Risk‑adjusted forecasting and planning

Navigating the ‘new normal’ of

increased volatility

Helping CFOs to protect and

enhance value in volatile times,
through an integrated approach
to finance, risk, and strategy
Foreword

The recent turmoil in financial My personal experience as a CFO

markets and the resulting disruption in a broad range of companies
to operating environments has forced across a number industries, is that
many companies to reassess how risk-adjusted planning should be
they incorporate risk into decision- an important tool in every CFO’s
making. With increased volatility and armoury.
uncertainty becoming an expected
part of doing business, it is a Improving the reliability of financial
top priority to build a balanced and strategic planning against an
approach to risk and return. evolving risk profile, is something
which CFOs should carefully
This timely paper from Deloitte consider to support value protection
outlines how risk-adjusted forecasting and creation – and to enhance
and planning capabilities should be communications with investors about
a key component in the strategic key risks and how companies are
toolkit for CFOs. It is clear that managing them.
enhanced analytics can generate a
better understanding of potential risk
and return, and hence enable faster
and more robust decision-making.
Risk-adjusted planning helps finance Andrew Bonfield
executives to better demonstrate to CFO
boards and investors how the company National Grid plc
is taking an integrated approach to
managing the business in challenging
times. This paper also provides useful,
hands-on advice on how executives can
think about the practical application
of these concepts – through case
studies and suggested first steps to
implementation.
Contents

The ‘new normal’: incorporating continued volatility in planning2

How the CFO can lead the response3

Targeting an integrated approach to finance, risk and strategy4

Risk‑adjusted forecasting and planning: equipping the CFO for the ‘new normal’5

Driving value through enhanced risk‑return capabilities9

Making it work in practice: embedding the capabilities 10

Five essential questions for the CFO to consider for successful implementation11

Summary: time to act12

UK contacts

Risk‑adjusted forecasting and planning  1

The ‘new normal’: incorporating
continued volatility in planning

Volatility has increasingly become the ‘new normal’. This is most starkly demonstrated by the recent and
ongoing turbulence in the global economy, coupled with continued, rapid globalisation across many industries.
In some cases, structural changes in markets and economies mean that companies are having to ask more
fundamental questions about their business models, and questioning how to gain competitive advantage within
continually‑changing operating environments. In the aftermath of the Global Financial Crisis, an associated
deleveraging has taken place within many companies, with corporate CFOs remaining cautious around the
transition from increased cash balances into next generation investment programmes and growth ambitions.

Alongside these macro‑economic challenges, organisations are also under ever‑increasing pressure from:

• New consumer and multichannel strategies

• Shifting demand drivers from fast‑growing developing markets

• Increasing digitalisation and technological shifts

• Higher levels of stakeholder/investor scrutiny

In the face of this complexity and volatility, the ability of CFOs and finance functions to interpret, quantify, manage
and leverage risk is more important now than perhaps ever before (see Exhibit 1). And yet, many organisations are still
seeking to find practical solutions for the incorporation of risk into planning and decision‑making.

Exhibit 1. Taking the pulse of corporate viewpoints on managing volatility

Recent Deloitte survey results1 indicate that a high percentage of companies have changed their approach to managing and responding to risk due to recent
volatility, and results also suggest that many risk categories are expected to become more volatile in the near future

Has your organisation’s approach to managing and How volatile do you think each of the following risk areas will be over the next three years?
responding to risk changed due to market volatility
over the last three years? Financial risk

Strategic risk
5%
Operational risk
17% Regulatory/Compliance risk

Political/Geopolitical risk
39% Technology risk
Corporate Responsbility/
Environmental/Sustainability risk
Reputational risk

Value and Supply Chain risk

40%
Talent/Human Capital risk

Tax risk

Yes, significantly Yes, somewhat 0% 50% 100%

No Don’t know More No Less Don’t

volatile change volatile know
(Note: Numbers may not add up to 100% due to rounding.)

1 Deloitte survey of 192 US corporate executives, across industries, 2012

2 ‘CFO in Transition: Four faces of the CFO’, Deloitte, 2010

2
How the CFO can lead the response

The role of the CFO and the finance function is evolving in response to this challenging environment. Deloitte’s
‘four faces’ model2 identifies the strategic leadership and catalyst roles that CFOs and Finance Directors are
increasingly required to fulfil, alongside the more ‘traditional’ finance roles of steward and operator.

The change in the focus of the CFO role, and hence a growing responsibility for playing a direct part in the
determination and execution of strategy will require fresh and innovative ways of thinking by many CFOs. There is
also the more immediate need for them to be accountable for marshalling the business within this ‘new normal’
environment of increased volatility. We are seeing a number of companies (notably in the energy, resources and
manufacturing industries) already developing enhanced risk‑return capabilities to position themselves to respond
effectively to these challenges.

Moving forward, therefore, there are several areas of enhancement which organisations are targeting to help
position themselves for future growth. We outline these in Exhibit 2.

Exhibit 2. Potential areas of enhancement for organisations in response to volatile operating environments

CFOs and FDs are playing a more direct role in the determination and execution of strategy and, with the CEO, lead transparent
communication with investors and the optimisation of risk and return in planning and decision‑making

Reliability of financial and Internal and external Risk‑return

strategic planning transparency optimisation

• Improving the reliability • Building transparency, • Developing stronger

of capabilities
Enhancement

of financial and strategic within the organisation approaches to risk‑return

planning, both at group and when facing off to the management to enable
level, and within the investor community optimal capital allocation
business units and segments
of the organisation

• How much confidence can • What profit forecast • Do we have sufficient
we place in the budgets and should we commit to and understanding of the
plans of the business units? communicate to our investor strategic risks and
community? opportunities across
• How can we build an business units?
executive leadership
Key questions for

understanding of the • What level of external

volatility of key cash‑flow disclosure is optimal and • What are the key emerging
and earnings elements appropriate across the risks we should be analysing
within the businesses? businesses? and managing?

• Are we sufficiently prepared • How can we build • Do we have a strong and
to manage the corporate transparency across the practical risk appetite
portfolio and respond to business units to ensure approach, which is
capital allocation challenges common assumptions and understood and respected
in a changing environment? inputs? across the organisation?

Snapshot case study

Building practical risk‑adjusted diagnostic tools to drive improved profitability

This Aerospace & Defence Company’s aftermarket maintenance program was experiencing poor profitability performance. To identify the
major drivers of low profitability, a risk‑adjusted diagnostic tool was built to evaluate key drivers of volatility in top‑line revenue (e.g. pricing,
contractual penalties) and bottom‑line costs (e.g. labour, parts, other costs). As part of this, a comprehensive Monte Carlo model was
generated using historical cost distributions, future pricing models, and contractual inputs to forecast risk‑adjusted program profitability.
Using the tool, significant bottom‑line savings from implementing the selected high‑priority initiatives were identified. To track and monitor
future program profitability, supporting infrastructure was designed to enable metrics and reports to be delivered by SAP to manage
profitability going forward, including functional specs for eleven reports and two dashboards.

Risk‑adjusted forecasting and planning  3

Targeting an integrated approach to
finance, risk and strategy

Traditionally, organisational capabilities to respond to these various challenges can often be found in silos – be it
within the finance community, the strategy function, the risk management group, or the investor relations team.
Increasingly, however, more integrated approaches are becoming essential to help drive sustainable and profitable
growth in the face of a challenging and volatile environment. Indeed, in order to improve reliability of financial
planning and build transparency for communication with investors and other stakeholders, improved coordination
of strategy, risk and finance is becoming a need‑to‑have, not a nice‑to‑have (see Exhibit 3).

Exhibit 3. Value‑enablers within the organisation

Stronger integration of finance, strategy and risk is essential as organisations respond to challenging external environment

Understanding the Continuing to grow the brand, Preparing the enterprise for
probability of a specific improve revenue growth, operating the risks and opportunities
budget/plan being delivered margins and asset productivity that inevitably lie ahead
in the face of increasing volatility
Finance Strategy

Focusing planning Effectively linking

discussions on a strategic planning
robust balance of Value process with
enablers
upside and downside risk-return approaches

Understanding the Reliably analysing the

best and worst case exposure to emerging
scenarios for risks and developing cost-effective
performance estimates mitigation strategies
and forecasts
Risk

Defining risk appetite and

tolerances, and apply in
decision-making

CFOs and Finance Directors, therefore, should be targeting the implementation of specific new capabilities to
support them as the scope and role of the finance function evolves to become more strategic, forward‑looking,
and value‑focused. The leading‑edge CFO will require a more flexible and analytical toolkit to ensure that the
business is equipped to manage the increased volatility of the ‘new normal’. Our research with some of the largest
corporates in the UK 3 indicates that many organisations consider enhanced risk‑return evaluation capabilities to
be increasingly essential in strategic and financial planning.

3 ‘The myth and reality of the corporate CRO’, Deloitte and Hedley May, 2011

4
Risk‑adjusted forecasting and planning:
equipping the CFO for the ‘new normal’

More advanced quantitative approaches can support CFOs in their risk‑return oversight role and provide greater
responsiveness in the face of increased complexity and interconnectivity (see Exhibit 4). Next generation financial
forecasting and planning will include a far greater awareness and quantification of risk and uncertainty within the
processes and the outputs.

Exhibit 4. Financial forecasting and planning for the ‘new normal’

Enhanced, quantitative approaches to building uncertainty into financial forecasting will be essential to equip the modern CFO to
prepare robust and reliable plans

Next generation financial planning is

Current approaches to financial forecasting
likely to include the following enhanced
and planning are characterised by:
capabilities:

• Forecasts based largely on single‑point • Migrate from single point forecasting

estimates and metrics and single input sensitivity to multi‑factor
perspectives
• Sensitivity analysis focused on single
variables • Build in the use of quantitative distributions
and aggregation of individual volatilities to
• Strong variability in assumptions and inputs evaluate ranges of possible outcomes
across business units
• Shock the financial forecasts with major
• Inadequate application of formal stress risk drivers to get a cash flow or earnings
testing approaches distribution for each period

• Limited integration between strategic • Better linkage between the uncertainty

planning, financial forecasting and in cash flow and earnings and the impact
budgeting, and risk analysis on key balance sheet metrics and financial
ratios
• Single sourcing of inputs

Snapshot case study

Strategic risk management in capital projects

A Global Mining Company delivered tangible value by improving the management of its investment portfolio by aligning it against group
strategy – with a key focus on risk‑return management. The principal risk areas associated with the capital investment process were
mapped, analysed, and aligned into a prioritisation framework. This technique helped the company to optimise and implement the massive
capital project pipeline over a 3‑5 year period, resulting in a stronger execution of corporate strategy.

Risk‑adjusted forecasting and planning  5

 Approach
Risk‑adjusted forecasting and planning involves shocking the financial forecasts with major risk drivers in an
integrated and flexible manner (see Exhibit 5). The approach allows a more robust and transparent evaluation
of volatility and risk within current plans – helping to build a better understanding of the potential upside and
downside inherent in the future of the business. The key elements are a set of inputs, a quantitative modelling
‘engine’, and a suite of outputs. The inputs consist of consolidated financial planning data together with macro and
micro risk drivers. The modelling engine uses quantitative techniques to combine the risk drivers with the relevant
components of the ‘base‑case’ financial forecasts.

Exhibit 5. The basics of risk‑adjusted forecasting and planning

Integrated financial forecasts are stressed with key risk drivers to produce cash‑flow‑at‑risk and earnings‑at‑risk outputs

Inputs Modelling engine Outputs Decision-making

Key inputs are required The modelling engine The outputs produced More robust and
to enable structured and utilises quantitative by the model allow transparent evaluation of
transparent evaluation of techniques to analyse assessment of the risk and uncertainty in
risk-return of financial risk-return across the uncertainty in budgets and plans
planning application areas forecasts and plans
Enabling scenario
modelling and multi-risk
Quantitative modelling Free cash flow (£m)
perspectives
Business financials
£7,000

techniques are applied across £6,000

all the interception points to

£5,000
Focus management time
General risk drivers £4,000

build a consistent picture £3,000 and efforts on the key risk

Specific risk drivers
across the financial plans £2,000

£1,000
and value drivers
£0
Past Reporting Periods (RPs) Current RP RP1 RP2 RP3

90th percentile Budget Expected value 10th percentile Enhanced confidence in

%
Dynamic models allow delivery of plans and
assessment of uncertainty budgets
Parameter
in cash-flow forecasts,
optionality for capturing Facilitates transparent
upside, and insight into challenge and review
key drivers of exposures
Better prioritisation of
executive time and
corrective action

Snapshot case study

Risk‑adjusted techniques to support corporate portfolio management

An Electricity Generation Company was investing significant amounts on innovation and business development to stay competitive
and secure future profitability. The company developed a risk‑based portfolio management model to facilitate efficient assessment,
prioritisation, selection, and monitoring of ideas and projects. The risk‑adjusted techniques helped create an overview of the R&D
portfolio and create metrics for measuring R&D performance and efficiency. This enabled the strategic management of the R&D
portfolio to be based on well‑founded decisions. This was supported by a governance structure for reporting, portfolio reviews and
decision‑making in R&D.

6
Outputs Exhibit 6. Cash‑flow‑at‑risk and earnings‑at‑risk outputs
The modelling approach produces cash‑flow‑at‑risk and earnings‑at‑risk forecasts, allowing
assessment of uncertainty and providing insights into opportunity for capturing upside as well
as managing downside risk
Risk‑adjusted outputs allow the organisation to identify
and understand key areas of volatility and exposure Free cash flow (£m)
from a value enhancement and protection perspective
£7,000
(for example, Exhibit 6). The techniques focus on
underlying factors rather than simply impact, meaning £6,000 See chart below
that multiple driver contributions to volatility can be
analysed simultaneously rather than looking at single £5,000
variables.
£4,000
This allows stress tests and risk analysis with a
common set of risk metrics and assumptions to shock £3,000
the aggregated cash‑flows. The outputs also facilitate
segmentation of ‘cash‑flows at risk’ by product, £2,000

business unit, market segment, or any other

£1,000
functional slice.
£0
Past Reporting Periods (RPs) Current RP RP1 RP2 RP3

90th percentile Budget Expected value 10th percentile

Probability of forecast value

5% Expected value

4% Budget
10th 90th
percentile percentile
3%

2%

1%

0%
£3,600 £3,800 £4,000 £4,200 £4,400

Free cash flow, RP1 forecast (£m)

Risk‑adjusted forecasting and planning  7

Exhibit 7. Risk driver analysis Hence, key areas of volatility and exposure can be
Risk driver analysis allows a quantitative understanding of which factors contribute most to
targeted for action (see Exhibit 7). For example,
earnings exposure, enabling organisations to evaluate risk mitigants (cost vs. risk reduction) in
a targeted and cost‑effective fashion and to capture upside opportunity elements with largest contribution to downside
earnings exposure and those which could help capture
upside.
Downside EBIT @ risk 46%

Commodity price movements 5% The approach will aid the development of practical
Key executive/technical personnel 9% approaches to determining and managing risk appetite,
focusing the organisational response to specific areas
Supply chain 8%
of high exposure and helping drive cost effective
Exchange rates 5% risk management decision‑making. The outputs can
11%
also build insight into how target financial ratios are
Regulatory change
affected by volatility within forecasts.
Other 8%

0% 10% 20% 30% 40% 50%

RP1 EBIT downside exposure (% on expected value)

Upside EBIT @ risk 31%

Taxation regime change 2%

Exchange rates 10%

Capital project delivery 7%

Commodity price movements 3%

Demand volatility 5%

Other 4%

0% 10% 20% 30% 40% 50%

RP1 EBIT upside potential (% on expected value)

Snapshot case study

Risk‑adjusted forecasting and scenario modelling to optimise asset performance

The main operating sites of this Global Metals and Mining Company frequently failed to meet planned production targets and budgets.
The underlying planning process relied on averaged values based on historical performance, and did not take process variance into account
during the limited scenario modelling that was conducted. By identifying and analysing key input variables, quantitative distributions were
able to be developed for each risk driver, and risk‑adjusted forecasting models were generated for each the sites. This resulted in an improved
understanding of how the underlying volatility was impacting production performance. On the back of this, more effective decision‑making
was enabled through enhanced scenario modelling, increasing confidence in plans and budgets – and ultimately improving profitability.

8
Driving value through enhanced
risk‑return capabilities

Enhanced risk‑return capabilities can significantly improve planning and enhance decision‑making at a group
level by building a quantified understanding of uncertainty in the plans. Furthermore, the practical application of
risk‑adjusted approaches within the businesses can help integrate strategic planning with risk and finance – driving
more value at BU level. Whilst the benefit of these enhanced capabilities can be realised in numerous ways, there
are four main areas of value which we identify in Exhibit 8.

Exhibit 8. Core benefits across the organisation

Risk‑adjusted approaches allow a more robust and transparent evaluation of volatility and risk within plans

Forecasting and Risk return

Decision‑making Transparency
planning optimisation

Forecasts based Basic sensitivity Limited integration Strong variability in

Current approaches largely on single‑point analysis carried out, between strategic assumptions
estimates and metrics using single variable planning, financial and inputs across
approaches forecasting, and risk business units
analysis

Enhanced risk‑return • Dynamic models • The techniques • Identifies cash‑flow • Builds stronger
capabilities allow assessment focus on underlying elements with communication and
of uncertainty factors rather than largest contribution interaction between
in cash‑flow and simply impact, to downside business units and
earnings forecasts which builds earnings exposure group
understanding of
• Outputs provide how to capture • Allows stress tests • Improves
insights into upside and risk analysis cross‑functional
opportunity for with a common set working and
capturing upside • Evaluation of risk of risk metrics and internal transparency
mitigants (cost assumptions through consistency
• Diverse input types vs. risk reduction) of assumptions and
(e.g. cyclical trends possible • Facilitates data across business
and event risks) can segmentation of units
be included in the • Multiple risk driver cash‑flows at risk by
same models contributions to product, BU, market • Facilitates
volatility can be segment, etc stronger dialogue
analysed – rather with markets
than using single and external
variable approaches stakeholders

Risk‑adjusted forecasting and planning  9

Making it work in practice: embedding
the capabilities

Embedding the approaches within the existing performance management framework is essential to generate
maximum benefit. A performance management framework ensures that the key value drivers of the business
are understood, owned, and measured, and a fully‑integrated performance management process drives
target‑setting, decision‑making and execution. An effective performance management framework is enabled by
the right technology, capabilities, governance and data. Exhibit 9 highlights how this can support the successful
implementation of risk‑adjusted capabilities.

Exhibit 9. Performance management considerations

Embedding the approaches within the company’s existing performance management framework can help generate maximum
benefits

How a performance management

Key characteristics of an effective
framework can support building
performance management framework
risk‑adjusted capabilities

• Focussed and aligned management • Makes the process more effective and
information across functions efficient

• A common data warehouse with harmonised • Drives faster and more reliable decision‑making
financial and non‑financial data sets and at various levels within the organisation
common global hierarchies
• Helps target the best ‘intervention points’
• The right tools for consolidation, planning, for the different outputs
reporting, analytics and master data
management, integrated with the data • Enables scenario modelling and stress
warehouse testing to understand the likely range of
outcomes and thus make better decisions
• A global, cross-functional governance model
for processes, data and systems • Focuses senior management efforts on the
key strategic questions and drivers
• Integrated planning, reporting and
performance analysis processes • Builds stronger confidence in delivery of
plans and budgets
• Development of business partners and
business analytics capabilities focused on • Facilitates transparent challenge and review
key value creation opportunities across the and improves communication with the
value chain investor community

Snapshot case study

Risk‑adjusted forecasting to support strategic decisions

A Pharmaceutical Preparation Manufacturer’s hospital and urology franchises were the cornerstones of its portfolio. The company
developed risk‑adjusted forecasts to better understand, assess and prioritise disease areas based on commercial attractiveness and
strategic fit. In this way, the company identified high‑potential assets and M&A targets. The risk‑adjusted forecasts indicated that over
the next ten years the hospital franchise would face declining revenue, while the urology franchise would grow at a moderate rate.
Each franchise forecasted growth rate was below the organisation’s targeted growth rate, highlighting the need to explore inorganic
growth opportunities.

10
Five essential questions for the CFO to
consider for successful implementation

CFOs in many organisations struggle to clearly identify the best way in which to approach the ‘proof-of-concept’
and implementation of these new capabilities. Common pitfalls include: focusing too quickly on the underlying
techniques rather than what the value objectives are; moving too quickly to one specific application area, rather
than considering how the approaches can enhance multiple areas (e.g. planning, decision‑making, market
communication); and not identifying the most suitable part of the business for a pilot or proof-of-concept project.

It is therefore clear that implementation considerations are vital when exploring how to successfully build
risk‑adjusted approaches. What is encouraging for CFOs who aspire to build more enhanced capabilities to
optimise risk and return is that there are some achievable quick‑wins and progress areas, regardless of the current
capabilities and/or complexity within the organisation.

We highlight five essential questions for CFOs to consider to help identify the key considerations on the journey
to building risk‑adjusted forecasting capabilities (see Exhibit 10). The answers summarise our insights into how to
best position the initial pilot project to succeed and get embedded. Getting these right will improve the chances of
building sustained value via risk‑adjusted approaches.

Exhibit 10. Five essential questions

CFOs should consider drilling down into the detail behind these questions as they target the protection and enhancement of
value via risk‑adjusted approaches

How do we start to use

the output?

• Plan a roadmap for

‘first use’

• Build into existing

What is the basis of the managerial
technical approach? frameworks

• Outline desired • Continue internal

outputs buy‑in efforts

• Build and validate • Consider use in market

What level should technical model communication
we go to?
• Ensure consistent set
• Limit input to top of risks and forecasts
10‑15 risks
• Allow future flexibility
• Mixture of data and
Where should we start? SME input is required

• Consider expert
• Initiate pilot project or challenge of risk
proof‑of‑concept inputs

• Use group‑level • Quantification is

How do we build the forecasts essential
business case?
• Consider additional
• Quantify core benefits BU‑specific input

• Outline quick wins • Build executive buy‑in

and long term value

• Focused use of
resources

• Set‑up internal
working group

Risk‑adjusted forecasting and planning11

Summary: time to act

The ‘new normal’ of increased volatility, complexity and interconnectivity means that existing approaches in place
to reflect uncertainty in business planning are no longer sufficient. There is increased pressure on CFOs from
boards, investors, and financiers to manage and optimise the risk‑return balance of the company, and to reliably
reflect the volatility in forecasts and plans.

CFOs have a need and a responsibility to act decisively to build new capabilities in order to fulfil the strategist and
business‑partner role, and to target more value from strategic risk‑return management. Risk‑adjusted forecasting
and planning is a powerful and pragmatic response that allows organisations to respond to these pressures and
to build lasting capabilities – focused on value protection and creation. The approach allows a more robust and
transparent evaluation of volatility and risk within current plans – helping to build a better understanding of the
potential upside and downside inherent in the future of the business.

For CFOs who aspire to take action and enhance the organisational risk‑return capabilities, it need not require a
major new initiative. The route to implementation is through a flexible and targeted pilot rather than a firm‑wide
reengineering project – acting on specific problems or areas, making significant quick wins, and contributing
tangibly to the competitive positioning of the business.

Snapshot case study

Economic forecast modelling using risk‑adjusted techniques

This Energy Utility Company was frustrated with the deterministic nature of the organisation’s long range economic forecasting. The organisation
targeted the development of advanced, stochastic economic forecasting models that could effectively analyse the business in such a way
that the organisation could understand their business issues from a risk‑weighted probabilistic perspective. The company developed an
economic forecasting engine that utilised Monte Carlo simulation and linear programming techniques to simulate the behaviour of commodity
markets (power, natural gas, coal), interest rates (treasury rates, credit spreads etc.), customer demand, power generation dispatch and other
uncertainty factors in order to generate a set of defined probabilistic key performance indicators.

12
UK contacts

Hans‑Kristian Bryn
Partner
+44 (0) 20 7007 2054 
[email protected]

Malcolm Wilkinson
Partner
+44 (0) 20 7007 1862 
[email protected]

Nick Pope
Director
+44 (0) 20 7007 3632 
[email protected]
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