Three Forecasting Models Are Better Than One

The Inside Model

The goal of the Inside Model is to answer the question, “Given our intimate knowledge of ourselves, what do we think will happen?” Its use is most common – and most effective – when the finance team gathers information from across the company, assembles assumptions, establishes driver-based calculations, calculates run-rate and historical trends, and in the end produces forecasted financial statements.

The Inside Model represents the expertise of the entire organisation at discrete levels, such as cost of goods sold (COGS), unit cost or direct marketing costs. The Inside Model paints a complete organisational picture, including the interconnectedness of varied business units. It allows for continuous learning because variations between the forecast and actual results can be identified, studied and re-forecasted with the benefit of experience. Overall, it forces a process discipline across the company.

The Inside Model poses risks as well. As the Inside Model gets larger, more complicated and more entrenched, it tends to become “too big to fail.” Its strengths – nuanced, tied to reporting infrastructure, and well understood around the organisation – create huge opportunity costs in replacing it. Even tweaking the model can become challenging, so the model can become rigid, with a bias for the historical conditions that were applicable when it had its last major update.

As Inside Models grow and gain detail over time, they can become ‘the authority’ with a monopoly over forecast opinions. You can tell this is true when someone rebuts a challenge by saying, “Well, the model says….”

The Outside Model

The first response to the Inside Model is the Outside Model, whose goal is to the following: “Does the Inside Model make sense from the perspective of the marketplace? Do I need to go back and adjust my inside assumptions?”

One client working on a five-year strategic plan built an Outside Model based on market growth and changes in market share relative to competitors. After setting expectations, the client worked backward into the planning horison of the Inside Model – a rolling 18-month forecast. At that point, a gap emerged between the expectations of growth and profitability between the two perspectives. The company asked some tough questions: Why were the views different? Which view was ‘right’? Could the current platform lead the company to change its competitive positioning relative to peers? The company was shaken out of the reliance on the Inside Model and forced to reconcile different views of the future.

The Outside Model should have fewer variables and more standard calculations than the Inside Model. For one firm, it could mean re-packaging the data from the Inside Model in a way that presented an external outcome of their thinking. For another, it could mean revenue growth model with simplified cost assumptions. The simple structure should make the Outside Model more flexible and able to incorporate new variables and assumptions, such as new products, cost structures, or other forces. It may be useful for this model to be owned by a team other than the one that owns the Inside Model.

The Wiki Model

Sometimes gut feeling is highly predictive of subtle changes and can identify variables outside the scope of a fixed model. Sometimes, though, intuition is subject to emotions, recency bias, risk tolerance, feelings on a given day, or any number of factors. What is needed is a process that allows for these conversations but keeps them in proper perspective.

The Wiki Model is simple: Harness the collective knowledge of your team by inviting them to participate in a forecasting game. Periodically ask colleagues in different parts of your organisation for their prediction of a few key drivers and outputs. Ask them to support their answers with brief explanations. The average of all the collected forecasts becomes your Wiki Model.

The Wiki Model can expose incompatible expectations between the formal, systematic process and dynamic, judgmental expectations. The gaps between models can surface insights from deep within your organisation and express them through a new communication channel that transcends seniority. The Wiki data can also cut through bureaucratic levels to uncover different perspectives around the company, and non-model information can be captured through text comments.

The Wiki Model involves more people in the forecasting effort in a very direct manner. This becomes a virtuous cycle. A wide swath of your company will participate and appreciate that the company values their input, which means more people become vested in the standard forecasting process for the Inside Model as well. The Wiki Model creates a friendly game in the office, builds a culture of dialogue, and makes it permissible to challenge Inside assumptions.

Bringing it All Together

Too often organizations fall into a forecasting rut of running a process because “it has always been done that way,” or the business is too hard to understand without the complex machinery that has been built over time. It is easier to stand up to the official corporate model if you remember its limitations and recall that all models are wrong. It also easier to stand up to if you have an alternate model. Most importantly, however, it is possible to make the overall forecasting exercise meaningful, inclusive, interesting and valuable by having multiple points of view.

Over time, the challenger models may be tweaked, fall away or be replaced by new models. Or, they may prove to be more accurate, nimble and easier to maintain than the Inside Model. These are all desirable outcomes because they achieve the

main goal: to break the tyranny of the single, supermodel.

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