Why a “Perfect” Financial Forecast Is a Red Flag (And What to Do Instead)

The Myth of the Perfect Forecast: Finding Value in the Deviations

Having accurate forecasts should give you reservations, instead of reinforcing your intuition. When your forecast and actual results align perfectly, this should be expected. In the fluid nature of business, forecasts are not meant to be reverential, but to serve as a method of understanding your business operations without expecting complete accuracy. Rather than assessing whether your forecast was correct, you should learn from it by comparing it to reality.

The most pragmatic lesson I learned during my master’s degree in finance was understanding forecasting as the development of a structured hypothesis to understand how a business functions.

This allowed me to deepen my comprehension and make corrections when reality began to deviate from my forecast.

Forecasting Provides a Structured Hypothesis

Financial models contain a structured hypothesis based on various assumptions made in developing the model:

• Revenue drivers growing rates, pricing power, or customer demand.

• Cost Behavior: Variable and fixed costs, or efficiency.

• Operating Conditions: The market is stable or competitive and the quality of execution.

When developing these assumptions, you will utilize historical data as presented to you, but they will remain static until the end of the forecast period. Markets can change, customers can change what they are currently purchasing and how they purchase things, and the execution of your business may not be as smooth as planned.

When your actual results do not match your forecast, this is not a failure; rather it is valuable data that provides you with information. The value of the information is lost when you attempt to defend or explain away the deviations from the original forecast. Professional FP&A teams utilize forecasting as a diagnostic tool rather than a scorecard.

What Variance Analysis Actually Does: From “What” to “Why”

Variance analysis provides valuable information regarding the variations of drivers from planned or expected results. Moving away from the simplistic concept of being “over or under budget”, variance analysis allows organizations to analyze the reasons for their results by answering the following questions:

1. What caused our results to vary from what we expected? Did volume, price, or product mix cause variance?

2. Did the cost structure or efficiency cause margins to vary from what we expected?

3. Did we miscalculate our assumptions, or did conditions change from what we expected?

By breaking down the variance analysis into its component parts, variance analysis provides forward-looking insight to assist with decision-making rather than simply providing insight into what has occurred.

A Picture is Worth a Thousand Words: The Variance Bridge

The value of driver-based variance analysis can be demonstrated with a visual representation. A waterfall or “bridge” chart will display the components of a single net variance, in ways that you would not be able to see from just looking at the net data.

For example, the total revenue variance of +$10 million may consist of the following components:

• +$15 million - Increase in price due to strategic pricing changes

• -$10 million - Decrease in volume due to lower than anticipated customer demand

• +$5 million - Increase in revenue due to a change in product mix

The use of a variance bridge can provide a clearer picture of why the variances occurred as opposed to simply reporting results. The use of a well-constructed bridge chart will provide the basis for discussion in the management meeting in addition to reporting results going back to the time frame being considered.

Illustrative FP&A Example Using Public Data from Microsoft

Microsoft’s public financial results, together with their management commentary, provide a good illustration of how variance analysis supports decision-making. Microsoft has reported continued revenue growth from fiscal periods recently concluded primarily driven by Cloud Services (Azure specifically); however, there has also been noted moderation in some of the core Enterprise & Discretionary IT expenditures. Therefore, the headline growth rate could have differed from the expectations during the initial phases of the growth of the company’s business or the realization of the headline growth through execution of its business strategy; rather, the headline growth rate did not match expectations due to changes in the drivers of the growth within the business.

A variance analysis perspective helps understand the drivers of revenue, as opposed to simply aggregating revenue:

1. Revenue Mix Driver Impact: The overall revenue growth from Cloud solutions (primarily Azure/Azure-based revenue) and AI-enabled solutions has made up for slower revenue growth (in accordance with quarterly expectations) in traditional Licensing solutions.

2. Demand Timing Driver Impact: The enterprise demand for IT-related expenditure has varied in response to the macroeconomic uncertainty within their current fiscal year.

3. Margin Stability Driver Impact: Cost discipline and economies of scale are helping to maintain operating margins, despite the recent downward shift in demand for IT-related expenditure (as previously mentioned).

Although public disclosures do not divulge the detailed internal variance bridges employed by FP&A teams it is clear from the reported trends that understanding the composition of growth provides more value than focusing on headline variances alone.

Variance analysis provides a framework through which to analyze deviations from forecasted growth. Variance analysis allows FP&A professionals to reframe outcomes in terms of changes in the underlying assumptions (assumptions related to customer behavior and revenue composition). This allows the finance team to improve model forecasting capabilities, to reweight growth drivers, and to direct the allocation of resources toward higher growth segments thereby reinforcing FP&A’s role as a strategic partner as opposed to merely providing reports.

This example is purely illustrative, utilizing Microsoft Corp.’s publicly available financial disclosures and commentary pertaining to earnings.

Management by Exception vs. Overreaction

Not all variances require management intervention. The principle of management by exception, which underlies the application of FP&A principles, emphasizes the need to focus resources on those variances that are:

• Material in size

• Recurring in nature

• Structural in cause

Effective finance teams assist leadership to differentiate:

• Signal vs. noise

• Short-term disruptive forces vs. longer-term trends

• Execution slip(s) vs. flawed assumptions

Practicing this discipline either prevents or mitigates reactive decision-making and fosters development of long-term strategies.

Seeking Insight to Execute: Three Questions Analysis

Variance Analysis ultimately has value to the degree to which the variance analysis leads to informed decisions. The most important aspect of effective FP&A reporting is that it turns numbers into actions through answering the three questions:

• What has changed? - factual driver variances

• Why has it changed? - market/customer/internal

• What are we to do? - forecast updates, resource shifts, strategic pivots

For example:

• What has changed? - Cloud business performing while licensing business forces

• Why has it changed? - customers have pushed back on non-mission critical IT projects

• What am I to do? - Reallocate sales enablement from traditional application licensing business to cloud-focused migration specialists and adjust short-term growth assumptions for application licensing.

When analysis links results to decision making, finance begins to play a strategic partner role versus a historical documentation role.

A Brief Nuance: When is a “Perfect” Forecast Useful?

The employee goals are not to be incorrect. In stable and predictable environments like regulated utilities or mature SaaS portfolios having low variance is expected and desired as high variance is an indicator of a business that is well understood.

Even in these types of environments, though, it is critical to state that low variance should be a conclusion reached from analysis, rather than an assumption made prior to analysis. Depending on the nature of changes that are occurring within the business, assuming low variance is more common is detrimental to effective management by agility.

Key Takeaways

A perfect forecast is a myth. An insightful variance analysis is a competitive advantage. There is far greater value in a forecast missing and having the ability to show the inherent reasons for the miss, than in a forecast that is accurate through luck and/or manipulation. This allows finance to claim a strategic position within the company, not through predicting the future but by building a company capable of learning from what is happening today.

Forecasting is not a “guessing game”, it is the structured process of hearing what your company is communicating to you about the business (current performance) on an ongoing basis.

Definitions

Forecasting - Estimating future financial results based on historical performance, coupled with many possible assumptions and reasonable estimates of current economic conditions. The data used to estimate future results creates a dynamic, continually evolving hypothesis based on updated, real-time information.

Variance Analysis - The process of evaluating actual results against budgeted or estimated results and quantifying and explaining the variance caused by the basic business drivers.

Management By Exception - A control methodology whereby management is focused on reporting any significant, meaningful variances from the company’s financial plan rather than reporting all routine fluctuations.

RFERENCES

CFA Institute. Financial Analysis Techniques: Forecasting and Planning.

Drury, C. Management and Cost Accounting. Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. Cost Accounting: A Managerial Emphasis. Pearson Education.

Microsoft Corporation. Form 10-K and Quarterly Earnings Releases. U.S. Securities and Exchange

Commission. https://www.sec.gov/edgar/browse/?CIK=789019