.g., divestiture or a large capex project) or to one business unit, and then build up the capability over time. This phased approach can help you show real benefits along the way instead of convincing management to shell out a big budget for a big project. You start with a pilot, select two or three key risks to your organization and incorporate them into the FP&A process. Here are some practical steps:
- Describe each risk from a probability and an impact perspective.
- Avoid trying to incorporate 100 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 difference aspects—the base plan and the risk-adjusted plan.
- Ask the right questions: How realistic is the budget? What are the key downside drivers to that budget? What would be the impact on the balance sheet if the company experiences a 1-10 worst case scenario?
- Look at a combination of risks (aggregate risks) with high impact or high probability versus continuous business exposures.
- Remember, it’s not just about number crunching. Do some white-sheet thinking to pinpoint the factors that could cause disruption in the forecast, and then focus on those key variables in creating the business outlook.
Make it practical
Experts caution this should not be done as a mechanical exercise. What really makes it beneficial is building in a learning loop. The idea is to look at the risk variables that could cause the company to over- or underperform its forecast and come up with contingency plans to handle either scenario. The real value of risk-adjusted forecasting is preparing the company to be much more dynamic. It doesn’t need to be overly complex, but it requires a change in thinking and building the tools and discipline.
“One of the possible responses to the risk complexity issue is to focus on facilitated sessions doing individual scenarios,” PwC’s Hooper suggested. This is also called pre-mortem analysis. “Rather than focusing on the probability of particular risks, assume the future is here and an event has happened. What’s your response to that? Such facilitated discussions force companies, business leaders, and planning groups to focus on how to respond and to put a plan in place as to how to prepare for future scenarios.”
Very typically, companies only take a single variable into account when looking at forecasting variability, but history tells us that it takes more than a single variable to accurately anticipate performance. “You need to look at it from a holistic perspective regarding what would affect the deliverability of the plan,” said H-K Bryn, and independent strategic risk management and governance advisor. “It’s a way to integrate multi-risk perspectives into your financial planning process.”