Predictive Accounting: Driver-Based Budgeting and Rolling Financial Forecasts

The annual budget is often perceived as a fiscal exercise done by the accountants that is: (1) disconnected from the executive team’s strategy, and (2) does not adequately reflect the future volumes of drivers. The budget exercise is often scorned as being obsolete soon after it is produced and is biased to politically muscled managers who know how to sand-bag their budget request. Some organizations revert to rolling financial forecasts, but its projections may include similar flawed assumptions that produce the same sarcasm about the annual budgeting process. What is the solution? 

As background there is a widening gap between what accountants report and what managers and employee teams want. This widening gap involves the shift from analyzing descriptive historical information to analyzing predictive information about future costs, such as with budgets, rolling financial forecasts, and what-if scenarios. Although accountants are gradually improving the quality of reported history (e.g., applying activity-based costing), decision makers are shifting their view toward wanting a better understanding of the future.

An Accounting Taxonomy

There are three domains of the accounting taxonomy: tax accounting, financial accounting (e.g., regulatory compliance), and managerial accounting (e.g., internal decision making). The managerial accounting domain can be segmented into these three categories with the first two descriptive and the last one predictive:

• Cost Accounting represents the transformation of incurred expenses into the calculated costs of outputs, such as for product, service-line, channel, and customer costs for profit margin analysis.
• Cost Reporting for Analysis represents the insights, inferences, and analysis of what has already taken place in the business in order to track and improve performance.
• Decision Support with Cost Planning involves decision making. It also leverages historical cost reporting information (e.g., unit level cost consumption rates) in combination with other economic information, including forecasts and planned changes (e.g., processes, products, services, channels), that lead to financial improvement from better decisions. Budgeting resides here.

What? So What? Then What?

The degree of value-adding information for decision making increases with the sequence of the three categories. The cost accounting data establishes a foundation. It is of relatively low value for decision making compared to the next two categories. The cost reporting for analysis information converts cost data into a context. Cost reporting provides answers to “What?” For example, what did things cost last period?

However, an obvious follow-up question should be “So what?” That is, based on any questionable or bothersome observations, is there merit to making changes and interventions? How impactful to improving performance will the outcome of proposed changes be? But this leads to the more critical, and relatively highest value-added need to propose actions – to make decisions – which surfaces from cost planning. Cost planning answers the “Then what?” question. For example, what change can be made or action taken (such as a distributor altering its distribution routes), and what will be the ultimate impact? This gets to the heart of that widening gap between accountants and decision makers that use accounting data. To close the gap, accountants must change their mindset from managerial accounting to managerial economics.

However, there is a catch. When the cost reporting for analysis category shifts to the decision support with cost planning category, then analysis shifts to the realm of decision support via economic analysis. For example, one needs to understand the impact that changes have on future expenses, such as workforce headcount levels and spending. Therefore, the focus now shifts to resources and their capacities. This involves classifying the behavior of resource expenses with future changes as sunk, fixed, step-fixed, linearly variable, non-linearly variable, or discretionary with changes in service offerings, customer demand volumes, processes and the like – which gets tricky.

Capacity Analysis

A key concept with economic analysis is this: The “adjustability of capacity” of any individual resource expense depends on (1) the planning horizon, and (2) the ease or difficulty of adjusting the individual resource’s capacity. As the time horizon extends into the future, then capacity becomes more easily adjustable. For example, assets can be leased, not purchased; and future workers can be contracted from a temporary employment agency, not hired as full-time employees. Therefore, these once “fixed” expenses become classified as “variable”. This wanders into the messy area of marginal and incremental expense analysis that textbooks oversimplify but is complicated to accurately model and calculate in the real world.

Since decisions only affect the future, the predictive view of accounting is the basis for analysis and evaluation. This is the highest value of the three managerial accounting categories. The predictive view applies techniques like driver-based rolling financial forecasts and what-if scenario analysis.

What Types of Decisions are made with Managerial Accounting Information?

The broad decision-making categories for applying managerial accounting are: 

Rationalization – Which products, services, channels, routes, customers, etc. are best to retain or improve? And, which are not and should potentially be abandoned or terminated?

Planning and budgeting – Based on forecasts of future demand volume and mix for types of services or products, combined with assumptions of other proposed changes, how much will it cost to match demand with our supplied resources (e.g., workforce staffing levels)?

Capital expense justification – Is the return on investment (ROI) of a proposed asset purchase, such as equipment or an information system, justified? This is where capital budgeting analysis (e.g., net present value and discounted cash flow math) fits in.

Make-versus-buy and general outsourcing decisions – Should we continue to do it ourselves or contract with a third party?

Process and productivity improvement – What can be changed? How to identify opportunities? How to compare and differentiate high-impact opportunities from nominal ones? 

The Value from Predictive Accounting Trumps Descriptive Accounting

Cost accounting data is not the same thing as cost information that should be used for decision making. The majority of value from cost information for decision making is not in historical reports – the descriptive view. Its primary value is in the predictive view involving planning the future (such as rolling financial forecasts), marginal expense analysis for one-off decisions, or trade-off analysis between two or more alternatives.