Because the Model Says So

Quick Summary: In reality, business models accurately predict what most likely will not happen.


With the incredible capability of Microsoft Excel(tm) and other forecasting tools, the sophistication of financial models continues to increase.  With every new chart type and the ability to “slice and dice” the resulting information in a seemingly limitless number of ways, our confidence naturally grows.  Unfortunately, models are based on assumptions about both internal and external events that may be totally inaccurate, negating the accuracy of the model; sometimes entirely.

Of course, no entrepreneur would ever say the title of this article out loud, but many believe their models with all their heart and soul.  After all, they spend almost countless hours perfecting it to at least three-digit accuracy.  Unfortunately, anyone that has spent time creating business forecasts understands that the model, more than likely, predicts what won’t happen!

Whether it is the Butterfly Effect predicted by Chaos Theory, Black Swan events, unknown unknowns, incorrect assumptions, or just plain extenuating circumstances, unpredictable outcomes WILL, most certainly, occur.  However, this pessimistic view is not a reason not to spend time and energy to build the best, most practical model possible.  The key word is “practical” not “possible”.  Think of the model, not as a precise forecasting tool, but as a “directionally correct” indicator of how the business is likely to unfold given the assumptions made.

There are three specific actions that should be applied to every model:

  1. Be willing to change the model as factual data becomes available that replaces forecasts or speculation.  Further, try to understand why the actual data varied from the forecasted amounts.  Will the variations continue or are other forecasted numbers in equal jeopardy of being incorrect?
  2. Pre-establish checkpoints based on projected time or anticipated results.  If those check points are missed or exceeded, carefully think through their long-term impacts.  Watch for both hits and misses.  The impacts of misses, such as product delays or sales below forecast, are obvious.  However, exceeding forecasts can be equally problematic.  For example, if sales exceed the plan, inventory may not be available or quality may slip causing increases in costs.
  3. Perform sensitivity analysis on virtually all variables.  It is remarkable how something that appears to be minor can have a significant impact on the model.  Some of the factors may not even be directly in the model.  For example, a slip in the documentation availability plan may delay partner sales training that may cause a significant, unexpected delay in sales due to customer seasonal buying profiles.

Oliver Cromwell (circa 1640) has been attributed with saying: “Trust in God, but keep your powder dry”.  Applying this same notion to business today could be: “Trust your model, but keep alternatives at the ready”.  Invariably, those alternatives involve having adequate available cash!  Think about the impacts of missed sales, missed shipment dates, higher product costs, slower customer acceptance, and virtually every other business variable.  In most cases, they impact the amount of cash generated or required.  In the end, isn’t accurate cash consumption and generation what a financial model is all about?

Article Number : 3.020401   

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