New thoughts on rolling forecasts

Brian Kalish worked with a spirits company not long ago whose products were so popular it periodically underestimated demand and lost sales from a lack of inventory.

"They had no stranded inventory," Kalish, a financial planning and analysis (FP&A) consultant, told CFO Dive. "They sold everything they could make."

Kalish said the company was on the classic Dec. 31 calendar-year close. "They were forecasting to the wall," he said. "They went into the budgeting process in late September, early October, to put together the budget, plan and forecast, but they weren't really getting a lot out of it. It was just more variance as they went through the year."

Absent accurate forecasts, the company could never be sure it would have enough product available to meet demand, he said.

"They were basically looking over what had happened the last 12 months, [made] a best-guess growth estimate, and assumed that’s how they were going to do it," Kalish said. “And it wasn’t bad. But the problem was stock-out. All of a sudden, orders were coming in and they just couldn't fill them as efficiently.”

His prescription: Replace their static, 12-month forecast with a rolling 12-month forecast, updated quarterly.

Longer shelf life

A rolling forecast covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated at regular intervals. As you update your forecast with the latest monthly or quarterly data, the data from the earliest month or quarter of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

"By going to a rolling forecast, it gave them a much better idea, not only because they could see their internal information but because we structured it so they could start bringing third-party information in there," Kalish said. "All of a sudden, you can start seeing ramp-up."

The transition has been easier than it might have been, he said, because the company was ready to make a big move. "To make any of this work, you have to have four pillars: culture, process, people and technology," he said. "They wanted to go from having pretty immature to world-class analytics, so that's a beautiful situation to walk into. It's not a question of convincing someone."

The company is 25 years old, sells globally, and its finance function used Excel and an enterprise resource planning (ERP) platform. After conducting an audit to identify the tools and processes the finance operation was using, Kalish changed the company's architecture on the data analytics side and brought in a cloud-based tool for forecast planning and budgeting.

"What you don't want to do is what we call a lift and shift, which would be taking the [Excel] process and doing it in [a cloud] environment, because then you're missing 95% of the advantage of bringing on the new technology," he said.

Go for small wins

Kalish said it's unnecessary for a company to transition its entire forecasting process to a rolling system at once, especially if you're a larger company with multiple lines of business. In such cases, it can make better sense to pick a discrete line of business and forecast just that part on a rolling basis.

"It's always a challenge if you try to do something enterprise-wide, so I always argue, make little bets and wins and let them build, so there's nothing stopping you from doing it in parallel," he said.

Once you have a pilot underway, you can compare the rolling forecast to the old, static forecast to see whether you're getting more accurate numbers. "You can go back and model it," Kalish said. "These were the numbers we had the previous 12 months, say three years ago. What would the model have been that we constructed going forward?"

The spirits company is small enough that it made sense for it to transition its forecast as a whole. "They had no problem going all in," he said.

You also don't have to include in the forecast all of the data you're watching; you only need to include metrics that are actually driving your business. "You don't need to include things that aren't going to impact the company, aren't going to cause a decision to be made," he said. "You don't have to forecast them as frequently as something that has a much greater impact."

People focus

In addition to transitioning the process and tools, you have to transition the people and, in some cases, that can mean rethinking whether the people who are most adept at using Excel are best positioned to manage the forecast under the new system.

Kalish said he worked with a long-established insurance company that saw the transition as a way to cut its finance staff. The new system required fewer people because so much of the work was automated, but the company erred by keeping its most experienced Excel staff.

"They found out shortly after these weren't the right people because they didn't have the skill set," he said.

The company ended up letting the Excel specialists go and hiring back some of the people originally laid off. "Some had moved on, of course, and they basically had to go out and find new talent," he said.

At the spirits company, the CFO will hire a director to oversee forecasting under the new system. It will either be an existing finance manager or a new hire, depending on internal personnel matters, but having someone who can oversee the system is key, particularly during the transition. The first year tends to be labor intensive, because you're asking your finance team to update the forecast every quarter, when in the past, they only had to do so once a year. 

"If someone tells you it's not going to hurt, they're lying," he said. "It's painful. At first, people are going, 'You're asking us to do four times as much work if we do this on a quarterly basis.' But the point is, you have to look at the whole year, because what happens is, when you get to September, you've already done it. You're just going to push yourself out 12 months.

"The beauty is," he added, "you build it once and you get better and better at it, get better information in it. When you're looking at your forecast, your next 90 days should be more accurate than your second quarter, your third quarter, your fourth quarter. And that's always rolling forward. And if you have not just the proper processes but the proper culture, you get your forecasts in a more timely, efficient and, arguably, smarter way."

Putting together your annual budget and forecast are among the most time-consuming exercises your finance and accounting teams undertake, and yet these planning tools tend to become outdated quickly when they're put together using a traditional, snapshot-in-time approach.

That's why financial planning and analysis (FP&A) consultant Carl Seidman recommends you transition to a more dynamic process by producing a rolling forecast.

"These dynamic forecasts are not replacements for annual budgets — they are complements to them," Seidman says. "Static budgets are generally inflexible and reactive. They are time consuming to build and update and quickly become outdated after only a short time. They often aren't used effectively, thus causing employees to lose faith and not take the budgeting process seriously."

A rolling forecast covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated monthly. As you update your forecast with the latest monthly data, the data from the earliest month of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

Seidman, an adjunct faculty member of the American Management Association and a longtime FP&A specialist, points to research showing that organizations are better at leveraging the financial and operational data they collect to predict trends when they use a rolling, instead of a static, forecast.

"With the advent of big data, more companies are able to utilize their information to perform analytics, identify drivers of performance, and make better business decisions in real time," he said.

8-step process

You take a risk any time you transition from a long-held practice, so Seidman recommends you give yourself sufficient time to implement the changes. "It should be done in a sequential order to avoid missteps and rework," he said.

Here are the transition steps he outlines:

• Objectives. Start with your goal in mind. "The individuals tasked with building and managing the rolling forecast should be clear about its objective," Seidman said. To identify your goal, try to answer questions such as, Who will be relying on the forecast? What business decisions will be made using the forecast?
• Time horizon. Determine how far into the future you want the forecast to go. "The further out into the future, the more insightful the forecast may be, but the less accurate," he said. In addition to the time horizon, you need to set what Seidman calls forecasted increments. "Will the forecast look into the future one week, one month, one quarter, or one year at a time?" he said. The longer the increments, the less detailed they will be, but the less frequently they will need to be updated, he said.
• Level of detail. Seidman calls for setting the level of detail based on the importance of the decisions being made using the forecast. "If the consequences of a bad decision are large, more time and effort must be spent to improve accuracy," he said.
• Contributors. Limit who takes part in the forecasting process to people who can contribute insightful, unbiased intelligence. "Participants should be empowered to contribute and held accountable to achieving or failing to achieve targeted performance," he said.
• Elements of value creation. Seidman recommends limiting the elements that get updated each increment to quantitative and qualitative indicators you've identified as value-drivers. "Assess what dimensions of the business are most important to its success rather than focus on every line item in the chart of accounts," he said.
• Vetting. Before you include a data source, be comfortable with its quality.
• Scenarios. Moving to a rolling forecast lets you test scenarios by asking what-if questions and then running the data, so Seidman suggests you make this part of your practice. "As new information becomes available or as assumptions change, the flexible rolling forecast can be easily updated and new scenarios can be run," he said.
• Tracking. As you would with a static forecast, you can assess variances between actual and expected performance, although with rolling forecasts, it's recommended you do this on an ongoing basis.

Ultimately, moving to a rolling forecast is about using the technology available today to better understand what's affecting your business. "It is no longer enough to install basic financial systems and employ someone to maintain them," Seidman said. "In a constantly changing world, companies must aspire to change with it."

Barneys faced tough times even before the pandemic. The luxury retailer shuttered 15 of its 22 stores and turned its holiday season a few years ago into a fire sale as it prepared to close its signature store in Manhattan. Other major retailers struggled, too, with at least 16 of them filing for Chapter 11 bankruptcy. 

The rise of online sales, now more than 11% of commerce in the Unites States, is a factor, and so are tariffs. Some of last year’s most popular goods, including electronics, shoes, and hats, were affected by the trade standoff with China. Then came the pandemic. 

But retailers do themselves no favors by missing the mark on the forecasting side. The stock price of Macy's, the largest department store company in the U.S., plunged 13% to a 9-year low of $15.82 in the last quarter before the pandemic in part because of weak forecasting.

"A fashion miss in our key women's sportswear private brands [and] slow sell-through of warm weather apparel" forced the company to take markdowns to clear excess inventory, Jeff Gennette, the company's chairman and CEO, said at the time.

Anticipating demand is always a guessing game, but many retailers make unforced errors by clinging to inadequate forecasting processes, financial planning and analysis (FP&A) consultants told CFO Dive. 

"Retail forecasting is a little bit of science and a little bit of art," Carlos Castelán, founder and managing director of retail consultant the Navio Group, told CFO Dive. "We think of sales as an outcome of the transaction but there are a lot of steps ahead of that. Having a sense of, more broadly, the larger sales funnel can greatly improve your forecasting."

Here are three common forecasting mistakes retailers are making.

Running into the forecasting wall

Many retailers think they're engaging in dynamic forecasting when they build in a way to make updates throughout the year, but in reality their process is static, FP&A consultants say, because what makes forecasts dynamic isn't the updating process, but the time horizon.

"One of the common mistakes CFOs are making is what we call forecasting to the wall," Steve Player, managing director of the Player Group, told CFO Dive. "Large companies will many times prepare a forecast, but if you look at what they’re really doing, they’re preparing a descending forecast.

A descending forecast, or what planning specialists call forecasting to the wall, is when CFOs create a six-, 12- or 18-month plan and make subsequent updates as new data come in, but the time horizon remains unchanged. 

In a common scenario, the CFO will create a 12-month forecast starting in January, make quarterly updates, and leave the time horizon fixed at December 31. As a result, the company forecasts for shorter and shorter increments. 

"The first one is 12 months, the second's nine months, the third is six months and the fourth one's three months and then they pop out another year," said Player. "All they're really doing in that kind of situation is updating their projection to validate their budget target."

A better approach is to use a rolling forecast, in which the time horizon gets pushed out by the same number of weeks or months as the update. If you're using a 12-month forecast, in addition to updating your estimates every month or every quarter with new data, you push out the time horizon by another month or another quarter and remove the corresponding trailing time period. That way, the forecast remains 12 months, but you never reach the endpoint, or wall.

Brian Kalish, an FP&A consultant whose clients include retail companies, said the rolling time horizon enables executives to make decisions based on market dynamics rather than an artificial target. 

"If your sales compensation is based on hitting your numbers for December 31, your behavior will be very different than if you're ignoring that deadline," Kalish told CFO Dive. "The business is going to exist on January 1, so what happens is, you start making economically suboptimal decisions to hit artificial targets."

For the past year, Kalish has been helping a spirits company move from a static to a rolling forecast to regain sales it was losing because of chronic inventory shortages. 

"They were basically looking over what had happened the last 12 months, [made] a best-guess growth estimate, and assumed that's how they were going to do it," Kalish said. "And it wasn’t bad. But the problem was stock-out. All of a sudden, orders were coming in and they just couldn't fill them as efficiently."

By going to a rolling forecast, he said, "it gave them a much better idea, not only because they could see their internal information, but because we structured it so they could start bringing third-party information in there. All of a sudden, you can start seeing ramp-up."

Conflicts of interest

Whether you're doing static or rolling forecasts, unless you change the incentive structure in your annual budgeting process, you're almost guaranteeing inaccuracy in inventory levels, and by extension sales, consultants say. This is because most incentive structures are built around sales targets, not accuracy. 

"Budgets are a little bit of a negotiation process," Karen Sedatole, professor of accounting at Emory University, told CFO Dive.

"The sales team negotiates lower budgets than what they think they can meet, because they want to make sure they meet that budget by the end of the year because they want to get their bonus. If I think I can sell 100 units, when I'm negotiating my budget targets with people higher up in the organization, I negotiate a target of 90, because I think I can sell 100. That way I make sure I meet my budget by the end of the year."

Player calls this practice a monstrous conflict of interest because it virtually guarantees sales estimates will be low-balled in the initial forecast. 

"The budget manager's not going to negotiate stretch goals or outstanding performance because he's going to be judged against that — and his bonus is going to be based on that — so now his incentive is to give a sandbag budget, with minimal acceptable returns," he said. "If you're designing an internal control system, the first thing you try to avoid are conflicts of interest, and here the budget puts one right in the middle of its mechanism."

This sandbagging is a recipe for inventory shortages, and therefore lost sales, because once the budget's approved and the forecast set for the coming year, production planners set in motion a process for producing an inadequate amount of inventory, which can lead to shortages at crucial points in the market cycle. 

A rolling forecast can address some of the problems of sandbagging, but it doesn't solve the root problem. It can help ease the inventory mismatch by giving executives a chance to revamp the demand estimate at regular intervals as data comes in showing sales beating forecasts, or vice versa. But making changes in production capacity in the middle of the year is an expensive way to solve a problem. 

"Is there going to have to be some kind of capital expenditure to make another production line live to meet demand?" said Kalish. "Do we think we're actually going to have to build a new factory? Do we go out and borrow money? How does that affect our credit rating? Are we going to spend the company's resources in these ways or are there better things to do instead of building another factory? It's not the most efficient in the long run."

The root solution is to remove the conflict of interest in the first place by aiming incentives at forecasting accuracy, not sales targets, but consultants say most companies are unlikely to change their practices any time soon. 

"Letting the bonus be dependent on forecast accuracy sounds like a great idea, but probably fewer than 20% of companies do that," said Sedatole. "The reason is, we want sales people selling. So, we want really high-powered incentives for them to sell."

Sedatole said she's working with a company that sells chemical products that incorporated accuracy into its incentive structure but it was a small percentage of the sales bonus.

"When I talk to the sales managers, they say, 'We don't want to pay attention to that,'" she said. "'We just want to pay attention to completely meeting the sales target.' So, although they had it in principle, it really wasn’t anything that's effective."

Real-time data sharing

One of the most straight-forward ways to improve forecasting accuracy is by communicating sales data to executives in as close to real-time as possible. By doing that, finance, sales, production, marketing and other business operations can track performance as it happens and make real-time adjustments. The more the forecast is updated using data with minimal lag, the more accurate the forecast becomes over time. 

"Communications is one of the biggest forecasting problems companies face," Kalish said. "What happens is, the information sits in silos. You’re just not leveraging it."

The most practical way to speed communication is to move from on-premise software to a cloud environment, because the cloud environment enables data to come in as it's generated and lets executives access it when and where they want.

"If you're in spreadsheets, get out of them," said Kalish. "That's what's killing people. There's just so much technology out there that can really help support the business."

Castelán of the Navio Group pointed to the success of Lululemon in leveraging real-time data. It was one of the first retailers to use radio-frequency identification (RFID) technology to feed sales and inventory data from all of its locations into a central hub, enabling it to manage inventory across its operations in the most efficient way possible. If a consumer in Chicago buys an item online, that item might come from a store with excess stock in South Carolina as opposed to a central warehouse. 

"That helps from a forecasting perspective, because you're able to use all of your inventory across the network, which increases your inventory churn as well," he said.

Having real-time sales communication among executives is especially important in retail sectors that move too quickly to make year-ahead sales forecasting practical. Kalish pointed to the cosmetic sector as a good example. 

"A perfume company's horizon might only be one year, because [product designers] go to the Paris show, find out what's in fashion, then make it," he said. "There's no way to predict what that's going to be, so they just have to be really good at being reactive." 

Another example are smart phone cases. "The dimensions are changing all the time, and they can't be off at all," Kalish said. "They have to be perfect. So, they don't try to predict how Apple or Samsung is going to change the width and the length of the phone; they just want to be really good at changing their production line fast." And that requires instant access to real-time information.

A better forecast

There's a saying among FP&A specialists that all forecasting models are wrong, but some are useful. If you want to move your model into the useful category, here’s how to start: transition to a rolling forecast if you're not already doing that, remove bias in your budget by aiming incentives at forecast accuracy rather than sales targets, and move to a cloud-based budgeting environment to generate, and then apply, actual sales data as close to real-time as possible. That way, the forecast can be tweaked before inventory problems affect sales.

If you make these changes, your forecasts likely will still be wrong, but they might lead your company to better performance.

If you don't already use a rolling forecast, implement one gradually and allow your finance team time to adapt, budgeting consultants say.

A rolling forecast covers a designated period of time — four months, a year, 18 months, whatever makes sense for your organization and industry — and is updated monthly. It's used in place of a static, annual forecast; some companies have even eliminated their formal annual budgeting process after putting one in place.

As you update your forecast with the latest monthly data, the data from the earliest month of your time period falls away, giving you a continuously changing forecast of your company's financial condition.

"It ensures you're always looking at the most current information," said Brian Martell, senior product marketing manager at Host Analytics. "So, it gets you as close to real time as possible, and it's going to give you more accurate and informed decisions than if you were just simply to look at a static, months-old annual budget."

Best practices

Rolling forecasts are considered a best practice, and today, about 60% of world-class companies use them, said Miles Buntin, director of enterprise performance management (EPM) transformation at consulting firm The Hackett Group.

Despite its popularity, the process is not yet commonplace. A Host Analytics survey found 75% of companies still use an offline annual budget process, typically based on Excel spreadsheets, but a survey conducted among the webinar attendees found that most of them wanted to make the transition in the next year or two.

Once the transition is made, rolling forecasts should save a company's financial planning and analysis (FP&A) team considerable time; the traditional annual process is notoriously time-consuming, involves most staff in an "all hands on deck" exercise, and leaves executives with data that quickly becomes outdated, Martell said.

"It takes six months to build an annual budget," he said. "It's just an incredibly laborious exercise."

The rolling forecast can also help companies grab savings mid-cycle if expenses or revenues change, said Maria Cherry of Planful. 

"If something comes in a little higher, you can adjust for that in real time," Cherry said. “If something comes in lower, you can reprogram [your savings] to something you need."

Start small

To maximize efficiency, focus on big value-added areas of the budget cycle, Martell said. "Get comfortable, and as it becomes a habit, expand the scope over time."

Unlike traditional annual forecasting, which typically uses Excel, rolling forecasts are principally based on third-party online platforms that provide analytical tools already built in.

Transitioning to rolling forecasts is part of a broader move by companies to use cloud-based EPM platforms to improve their operational efficiency, Buntin said.

"Improved predictability is one of the strongest use cases for the deployment," Buntin said. "A lot of these new tools use algorithms to identify patterns, pull in data from outside sources, as well as internal financial and operational systems and — here's the key point — take out potential bias. These can vastly improve the accuracy and objectivity of your forecast."

The concept of a rolling forecast is straightforward: Time does not stop at the end of the fiscal year, and so your forecast should add new periods as old projections become actuals.

The process is similar to how a meteorologist provides a five-day forecast by adding another day as the current day ends. In finance, when we provide a rolling forecast, we provide an update to the forecast period, the addition of a new forecast period, and, of course, an understanding of the variances for the completed period.

Effective rolling forecasts

An effective rolling forecast has significant uses in your company’s risk management program. Risk is defined as "the possibility that events will occur and affect the achievement of objectives" in the COSO Enterprise Risk Management framework. It's defined as "the effect of uncertainty on objectives" in ISO 31000:2018.

Though risk generally refers to negative outcomes, risk management, as a practice, expands the definition to include anything that reduces enterprise value or effectiveness (in the case of nonprofits).

Finance, and specifically the financial planning and analysis (FP&A) organization, is tasked with recommending to executive leadership the allocation of resources to their best value-add usage, and also curating the company’s outlook to determine whether the company will likely create the intended value or need to take corrective actions. 

Evidence of a strong forecasting process is critical when a CFO reports to the board of directors. The Deloitte 2018 Audit Committee Resource Guide notes that, unless there is a specific risk committee, "risks not assigned to a specific committee are often delegated to the audit committee." The CFO is firmly in the risk management business, and rolling forecasts help in several ways: 

• Assessing changes while pursuing your strategy. The obvious reason for rolling forecasts is to view opportunities and challenges beyond the fiscal year and to fight the myopia that comes with overemphasis on current-year targets. Strategy is almost always a long-term vision, with objectives in the current fiscal year, medium-term and long-term, and so the forecast should roll out to continuously measure against these different time frames.

• Establishing operating structures. Risk management frameworks focus on the need to develop “operating structures in the pursuit of strategy and business objectives.” FP&A is the department assigned the role to manage the plan and forecast processes; it should be staffed with qualified professionals using appropriate tools.

• Making longer-term decisions. Business models that focus on customer lifetime value and recurring revenue recognize that the value of today’s decision may come in future years. Rolling forecasts can show that value and provide an incentive for long-term, value-maximizing behavior over short-term, bonus/target-based decisions rooted in the current fiscal year.

• Allowing for event-based forecasting through operational excellence. Achieving the rhythm and organizational muscle to develop good forecasts becomes more important when either negative or favorable events happen. An economic shock can reverberate for months or years, and finance should be ready to generate a new forecast that contributes to the organizational response. 

The CFO plays a pivotal role in a firm’s ongoing risk management, and that role can be strengthened by using rolling forecasts.