FP&A | Basic approaches & technique
Financial planning & analysis is a flourishing area of practice for finance professionals. CFO’s of large companies have at some point worked in FP&A, this makes it really attractive for young professionals.
Those who want to pivot to FP&A from controllership or allied fields need to understand the basics of it.
Broadly FP&A function revolves around forecasting, budgeting/AOP and LRP.
There is a definite order in which these 3 activities happen. First LRP is closed, then AOP and lastly forecast is done with each MEC. Please note that LRP and AOP are typically done before the start of financial year, while forecast happens throughout the year (every month or quarter).
FP&A business/execution teams are often divided into multiple layers of hierarchy:
Long range planning:
Team structure -Headed by CFO. CFO’s direct reports work on ground to finalize the numbers. As the level of confidentiality is “highly sensitive”. younger professional or larger teams are not involved in the nitty-gritty of LRP.
Budgeting/AOP:
Team structure- Senior professionals with experience of 10–15+ years are entrusted with the finalization of budget numbers. Budget numbers have to be inline with LRP aspirations of the organization.
Forecasting:
Team members would include right from analysts to directors who own the preparation of monthly forecast numbers. This is the place younger professionals shall start as they will learn more, compared with AOP or LRP teams.
Approaches used in FP&A
Top down: This simply means that the professional will try to start from the high level guidance provided by leadership say during LRP and then work their way down to AOP numbers e.g. If LRP has provided guidance of 10% growth YoY, a top down approach would mean that while finalizing the budget/forecast numbers FP&A professional with make sure that revenue & profit grow by at least 10% YoY. They will try to cascade the growth projections on various product lines. This approach is never deployed in isolation.
Bottoms-up: In this approach bulk of the estimation happens with granular data e.g. analyst will start from historical numbers at general ledger level and will try to extend the trend to next fiscal year and try to consolidate the numbers to get organization level AOP/forecast. This approach provides a reality check to business but totally miss-out on new business/inorganic growth.
Zero based budgeting(ZBB): As the name suggests, this approach is mostly deployed in AOP/budgeting activity. Here the analyst will start from a “blank canvas”. They will try to construct the numbers themselves by gathering market data, business drivers, etc. e.g. Many times HR/workforce planning teams plan their numbers using this approach, this is easier for them because they have the accurate and real-time headcount and wage bill data. The only downside is that there is a risk of completely missing out an expense head/item. But this is great when organizations are aiming for strict cost controls.
Typically in a ZBB, business heads are challenged to provide rational for the spend and business case is required for all spends. e.g. Legal budget for professional services is planned according to ongoing and expected legal disputed. Organizations may reach-out to their solicitor/lawyers to submit their intended charges based on number of cases. This can lead to significant cost savings and avoid overcharging by vendors. I used to work for a large consulting firm, I was involved in the project where they saved ~50Mn USD just by implementing ZBB in technology cost spend.
Driver based:
This is more of a technique rather than an approach in itself. Here the analysts try to wear the pragmatic hat by scientifically calculating the numbers by using drivers .e.g. If we deploy this technique for Travel cost we shall start with number of trips* (Flight cost per trip+ visa cost+ hotel cost+ per-diem allowance). Then they might layer the numbers with additional budget for business class travel, domestic vs international travel, etc.
Here the entire emphasis remains on the cause and effect i.e. if you do X then Y is your cost.
Driver based technique can be applied in ZBB, bottoms-up approach and is quite popular in forecasting and budgeting exercises.
What is done in real world FP&A teams?
Honestly it’s a combination of all approaches viz; top down, bottoms-up and ZBB. Driver based cost estimation is also widely used across the board except in LRP.
Some readers might be thinking how can LRP have top down approach, the answer is industry research and market surveys. Large companies heavily rely on macro economic factors to determine their future growth.
I hope above will help you pivot to FP&A team or at least make you more curious.
I am available to LinkedIn if you want to ask any question.
Click here CA Shrestha Jain