Financial Planning: The Layer Cake
If 2020 and the COVID-19 pandemic have taught us anything, it’s that nobody can predict the future.
And yet, Finance departments of all stripes spend untold hours constructing annual budgets and financial plans which – inevitably – are later painstakingly amended once reality moves on.
So as financial institutions stare down the barrel of this year’s planning exercise, surely it’s time to consider a better way of doing things?
The answer, we believe, lies with the concept of ‘planning in layers’.
‘Planning in layers’ is a process whereby plan financials are constructed as a series of standalone additive layers, stored as separate ‘versions’ within a financial planning system, each designed to capture the impact of a given (set of) action(s) or macroeconomic circumstances on an organisation’s financials.
The key advantages that a well-implemented ‘planning in layers’ approach provides – particularly in the context of an ever-changing world – are two-fold. The first is mechanical; by leveraging enhancements in financial modelling and planning technology, projection of the majority of the plan financials can be automated, enabling them to be constructed with significantly less manual effort than current spreadsheet-heavy data gathering processes.
Second, the clear division of the plan into distinct layers within a financial planning system means that when there is a material change to the operating environment or business strategy within a financial year, it is far simpler to isolate and re-plan for the impact the change is anticipated to have on the overall financial performance of the organisation. Thus, when things change in year, as they always will, the plan can be adjusted for the impact relatively quickly.
To bring this to life, the annual operating plan of a typical financial institution could be best constructed in the following sequence, with the layers ordered in terms of materiality:
- Layer 1: Fully modelled ‘base case’ – The first, and historically most difficult to achieve, layer of the financial plan for financial services organisations. Leveraging improvements in financial modelling technology, organisations should construct a forward-looking financial model of the organisation’s performance based on underlying economic or operational drivers, assuming all other factors remain unchanged (Note: this is not the same as prior year +/- x%!). In a typical year, for an established business, layer 1 should account for the significant majority of the financial plan.
- Layer 2: Strategic actions – The second layer should account for the financial impact of known strategic actions. For example, acquisitions, disposals, new product lines, or cost cutting programmes would all fall within this layer. The anticipated impacts should be expressed as absolute values to the relevant P&L or Balance Sheet lines, and there should be a clear owner of each strategic action.
- Layer 3: ‘Stretch’ targets and expert judgement – This layer should be used to account for the financial impact of ‘stretch’ objectives, or any adjustments to be made to the outcome of layer 1 based on the opinion of subject matter experts. Adjustments of this nature should be kept to a minimum, and must be clearly documented, with strong underlying rationale as to why the change was made and how it will be achieved operationally, signed off by the owner of the relevant business, product, customer segment, or geography. As with layer 2, there should be a clear owner of each adjustment, and the financial impacts should be expressed as absolute values to the relevant P&L or Balance Sheet lines.
- Layer 4: ‘Plug’ to board-level targets – The final layer, which should be kept to an absolute minimum or, preferably, eliminated, is a holding pen for ‘plugs’, representing the gap between the sum of layers 1-3 and any top-down mandated board targets. These should be reviewed monthly to determine whether or not they are achievable or need to be revisited.
The benefits of planning in this manner are significant.
First, by focusing on an almost fully modelled layer 1, the vast majority of the plan can be constructed quickly, and with limited effort. What’s more, these models, once built, can be leveraged to achieve similar efficiencies in other core finance processes (e.g. forecasting, stress testing etc.).
Second, by focusing on a limited number of items in layers 2 and 3, the number of adjustments required to accommodate an intra-year change in circumstances (e.g. an unforeseen global pandemic!) is minimised.
Furthermore, by placing a relatively high ‘burden of proof’ on the owners of these items before they are even included in the plan, their financial impacts are likely to be better understood and more accurate in the first place.
Finally, constructing plans in this way allows for far more effective, target-led incentivisation practices. Where the impact of a global economic downturn can be isolated to the first layer, it is far easier to evaluate whether or not front office departments have under or over-performed, including versus any ‘stretch’ targets they have set for themselves in layer 3.
All this leads to a plan that is quicker to construct, faster to adapt, and with greater accountability for the outcomes.
As with any business change, moving to a system of planning in layers may not be easy. It may well require changes to modelling and IT infrastructure, a cultural shift to relying more heavily on modelled numbers, new governance structures and processes to evaluate proposed ‘layer 3’ items, and many more.
However, done right, we believe that the benefits far outweigh the costs. In a world as uncertain ours, sticking to the status quo just doesn’t stack up.