Delivering scenario analysis in closed-loop EPM

There is broad agreement that the core methodologies that make up Enterprise Performance Management are budgeting, cost and profitability reporting, strategy management and financial reporting. There is also a lot of discussion of the importance of providing business managers with scenario modeling functionality so they can rapidly assess the impact that changes in internal or external factors have on future financial performance.

In fact as long ago as 2004, analysts Aberdeen found that providing such functionality was a key discriminator in the success of an EPM implementation with Best in Class companies delivering 5.4 percentage points more than their industry norm in return on assets and 4.8 percentage points more in gross margin. So if scenario modelling is so important, how exactly is it delivered?

Douglas T Hicks* and other writers have consistently pointed out that the application of the cause-and-effect principles that underpin activity-based costing continues to be the only method of creating a valid economic model of an organization. A well-designed model is based upon empirical relationships between key business volumes, (sales volumes, number of customers, invoices and returns), consumption and productivity data (held as resource and activity drivers and cycle times) and expenses, revenues and ultimately profits. But a cost and profitability model is not simply a turgid repository and classification of enterprise data. As Hicks indicates, it is a dynamic economic model of the enterprise inside which changes to any piece of data directly impacts other pieces of data and consequently financial outputs. In fact without an activity-based model, most organizations simply have a void.

 

Some organizations with cost and profitability models already extend their use beyond reporting on the historical cost and profitability of products and customers by using their “what-if?” functionality to test assumptions about the future. By modeling anticipated sales volumes and varying inputs such as the average salary cost in each department and the underlying business drivers to reflect changes to processes and productivity improvements, they can quickly generate a revised resource and capacity plan and a new high-level profit and loss account. The output of this type of activity-based or driver-based modeling does not typically go down to the detailed level of chart of accounts that is produced as part of the annual planning and budgeting process and excludes new business and other strategic initiatives that require zero-based or bottom-up budgeting. However it does provide significant benefits for generating the operating expenses for ongoing businesses that will expedite the more detailed budgeting process. I’ve recently been working with three organizations who have adopted such an approach – two from the public sector and a bank and the benefits they are reporting are

•  More accurate resource plans and budgets – which is a definite benefit for public sector organizations as it means they don’t have go back to central government with cap in hand for more funding during the year.
• Shorter budgeting cycle in that business managers don’t have to build up their budget submissions themselves and can simply review many of their key line items – particular those for staff and other variable expenses.
• Greater agility in that they can finally move to managing the business with rolling quarterly re-forecasts. Personally I have struggled to understand how rolling re-forecasts can ever be delivered unless some kind of modeling is involved.

So this is encouraging news for those folk who have been advocates of driver-based approaches to planning and budgeting and with the advent of finance-friendly tools such as SAP BusinessObjects Financial Information Management for moving data between previously silo-ed EPM applications, it’s now easier to deliver. Using such an approach also achieves a happy half-way house between those who criticize traditional budgeting as being unable to cope with today’s uncertainty and those who still regard it as the main performance management tool in their organization. Everybody wins.

* "I May Be Wrong, But I Doubt It: How Accounting Information Undermines Profitability", Douglas T Hicks, Lulu Publishing, 2008, ISBN 0557031591