Financial planning and analysis at Philips Health Systems Customer Services

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Financial planning and analysis at Philips Health

Systems Customer Services

Student: Pritam Sasmal Student number: 10839593

Supervisor: Dr. Rui J. Oliveira Vieira Submission Date: 13thof September, 2015

Program: Master of Business Administration (MBA)

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Statement of originality

This document is written by Pritam Sasmal who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Amsterdam Business School is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract:

Purpose- The purpose is to develop a framework and come up with suggestions to improve the financial analysis and planning methods so as to ensure that the financial forecasts for companies are more accurate and close to the actual results.

Approach/Methodology-To serve the purpose of the research, detailed information about relevant financial parameters and key performance incentives were collected from various financial reports. A thorough understanding of the various product categories and structures, and, knowledge of the global market break up was also developed. Philips internal documents and intranet system were also referred to get information about its financial system, conventions, standards, best practices and processes. A series of semi-structured interviews were conducted with director and senior financial analysts to know about the existing processes and solicit suggestions on improving them. The theoretical framework focussed on multiple aspects of forecast such as budgeting, variance analysis and also on decision making guidelines for managers.

Findings-The research shows that in order to improve the accuracy of the financial forecast it is important to understand the causes of past variances at the most granular level. The research gives a clear view of the financial business hierarchy of the Health Systems Customer Services division at Philips and the flow and distribution of information across the hierarchy. A flowchart was devised to structure the processes of financial analysis and data investigation based on various financial figures and the business hierarchy that would help the management and financial analysts to identify the root causes of deviations between the forecast and the actuals. On the basis of this information, the management may take necessary actions to resolve the issues and/or adjust their forecasting models which would eventually lead to improving the accuracy of their financial forecasts.

Limitations-The scope of the research is limited to the Health Systems Customer Services division. The forecasting methods used in other units could be different, and therefore, the findings of this research may not be completely applicable to all units across all organisations. Value-This paper offers a comprehensive picture of the financial data investigation processes followed at Philips Health Systems Customer Services division and provides suggestions and guidelines to improve the financial analysis methods in order to have more accurate forecasts.

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Over the years, the world economy has gone through major transformations, redesigning the economic scenario, making it more and more difficult for companies to read and adapt to the changes in their respective markets. Due to these volatile business conditions, the forecasting processes, methods and tools employed at various organizations across the world are becoming less effective, and therefore obsolete, resulting in poor forecasts. This fact is substantiated by the surge in the number of profit warnings over the last few years. With markets across the globe turning more impulsive and competition among the companies becoming fiercer, the benefits that an improving economy may bring to the companies may get offset. As quoted by Ernst and Young in the British newspaper Telegraph website (25Jan2015):

“The six-year high in profit warnings might look incongruous next to improving growth, but it’s a reminder that economic recovery isn’t a panacea for many companies,”

The finance managers should take cognizance of this fact and take necessary steps to battle the malaise the financial processes are suffering from. A prudent and logical approach would be to understand the reasons causing the poor forecast at the most granular levels and address the issues by either eliminating the causes or adapting to the new market demands and conditions. As mentioned by Player and Morlidge (2010, p.2):

“First, finance managers should recognize what ails them by identifying and addressing the common symptoms of forecasting illness. Second, equipped with that understanding, finance managers can implement cures that lead to healthier forecasting practices and, ultimately, more flexible and profitable organizations.”

The first step is very crucial as that decides the direction for the way forward. With an emphasis on improving the forecasting practices, this paper presents a guideline to navigate through multiple levels of data hierarchy, gather information about the underlying issues, assess the impact at the top level and set the platform to decide the necessary course of action. Also, given the current dynamic market environment, organizations can no more afford to rely on information from only the past to make predictions. They would also need information based on the managers’ beliefs on the future and their anticipation about the outcomes, which is developed during the forecasting processes. So, directly or indirectly, the forecast processes adopted in an organization play a significant role in determining the accuracy of the forecasts. Of late, poor forecasting practices in companies have resulted in financial losses and erosion of shareholder value. Sometimes the financial managers have to alter between conflicting

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demands (making an accurate estimate or create a more optimistic forecast), and these contradictory demands complicate the approach of their forecast activities and make them inefficient to a certain extent (Player and Morlidge, 2010). If the companies want to avoid wasting time on such inefficient activities they must start looking analytically at the reasons behind the forecasting inaccuracy. One of the tools that the companies (may) use to do so is variance analysis. It helps to scrutinize the aspects that caused the actual numbers to deviate from the predicted ones and measures the accuracy of the predictions. This paper uses the concepts of variance analysis to create a structured data analysis framework that could help finance managers to recognize the reasons for fluctuations at different levels of business and contribute meaningfully towards identifying the root causes of the forecasting failures, thereby improving the forecasting processes and creating value for the companies. Moreover, collecting information methodically and realistically would give the financial managers a better visibility about possible results and the potential risks associated with them, and guide them to come up with more accurate forecasts.

The purpose of this paper is served through a research done on the forecasting processes and methods followed by the Financial Planning and Analysis team of the Global Health Systems Customer Services division of Philips. This paper looks at the various factors (both internal and external) driving the numbers of multiple financial KPIs in different reports and comes up with suggestions to make the predictions of those numbers more accurate.

Though improving the forecasting processes and methods necessitates taking an array of generic high level steps, every company (or business units within a company) should take an approach that complements its distinctive mix of business processes, resources, culture and people.

Coming to the structure of the paper, first, the theoretical framework will briefly explain the concepts of budget, the budgeting processes, variance analysis and also discuss how manages can use information to make better forecast. It then presents the research methodology that tells about the various data collection methods and data sources. Then the case study illustrates details about the company and the division, explains the importance of improving forecasting methods in the current context, the current forecasting practices followed and the scopes for improvement. The next section, discussion, explains in detail the ways to improve the forecasting processes and the impact each of those improvements can have on the accuracy of the forecasts. Lastly, the conclusion gives an overview of the research, presents

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its limitations and discusses proposals for further research related to improving forecast accuracy.

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2. Theoretical Framework:

2.1. Budgeting:

Budgeting pertains to the application of the long-term plan for the year ahead. As the budgets are done with a short time frame perspective they are very specific and detailed. Budgets are a reflection of what is estimated to be accomplished during the budget period where as long term plans are indicative of the board directions that the top management is supposed to follow. Drury (2013, p.227) explains:

“The budget is not something that originates ‘from nothing’ each year – it is developed within the context of on-going business and is ruled by previous decisions that have been taken within the long-term planning process.”

Initially the activities that are approved and included in the long-term plan are done on the basis of tentative estimates that are projected for many years. However, they must be reviewed and revised to reflect the more recent business environment. This review and revision process is often done as part of the annual budgeting process, and this may lead to critical decisions about certain adjustments and modifications within the current budget period.

Drury (2013, p.227) further mentions:

“The budgeting process cannot therefore be viewed as being purely concerned with the current year - it must be considered as an integrated part of the long-term planning process.”

The key process for controlling a budget begins with the preparation of annual budget when managers must establish specific measurable budgetary goals. “Budgets are recognised both as a plan for allocating resources and the process through which the plan is controlled.” (Francisco, 1989, p.40)

2.2. Control process:

The next stages after budgeting process, as shown in Figure 1, compare the actual and estimated results and respond to any deviation in the plan.

Planning is closely associated with control. Planning is a forward looking activity to decide upon the actions necessary to achieve the goals of the organisation. Control is about looking back to determine what the actual results are and then compare them with the planned ones. Effective control is about taking the remedial action so as to match the actual results as closely as possible with the planned results. Having mentioned that, it is also possible that the plans have to be changed in case the comparisons show that the plans are no longer achievable. The corrective action is shown by the arrowed lines in the figure below linking

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stages 5 and 2 and 5 and 3.They are the feedback loops. They tell us that the process is dynamic and highlight the interdependencies between the various stages in the process

Figure 1. Strategic planning and control process

(Drury, 2013, p. 227)

The feedback loops between the stages show that the plans should be frequently revised, and if they are no longer achievable then alternative course of action must be devised for meeting the organisation’s targets. The arrow between 5 and 3 also indicates the corrective action that may be taken so that actual outcomes conform to planned outcomes (Drury, 2013).

2.3. Feedback:

As Horngren, Datar and Rajan (2012, p.200) mention:

“Budgets coupled with responsibility accounting provide feedback to top management about the performance relative to the budget of different responsibility centre managers.”

They suggested that variances, the differences between the forecast figures and the actual figures, can be used to assist the management to implement and assess their strategies in the following three ways –

Early warning: Variances give early warnings to managers about events which are not very apparent thereby allowing managers to take corrective measures or use the opportunities to their benefit.

Performance evaluation: Variances allow managers to assess the performance of the company in implementing the strategies.

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Evaluating strategy: On certain occasions, variances inform the managers about how effective their strategies are. For instance, a company trying to improve sales may figure out that it achieved its objectives but that really didn’t improve their margin. This allows the management to re-assess their strategies and take a different approach if necessary (Horngren et al. 2012).

2.4. Rolling budgeting (Forecast):

The conventional approach for budget is that the manager of each budget/cost centre formulates a thorough budget for a year, once in a year. The budget is categorised into either 12 monthly or 13 four-weekly periods for the purpose of control. A yearly budget has been criticised strongly as it is considered too rigid and also because it coerces the company into a 12-month commitment which is highly risky given the volatile nature of the business environment and the uncertain forecasts that it is based on.

A different methodology would be to break down the budget by months for the first three months, and by quarters for the remaining nine months. The quarterly budgets are then prepared or adjusted every month in the year. Drury (2103, p.230) explains:

“For example, during the first quarter, the monthly budgets for the second quarter will be prepared; and during the second quarter, the monthly budgets for the third quarter will be prepared. The quarterly budgets may also be reviewed as the year unfolds. For example, during the first quarter, the budget for the next three quarters may be changed as new information becomes available. A new budget for a fifth quarter will also be prepared. This process is known as the continuous budgeting or the rolling budgeting, and ensures that a 12-month budget is always available by adding a quarter in the future as the quarter just ended in dropped.”

On the other hand, in case of the yearly budget, the period for which the budget is available will shorten until the budget for the next year is ready. Unlike in the yearly budget, the planning process in the rolling budgets is not a once-in-a-year activity. In fact, rolling budget is a continuous process and managers are expected to constantly look forward and adjust the future goals to suit the business demands. One more benefit is that the actual performance will be compared vis-à-vis a more realistic target as the budgets are being constantly revised and adjusted. The main area of concern for the rolling budget is that it can create uncertainty for managers as it is adjusted and updated with the passing year (Drury, 2013). “Irrespective of whether the budget is prepared on an annual or a continuous basis, monthly or four-weekly budgets are typically used for control purposes.” (Drury, 2013, p. 231)

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2.5. Stages in the budgeting process:

Drury (2013, p.232) listed down the following important stages of budget:

“1. communicating details of budget policy and guidelines to those people responsible for the preparation of budgets;

2. determining the factor that restricts output; 3. preparation of the sales budget;

4. initial preparation of various budgets; 5. negotiation of budgets with superiors; 6. coordination and review of budgets; 7. final acceptance of budgets;

8. Ongoing review of budgets.”

Communicating details of the budget policy-

Most of the decisions pertaining to the budget year are already taken as part of the long-term planning process. So, the long-term plan is actually the starting point for preparing the annual budget. It is therefore mandatory for the top management to communicate the policy changes to the managers and teams working on the current year’s budget. There could be possible changes in sales mix, or the expansion or contraction of certain activities. Any other guideline that has an impact on the budget, such as price allowances, wage increases, expected productivity changes, also has to be mentioned. Top management should also make the managers, responsible for the budget, aware of the recent developments or changes in the industry demands (Drury, 2013).

Determining the factor that restricts performance-

Every organisation has certain factors that restricts its performance in a given period. Sales demand is the factor in most of the organisations. But production capacity may restrict performance even when sales demand is in excess of the available capacity. It is up to the top management to figure out the restricting factors prior to the preparation of the budgets as these factors are critical for deciding the starting point of the annual budgeting process (Drury, 2013).

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Preparation of the sales budget-

The most important plan in the annual budgeting process is the Sales budget. “When sales demand is the factor that restricts output, it is the volume of sales and the mix that determines output” (Drury, 2013, p. 232). This budget is also the most difficult one to create as not only the total sales revenue depends on the behaviour of customers but also the sales demand is sometimes impacted by economic state and/or the action of competitors (Drury, 2013).

Initial Preparation of budgets-

Managers responsible for meeting the budgeted targets should make the budget for their respective business areas or cost centres. Budget preparation should follow a ‘bottom-up’ approach. Basically, it should originate at the lowest levels of management, and, reviewed, integrated and coordinated at the higher levels. This allows the managers to participate in the budget making process, and hence, increases the chances of them accepting the budget and striving to achieve the targets (Drury, 2013).

There is no particular method for coming up with the estimates in the budget. Typically, the budget is prepared taking the past data as the starting point. However, it is incorrect to infer that budget is based on the assumption that the past actions would be repeated in the future. Past data may be used as reference, but future business environment and conditions ought to be considered while preparing the budget. Also, the managers may refer to the guidelines received from the top management to work on the budget numbers. As Drury (2013, p.234) explains:

“For example, the guidelines may provide specific instructions as to the content of their budgets and the permitted changes that can be made in the prices of purchase of materials and services.” Negotiation of budgets-

Budgets should be a participative process. As mentioned earlier, the budget process should start at the lowest level of management and managers at this level should submit their budget to their superiors for approval. The mangers who prepare the budget and the superiors negotiate on the budget and eventually come to an agreement on it. So, the final figures in the budget report are actually results of the bargaining process between a manager and his or her superior.

Also, it is important to note that the managers who prepare the budget do not try to come up with budgets that are easily attainable. At the same time the superiors should not try to impose extremely difficult targets assuming that a strict tactic will produce the desired results. The

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desired results may be achieved in the short term, but only at the cost of a loss of morale and increased labour turnover in the future (Drury, 2013).

Coordination and review of budgets-

It is important to examine and review the individual budgets with respect to each other as they move up the hierarchy structure in the negotiation process. It is possible that few budgets are not in sync with each other and need adjustments so as to be compatible with the conditions, restrictions and plans that are beyond a manager’s knowledge or control. As Drury (2013, p.235) explains:

“For example, a plant manager may include equipment replacement in his or her budget when funds are simply not available. The accountant must identify such inconsistencies and bring them to the attention of the appropriate manager.”

Every change should be made by the responsible managers and this may necessitate moving the budget move up and down the hierarchy a few times until it is coordinated and accepted by all the parties involved. A budgeted profit and loss account, a balance sheet and cash flow statement should be prepared during the coordination process to ensure that all the parts combine to produce an acceptable whole. Otherwise, further adjustments and budget recycling will be necessary until the budgeted profit and loss account, the balance sheet and the cash flow statement prove to be acceptable (Drury, 2013).

Final acceptance of budgets-

When all the budgets are ready and in sync with each other, they are summarized into a master budget consisting of a budgeted profit and loss account, balance sheet and a cash flow statement. Once the master budget is approved, the budgets are then rolled across the organisation to the respective cost centres. The approved master budget gives the manager of each responsibility centre the authority to carry out the plans mentioned in the budget (Drury, 2013).

Budget review –

Agreement on the budgets should not be the last step in the budgeting process. The actual results should be compared with the budget numbers periodically. Typically these comparisons should be made every month and a report should be available in the first week of the following month so that it can motivate the managers and team members to perform better. This would help the managers to identify the areas where they could not achieve the desired results and hence deep dive to investigate the reason for the differences. If the differences are

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within the control of management, corrective action can be taken to avoid similar inefficiencies occurring again in the future. Drury (2013, p.236) explains:

“During the budget year, the budget committee should periodically evaluate the actual performance and reappraise the company’s future plans. If there are any changes in the actual conditions from those originally expected, this would normally mean that the budget plan should be adjusted. This revised budget then represents a revised statement of formal operating plans for the remaining portion of the budget period. The important point to note is that the budgetary process does not end for the current year once the budget has begun; budgeting should be seen as dynamic and continuous process.”

2.6. Sales budget:

The sales budget tells about the quantities of each product or amount of services that the company plans to sell and the intended selling price. It gives an approximation of the total revenue from which cash receipts from customers will be estimated, and also provides the basic data for preparing budgets for production costs, and for selling, distribution and administrative expenses. As mentioned by Drury (2013, p.236):

“The sales budget is therefore the foundation of all other budgets, since all expenditure is ultimately dependent on the volume of sales. If the sales budget is not accurate, the other budget estimates will also be unreliable.”

2.7. Production budget and the budgeted inventory levels:

The production budget is the next stage after the completion of the sales budget. The production manager is responsible for this budget which is represented only in quantities. The idea behind this budget is to ensure that the production is enough to meet the demands of the sales and that the economic stock levels are maintained (Drury, 2013).

2.8. Direct materials usage budget:

The managers of different cost centres or departments will make an estimate of the required material quantity to meet the targets of the production budget (Drury, 2013).

2.9. Direct materials purchase budget:

The purchasing manager is responsible for this budget as it is his/her responsibility to get the estimated quantities of raw materials to satisfy production requirements. The goal is to purchase them at the right time at the planned purchase price. The planned raw material inventory levels must also be considered for this budget (Drury, 2013).

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2.10. Direct labour budget:

Managers of individual departments are responsible for preparing this budget. They make an estimate of the labour hours, for their respective departments, needed to achieve the estimated production. Different grades of labour, if present, should be mentioned specifically in the budget (Drury, 2013).

2.11. Factory overhead budget:

The department managers are responsible for the preparation of factory overhead budget as well. The individual overhead items costs, with respect to the expected production level, will determine the total overhead budget. Analysis of the overheads is done depending on whether they are controllable or non-controllable for controlling cost. Drury (2013, p.241) explains:

“The budgeted expenditure for the variable overhead items is determined by multiplying the budgeted direct labour hours for each department by the budgeted variable overhead rate per hour. It is assumed that all variable overheads vary in relation to direct labour hours.”

2.12. Selling and administration budget:

The sales manager and the chief administrative officer will have the responsibility for preparing the selling budget and the administration budget respectively (Drury, 2013).

2.13. Departmental budget:

The direct labour budget, factory overhead budget and materials usage budget are pooled into different departmental budgets for the purpose of cost control. Usually, these budgets are divided into 12 monthly budgets, and the budgeted amount for each of the concerned items are compared with the actual monthly expenditure. This comparison is useful in assessing the effectiveness of managers for controlling expenditure they are responsible for (Drury, 2013).

2.14. Master budget:

Regarding the master budget, Drury (2013, p.242) states:

“When all the budgets have been prepared, the budgeted profit and loss account and balance sheet provide the overall picture of the planned performance for the budget period.”

2.15. Cash budgets:

It is of paramount importance for any company to ensure that it has enough cash at its disposal at all times to meet all levels of operations mentioned in various budgets. Given the uncertain nature of cash budget, it is important to allocate more than the minimum necessary

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amount to allow for some margin of error during planning (Drury, 2013). Cash budgets enables management to act proactively to invest surplus cash in short term investments to avoid cash balances in excess of its requirements. Also, it can help to identify cash deficiencies in advance, and therefore, allow management to take steps to ensure availability of bank loans during temporary short-falls. Drury (2013, p.244) mentions that:

“The overall aim should be to manage the cash of the firm to attain maximum cash availability and maximum interest income on any idle funds.”

2.16. Budgeting in Multinational Companies:

A business spread across multiple countries has its own set of advantages and disadvantages. While a multinational company has access to different markets and resources, it has to face the liabilities of being a foreigner while operating in unfamiliar business environments and is also exposed to currency fluctuations. Multinational companies earn revenues and incur costs in multiple currencies and have to convert their operating performance in a single currency so as to report their results to their shareholders every quarter. This conversion is done based on the currency exchange rate prevailing during the particular quarter. As a result, apart from budgeting in different currencies the companies also have to prepare budget for foreign exchange rates. This is difficult as the management accountants have to anticipate the potential changes that may take place during the year despite the fact that the exchange rates are constantly fluctuating, and therefore, are highly unpredictable. Finance managers, hence, have to use different techniques such as forward, future and option contracts so as to reduce the possible negative impact of the exchange rates and minimize the exposure to foreign currency fluctuations. Moreover, the multinational companies also have to be aware of the political, legal and in particular economic environments of the various countries they operate in. Horngren, Datar and Rajan (2012, p.204) mention, “For example, in countries such as Zimbabwe, Iraq, and Guinea, annual inflation rates are very high, resulting in sharp declines in the value of the local currency.” Companies also have to consider tax issues due to difference in tax regimes that may arise because of their transfer of goods and services across different countries they do business in.

Budgeting is an essential tool for multinational companies operating in uncertain environments. They adjust their budgets according to the changing business environments. In such a scenario, the primary purpose of budget is not to assess the performance vis-à-vis the budget, as it won’t make much sense given the highly volatile conditions, but to allow the managers to learn to adjust their plans according to the changing conditions and to coordinate

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and communicate the actions that have to be taken within the organisation. Senior managers assess performances more subjectively on the basis of how well lower managers perform in unpredictable environments (Horngren et al., 2012).

2.17. Flexible budget:

Flexible budget is the most widely used flexible performance standard which is applied when the targets have to be adjusted to factor in the variations in uncontrollable factors caused by conditions not anticipated during the planning phase. In this budget, the volume effects on cost behaviour that can’t be controlled are removed. It is important to take into account the variability of costs while applying the controllability principle as some costs vary with the level and type of activity (Drury, 2013).

The flexible budget is prepared after the actual results are available, and hence, the budgeted revenues and budgeted costs are calculated based on the actual output in the budget period. Kaplan (1994) explained how integrating flexible budgeting and analysis of actual expenses with activity-based cost assignments and profitability information on products, customers, and services, and, periodic reporting on actual activity demands and resource expenses can help the managers to better understand the different categories or types of costs which would lead them to make better decisions and more accurate predictions in the future. According to Kaplan (1994, p.108), “Managers can easily see which expenses are expected to vary in the short run and use this information in making short-run incremental pricing and product- and customer-mix decisions.”

2.18. Variance Analysis:

Variance analysis means analysing the factors that caused the deviations between the actual figures and the budgeted figures. It helps to distinguish between controllable and uncontrollable items and identify the key performance incentives who are accountable for the variances. For example, variances analysed by each type of cost, and by their price and quantity effects, enable variances to be traced to accountable KPI’s and also to isolate those variances that are due to uncontrollable factors (Drury, 2013).

Figure 2 presents a breakdown of the profit variance (difference between budgeted and actual profit) into variances at different levels.

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Figure 2. Variable analysis for a variable costing system

(Drury, 2013, p.300)

2.18.1. Sales variance

A precise sales forecast would allow a company to offer high quality customer services. If the demand prediction is accurate then the demand can be addressed in an efficient and timely manner (Moon et al., 1998). To improve the accuracy of the sales forecast it would be necessary to look at the past data and understand the causes of deviation from the forecast numbers. In this context, the sales variance can provide significant information to the finance managers. Drury (2013, p.311) mentions that:

“Sales variance can be used to analyse the performance of the sales function or revenue centres. The most significant feature of sales variance calculations is that they are calculated in terms of profit contribution margins rather than sales values.”

The total sales margin variance reflects the impact of the sales function on the difference between budget and actual profit contribution. Drury (2013, p.312) defines it as:

“It is the difference between actual sales revenue (ASR) less the standard variable cost of sales (SCOS) and the budgeted contribution (BC):

Total sales margin variance = (ASR – SCOS) – BC”

Sales variances are caused only because of changes in variables that are driven by sales function, i.e., sales quantity and selling prices. The total sales margin variance can further be analysed into two sub-variances: sales margin price variance, and, sales margin volume variance (Drury, 2013).

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Sales margin price variance is used to analyse the impact of the sales price changes on the difference between the budgeted and actual contribution margin by comparing the budgeted sales price with the actual sales price. As Drury (2013, p.313) states:

“It is the difference between the actual selling price (ASP) and the standard selling price (SSP) multiplied by the actual sales volume (AV):

Sales margin price variance = (ASP – SSP) * AV”

Sales margin volume variance is used to determine the impact of the sales volume changes on the difference between the budgeted and actual contribution margin by comparing the budgeted sales volume with the actual sales volume. According to Drury (2013, p.313):

“It is the difference between the actual sales volume (AV) and the budgeted volume (BV) multiplied by the standard contribution margin (SM):

Sales margin price variance = (AV - BV) * SM”

2.18.2. Material variances

Material variances are related to the costs of the materials used in a manufactured product which is calculated from two primary factors: the price of the materials, and the quantity of used materials. So, there can be two possible cases - the actual cost will be different from the standard cost as the actual price paid won’t be same as the standard price, and/or, actual quantity of materials used will be different from the standard quantity. This leads us to two more variances – Price variance (Material price variance) and quantity variance (Material usage variance) (Drury, 2013).

Material price variance compares the standard price per unit of materials with the actual price per unit. As defined by Drury (2013, p. 302):

“It is equal to the difference between the standard price (SP) and the actual price (AP) per unit of materials multiplied by the actual quantity of materials purchased (AQ):

Material Price Variance = (SP –AP) * AQ”

An adverse price variance may be reflective of the failure of the purchasing department of the company to find the most beneficial sources of supply. Having mentioned that it would be incorrect to infer that the material price variance will always give a perfect idea of efficiency of the purchasing department. The actual prices may differ from the standard prices because of changes in the industry as a whole or changes in customer demands. In this case the price variance would be beyond the purchasing department’s control (Drury, 2013).

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Material usage variance compares the standard quantity that should have been used with the actual quantity that has been used. Drury (2013, p. 302) states:

“It is equal to the difference between the standard quantity (SQ) required for actual production and the actual quantity (AQ) used multiplied by the standard material price (SP):

Material usage variance = (SQ – AQ) * SP”

The material usage variance is usually controllable by the manager of the respective cost centres. Few common causes of material usage variances are sub-standard quality of material, careless handling by production personnel, or, changes in production/manufacturing methods. Material usage variances should be calculated separately for each type of material used and allocated to each type of cost centres.

Variance analysis can help managers to understand the reasons behind the deviations which can result from both internal (quality, procedures etc.) and external sources (price changes, work load etc.). Flexible budget variance analysis affords the opportunity to quantify, with line-item specificity, the dollars associated with a group of causes. These causes can be differentiated into volume variance, a price variance and quantity or use variance. The key to budget control is to be timely in reviewing variance, to correct negative behaviours and to correct rates promptly. If variances are not investigated promptly, the budget serves only as a planning tool and not as an aid to controlling operating costs. Improvements in budget performance will depend on the actions taken as a direct result of effective variance analysis (Francisco, 1989).

Variance analysis is particularly helpful in determining the causes of deviations between the actual numbers and the projected numbers when there are multiple mix features or drivers for different revenue, cost and margin KPI’s. Gaffney, Gladikh and Webb (2007, p.167) developed a variance analysis framework, for managing distribution costs, that incorporates:

“(a) mix variance calculations where there is more than one mix factor within a single cost element; (b) the impact of unplanned and unrealized activities; and (c) multiple nested mix variance calculations.”

This framework can be generalized to other manufacturing and non-manufacturing costs that have multiple mix features that may impact costs. This kind of framework can be used to calculate the cost impact of an actual mix that deviates from the budget.

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2.18.3. Labour variance 2.18.3.1. Wage rate variance

The labour price paid and the labour quantity used determine the cost of labour. There could be variances for both price and quantity. The price, or the wage rate, variance is determined by taking the difference between the actual price per hour and the standard price per hour. In the words of Drury (2013, p. 306):

“the wage rate variance is equal to the difference between the standard wage rate per hour (SR) and the actual wage rate (AR) multiplied by the actual number of hours (AH):

Wage rate variance = (SR – AR) * AH”

This variance is one of the least controlled ones by the management. Often, the variance is because of the wage rate standards not in line with the actual wage rates changes. Hence, the managers normally can’t control this variance (Drury, 2013).

2.18.3.2. Labour efficiency variance

This variance shows the variance in quantity for direct labour. Drury (2013, p. 306) mentions the following formula to calculate the variance:

“the labour efficiency variance is equal to the difference between the standard labour hours for actual production (SH) and the actual labour hours worked (AH) during the period multiplied by the standard wage rate per hour (SR):

Labour efficiency variance = (SH - AH) * SR”

Unlike the wage rate variance, this variance is usually controllable by the respective cost centre managers. The reasons could be various such as introduction of new machinery and tools and production process changes which affect labour efficiency, poor quality material usage etc. However it may not be always controllable by production supervisor; may be because of quality control standard changes or poor planning (Drury, 2013).

2.18.3.3. Total labour variance

As the name suggests, this variance gives the total variance prior to analysing the quantity and price factors. The variance formula, as mentioned by Drury (2013, p. 307) is:

“the total labour variance is the difference between the standard labour costs (SC) for the actual production and the actual labour cost (AC):

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2.18.4. Overhead variances

Overhead variances can be sub divided into two categories – Variable overhead variances and Fixed overhead (expenditure or spending) variances.

2.18.4.1. Variable overhead variances

The total variable overhead as described by Drury (2013, p. 307) is as follows:

“the total variable overhead variance is the difference between the standard variable overheads charged to production (SC) and the actual variable overheads incurred (AC):

Total variable overhead variance = SC - AC”

The variable overheads may vary due to input machine hours or direct labour but the total variable overhead will be because of price variance caused by difference between actual expenditure and budgeted expenditure, and/or, quantity variance caused by difference between actual direct labour and the anticipated hours of input. These lead to two more sub-variances, i.e., variable overhead expenditure variance and variable overhead efficiency variance (Drury, 2013).

2.18.4.1.1. Variable overhead expenditure variance

It is important to twist the budget to compare actual overhead expenditure and budgeted expenditure as it is assumed that variable overheads is a function of direct input labour hours. As Drury (2013, p. 308) mentions:

“the variable overhead expenditure variance is equal to the difference between the budgeted flexible variable overheads (BFVO) for the actual direct labour hours of input and the actual variable overhead costs incurred incurred (AVO):

Variable overhead expenditure variance = BFVO - AVO”

Variable overhead is actually a summation of many individual factors such as electricity, indirect materials etc. The variable overhead variance could be caused by changes in price of any of the individual items. Hence, the variable overhead expenditure does not provide too much of information on its own. A meaningful analysis would involve comparing the actual expenditure of each item of variable overhead expenditure with the budget (Drury, 2013).

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2.18.4.1.2. Variable overhead efficiency variance

Drury presents (2013, p. 309) the following formula for this variance:

“the variable overhead efficiency variance is the difference between the standard hours of output (SH) and the actual hours of input (AH) for the period multiplied by the standard variable overhead rate (SR):

Variable overhead efficiency variance = (SH – AH) * SR”

2.18.4.2. Fixed overhead expenditure or spending variance

In case of direct costing system, fixed manufacturing costs are not combined and allocated to items. The total fixed overheads for a period are instead shown as expense in the period they are incurred in. These overheads are not expected to change in the short term with changes in activity level. However, they may change due to other factors. As stated by Drury (2013, p. 311):

“The fixed overhead expenditure variance therefore explains the difference between budgeted fixed overheads and the actual fixed overheads incurred. The formula for the fixed overhead expenditure variance is the difference between the budgeted fixed overheads (BFO) and te actual fixed overhead (AFO) spending:

Fixed overhead expenditure variance: BFO –AFO”

The total fixed overhead expenditure does not provide too much relevant information on its own. A meaningful analysis would involve comparing the actual expenditure of each item of fixed overhead expenditure with the budget (Drury, 2013).

2.19. Reconciling budgeted profit and actual profit

The causes for the difference between the actual profit being and the budgeted profit are definitely of interest for the top management. By considering these variances in the budgeted profit, and reconciling the budgeted profit with the actual profit, the management team gets a broad picture that explains the major reasons for any difference between the budgeted and actual profits (Drury, 2013).

2.20. Using information to make better forecast

Managers are involved in lots of preplanning activities prior to the execution of business. However, uncertainties of markets and business environments that the companies face during the execution necessitates taking corrective action. Though the actual figures are compared with the budgeted figures of the activities and/or products, there are lot of uncertainties

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involved in the calculation of the budgeted figures. Managers responsible for different costs centres get useful information from reports on costs and financial result. If the current issues due to uncertainties are identified, then these reports would help the manager to take action to resolve them.

Because of the uncertainties involved in the business, managers are expected to use the available accounting information while preparing the budget so as to increase preplanning capabilities and project control during business execution. Preplanning could be improved by creating databases that provide more accurate cost estimation by factoring in the information on relationships between actual costs and business circumstances. Control could be improved if the actual costs information, which is compared to the budgeted costs, is more accurate. An important aspect of the planning activities is that there are lot of uncertainties and adjustments involved during the execution. Flexibility and improvisation are required.

A characteristic of road building activities is that there are many uncertainties. Uncertainties arise because the actual working conditions are different from the planned one as it is not possible to predict the exact conditions in advance. Uncertainties also involve operational mistakes or errors such as suppliers responding late or machine breakdowns etc.

With proper information at hand, managers can assess the actual performance of the cost centres against the expected performance and take actions, if necessary. Actual business environments are different from the anticipated ones and operational mistakes can always happen. Dealing with uncertainty is the core of cost management during the execution and the managers use multiple sources of information to do so.

Budgets and plans do not contain clear information about uncertainties and risks that might already be identified during the negotiation and work preparation phase.

Veeken and Wouters (2002, p.366) explain that:

“Information systems could incorporate risk management during all stages in the lifecycle of projects. Starting at the calculation phase, the estimated risks can be part of negotiations with the principal. At the work preparation phase, the second stage of the project lifecycle, risks could be anticipated by developing a flexible resource plan and budget, based on best practice scenarios. Information systems for cost management should facilitate such learning processes and allow managers to benefit from a larger experience base.”

Information systems could collect information on issues that occurred in the business and the circumstances under which they happened. These historical information would allow

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managers to anticipate certain problems that they haven’t encountered before and take actions pro-actively so as to avoid those problems.

Managers can refer the information from the Information system to think about ways to solve problems. The system could collect information on practical solutions for dealing with uncertainty, results of earlier uses of these solutions and the conditions under which they were tried. Such information could be used to come up with more reliable plans and to make more accurate predictions (Veeken and Wouters, 2002).

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3. Research Methodology:

As the objective of the paper is to look at different avenues that lead to making better predictions and more accurate forecast for the financial key performance incentives, the research required collecting detailed information about different financial parameters used in the financial reports, and therefore, involved extensive financial data analysis and investigation. The methodology used is a qualitative research method which is an analysis-driven approach involving systematic empirical investigation and which provides information about people’s views from a financial perspective.

A thorough understanding of the various product categories and structures, and, knowledge of the global market break up was developed. With most of the financial data residing on electronic databases and platforms, relevant data was be collected from various IT sources such as the relational database – Teradata, the SAP system and EFR. A number of company internal documents and the company intranet system was referred to gather information about the company’s financial system, conventions, standards, best practices and processes.

Table 1. Overview of interviews conducted

Interviewee Name Position Experience Duration

(Approx)

1 Vincent Fleuret Director 8 years 60 min

2 Leo Brorens Senior Financial

Analyst

26 years 30 min

3 Roel Gijsbers Senior Financial

Analyst 17 years 30 min

4 Morgan

Johnson Senior Financial Analyst 12 years 30 min

5 Willem Kan Senior Financial

Analyst

16 years 45 min

6 Yi Zhang Senior Financial

Analyst 12 years 30 min

7 Enrico Bonasera Senior Financial Analyst 2 years 60 min 8 Andrianna

Tzouveleki Senior Financial Analyst 3 years 30 min

9 Yanting Zhang Senior Financial

Analyst

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Interviews were conducted with a director and eight senior financial analysts from different financial planning and analysis teams to discuss about the research topic, know their viewpoints, solicit advice and take suggestions from them. A specific procedure was followed for the interviews that comprised certain guidelines that directed managing and conducting the interviews. All the potential interviewees were first contacted in person to brief them about the objective of the interview. And then, a meeting was set up through e-mail after consulting them and finalising a time and place.

At the start of the meeting the interviewees were explained that the information they share would be confidential and only the Universiteit van Amsterdam (UvA) professors will have access to the information. The context for the interview was then set by briefly explaining the purpose of the interview. The senior financial analysts were asked two primary questions – “What are the driving factors for preparing the forecast report for the next period? What can be done, in your opinion, so as to improve the forecast accuracy?” The director was asked an additional question, apart from the ones asked to the senior financial analysts, - “What factors led to poor forecasting that resulted in issuing profit warnings in the past?” The interviews were semi-structured, and hence, I posed questions to the interviewees that followed up their replies. The interview ended with me asking them if they had any further inputs to share that could be helpful for the research paper. All of them agreed to reach out to them in case I needed any further information from their end.

The interviews were conducted during the period 01-Jul-2015 – 31-Jul-2015. All interviews were conducted face to face at Philips office in Eindhoven. Face to face interviewing is considered to be the most appropriate method of interviewing as the researcher is able “to observe body language to see how interviewees respond in a physical sense to questions.” (Bryman, 2008, p. 457).

The first phase of the writing the paper involved jotting down all relevant information from various sources and editing them to keep the relevant information intact. The second phase aimed at reconciling the data collected earlier with the pieces of information from the interviews. The third and last phase focussed on structuring the paper to ensure consistency of the contents.

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4. Case Study:

4.1. About the company:

Royal Philips is a Dutch diversified health and well-being company, focused on improving people's lives through meaningful innovation in the areas of Healthcare, Consumer Lifestyle and Lighting. Headquartered in the Netherlands, Philips posted 2014 sales of EUR 21.4 billion and employs approximately 108,000 employees with sales and services in more than 100 countries.

The company is a global leader in cardiac care, acute care and home healthcare, energy efficient lighting solutions and new lighting applications, as well as male shaving and grooming and oral healthcare.

4.2. About the division:

The research was done in the Financial Analysis and Planning, Center of Expertise, Commercial, Customer Service division of Philips Health Systems. Figure 3 shows the position of this division in the Philips organizational hierarchy. The Customer Services unit deals with the financial analysis and planning of the global post sales services for medical equipment and had recorded annual revenues of approximately EUR 2.5 billion last year. It primarily includes two types of services - ‘Contracts’ and ‘Time and Material’. Contracts has two main areas – Extended warranty and Maintenance. An extended warranty, also called service agreement or service contract, is a prolonged warranty offered to consumers in addition to the standard warranty on a new items. The indemnity is to cover the cost of repair and may include replacement if deemed uneconomic to repair. It is generally offered at the point of sale. A maintenance agreement provides similar services but is offered at a non-point of sale. In the Time and Material category, the customer pays Philips according to the work performed by the technicians and the material used for the medical equipment. These kind of requests are generally ad-hoc.

The unit performs an array of financial activities such as provide forward looking actionable insights such as developing approach to generate insights to improve forecast accuracy and drive growth, month end closure activities to identify and resolve financial deviations, collect data for financial KPI’s from multiple sources and analyze the results for current financial period, prepare the rolling forecasts reports, so on and so forth.

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Figure 3. Health Systems Customers services in the Philips hierarchy

4.3. Case Context:

4.3.1. Profit warnings

In the last few years, companies’ failure to make accurate forecasts and absorb the market shocks resulted in the companies issuing profit warnings quite a few times which impacted their share prices, and hence, their shareholder's trust. By definition, profit warning is a warning declaration issued by a listed company to investors through a stock exchange. It warns that the profit of the company in the coming quarter will obviously decline or even have a loss with respect to that of the same quarter of previous year. Investors should be aware of the possible loss when buying or selling its stock. Looking back at Philips’ history from the recent past, it warned of sharply lower profit in 2011. It issued its second profit warning in less than a year in 2012 citing weakness in its health care and lighting businesses due to market conditions in Europe. More recently, in 2015, it issued another warning saying adverse market conditions and delayed start-up of its factory in the US city of Cleveland hurt its performance in the fourth quarter. In response to the question on the reasons for profit warnings, the director of the global customer services FP&A team in the interview also made a point on the Cleveland issue:

“Sometimes the management is optimistic about its performance and sets challenging targets which are difficult to meet. The management was not satisfied with the quality of products

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manufactured at the Cleveland factory and proactively decided to shut it down. But it expected the factory issue to be sorted out soon and was optimistic about sales of the machines and equipment manufactured at this factory. The forecast made for the sales of those machines were therefore a bit higher.”

Of late, profit warning has been a major area of concern for many companies, and therefore, the management of the companies has been trying to revisit, and if necessary revise, the processes within and guidelines followed by the Financial Planning and Analysis teams and come up with solutions so as to improve their forecasts accuracy. The advantages of more accurate forecasts are significant - from improved shareholder communications to more effective planning to better decision-making. To achieve this, companies needs to ensure that their forecasting and planning capabilities are current, fit for purpose, and able to adjust to more dynamic times. Stakeholders, particularly investors, do not react favorably to surprises. It reflects a lack of proper planning and control of business performance, even in volatile and unpredictable business environments. At Philips, the management has raised serious concerns about profit warnings and has been really keen on taking steps to avoid/minimize such warnings in the future. A major part of the profit warnings has been attributed to the inefficient and high level of forecast inaccuracy (big deviation between the forecast numbers and the actual numbers). The management, therefore, wants to focus and look at the current financial analysis and forecasting methods and processes, re-assess and fine-tune them so that the forecasts are more realistic than the current ones and as close as possible to the actual numbers, thereby, improving the accuracy of the forecasts.

4.3.2. Taking the first step in the right direction

The service P&L report is the most detailed, comprehensive and important source of information that provides a complete overview of all the performance measures, key performance indicators and financial parameters used in the services unit. Philips Healthcare global services operations are spread across 17 markets worldwide, viz., North America (Canada, USA), LATAM (Mexico, Brazil), DACH (Germany, Austria, Switzerland), UK & Ireland, Benelux (Belgium, Netherlands, Luxembourg), Nordics (Sweden), France, IIG (Italy, Israel, Greece), Iberia, CEE (Central Europe), Africa, Middle east & Turkey, Russia & Central Asia, Japan, India & Subcontinent, ASEAN & Pacific (South east Asian Countries and Australia) and China. And each of these markets span across a series of business lines. Earlier the finance team of each of these markets had their own view of business model for the P&L report and had their own set of financial parameters and KPI’s to measure the

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financial performance. They made their own choice of General Ledger accounts, which was used to sort and store balance sheet and income statement transactions. Figure 4 shows the P&L report of the Nordics market used earlier.

Figure 4. P&L report model used at Philips earlier

The finance teams from all the markets were only entitled to report the top-line margin and EBIT for their respective market. This structure led to a lack of harmonization between the reports from different markets, and therefore, it was extremely complicated and cumbersome to investigate missing or incorrect data for different business lines. Because of the incoherent data structure, it was very difficult to trace down the actual root cause for differences between the actual numbers and the forecast numbers.

As a first step towards improving the accuracy of the financial forecast, Philips financial management team decided to make a complete overhaul of the business models used for the P&L reports. With an objective to make the data more transparent and the analysis process more convenient, the management team modified the existing business models for the markets and came up with a common business model for all the markets. Figure 5 shows the current P&L Structure.

The whole idea was to combine the reporting processes in different markets and come up with an integrated view of value chain for the customer or end user. As such, a service P&L business model specific to the customer service was developed which is now used by teams across all markets.

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Figure 5. Current P&L report model at Philips

4.3.3. Existing Issues

Financial forecasting for companies is an extensive process that is based on innumerable factors and multiple drivers. To understand few of the underlying issues contributing to the lack of accuracy of forecast, it is important to know the company’s business structure, financial models used in the company and the processes followed by the financial teams. This thesis attempts to highlight few of the fundamental issues with the forecasting processes through the lens of the Philips Healthcare global services unit.

Philips Healthcare global services is categorized into multiple BG’s and each BG is sub-categorized into multiple BU’s. Furthermore, each BU consists of various MAG’s which further detail a business (individual healthcare equipment) and consist of one or more Article Groups. Every month, financial numbers are published for each of the business groups and business units based on periods such as ITM, QTD, YTD for an array of financial parameters in the service P&L report. The report also provides the corresponding figures for the last year and the last quarterly forecast so as to compare the current period’s performance against that last year and against the forecast for the last quarter. For instance, the P&L report for the month of July 2015 will have the actual ITM, YTD and QTD numbers for July 2015, July 2014 and the 2015 March forecast for various KPI’s such as Sales, margin etc.

The current practice is to look at the deviations (between actual and forecast), predominantly for Sales and Margin, at a high level (Total Market, BG and BU) and understand which BG or BU was responsible for driving up/down the Sales/Margin. The benchmark deviation amount used is typically 100,000 Euros.

Financial planning and analysis at Philips Health Systems Customer Services