Operational transformation, cost optimization and innovation have become the strategic drivers of enterprise value in an increasingly complex and competitive business environment. Most companies use a mix of related assessments to prioritize, plan and realize their innovation and transformational agendas. These tools most frequently include financial analysis to project total performance, strategic analysis to assess the impact of individual initiatives, and operational analysis to align the business to strategic and financial goals.
However, the pace and complexity of change in today’s competitive marketplace accentuates some of the inherent limitations of this composite approach. For starters, this approach requires a rigorous and time-consuming information collection routine and is predominantly driven by historic data and experience. Neither of these characteristics are particularly helpful in coping with the real-time dynamics and variability of a changing business environment. It is also not capable of reflecting the relational impact of multiple internal and external variables that can drive decisions in a new direction. As a result, the cross-enterprise consequences of even the simplest strategic choices can be missed or completely discounted.
The financial lever analysis method effectively addresses both these limitations. One, it directly interlinks financial, operational, and strategic variables and models the financial impact of each decision across the P&L, balance sheet, and cash flow statement for more accurate, fast, and consistent assessment. Two, its forward-looking modeling capability enables the use of up-to-date information and forecasts for real-time assessment of the enterprise-wide impact of all decisions and initiatives on an ongoing basis.
Financial lever analysis can be applied to multiple needs throughout an organization, from cost optimization initiatives for a specific function to enterprise-wide transformation and innovation programs. Here, we look at how the technique can empower three critical components of strategic decision making for any given objective:
- Accurately defining interconnected causal links between operational choices and financial impacts
- Drilling down to real root causes and quantifying the effects of controllable changes on strategy and performance
- Assessing specific projects and their total implications for the business real-time
Accurately defining interconnected causal links between operational choices and financial impacts
Most companies have an intuitive but broad understanding of the relationship between operational activities and financial performance: for example the impacts of pricing, product, placement and promotional decisions on revenue or the cost composition of different SG&A lines. However, when initiatives are deployed, these simplified connections often miss hidden costs or benefits in another area of the business. A granular understanding of the precise causal links between operational choices and financial performance is not often available.
System modeling enables companies to make direct links between multiple operational and financial variables and generate more nuanced insights into the cause and effect between variables. Modeling these insights in full sets the stage for companies to focus on initiatives and metrics that truly drive enterprise performance.
In the case of revenue, for example, there are multiple levers that drive growth, including the 4Ps but also including cost-based decisions and external factors like customer, industry and macroeconomic trends. These can all be defined in a system model comprised of process, statistical and feedback loop modeling that not only defines the direct links between these factors but also defines their magnitude of impact and hidden interrelationships. From this, it is possible to understand different permutations of multiple factors when they are changed together. For instance, the effect of a combined pricing and product decision can have an exponentially different effect to applying either of those decisions individually, and that in turn can have a different impact if projections for customers and competitors change dramatically.
This model allows companies to build a more accurate picture of the revenue impact of different choices, thus streamlining and focusing the decision making process on accurate results. The same technique can also be applied across cost lines on the P&L and to other financial metrics extending to the balance sheet and cash flow statement.
Drilling down to real root causes and quantifying the effects of controllable changes on strategy and performance
Strategic transformation is a time and resource intensive exercise. Large scale transformations typically comprise a number of major change initiatives focused on different parts of the enterprise that require the involvement of multiple stakeholders. In such a complex scenario, it become necessary to accommodate varying perspectives on strategic choice and value. Financial lever analysis can help speed up this process, enable participants to focus on true root causes, and gain more buy-in by identifying objective and quantifiable drivers.
Whether building on a robust financial model or pursued independently, process-based techniques provide decision makers with a more nuanced and systematic understanding of the deep factors underlying performance and impacting strategic choices. Techniques like root cause analysis, statistical factor analysis, failure mode analysis, bottleneck analysis, and barrier analysis can all help identify quantifiable levers as well as more nuanced factors and roadblocks that impact a performance. In addition to pairing well with systemic models, these process-based techniques are best applied in combination with facilitated stakeholder engagement to bring out all potential root causes and factors and to ensure focus and objectivity.
Assessing specific projects and their total implications for the business real-time
The system model can also be used to assess the true impact of individual projects on a case-by-case basis. Once the fundamental understanding of interconnections is laid out, even if it’s not fully modeled, it can be quickly leveraged to evaluate the systemic impact of any project. For example, a cost reduction initiative in one area may trigger a counterproductive reaction in revenue or drive costs up in another part of the enterprise. This becomes easier to see and manage when using financial lever modeling, and It becomes feasible to make calls on projects much more quickly.
A preemptive understanding all the key drivers and their interconnections and impacts further allows companies to accurately test the performance and indirect impacts of projects with a controlled pilot test prior to full rollout. With a better understanding of interconnected levers, the test can be designed to monitor the right metrics for all potential impacts and adjust necessary aspects before a launch.
Each of these three methodologies can operate on a standalone basis. However, they are most effective when applied as a unified model. This combination of approaches has been proven to help business leaders orchestrate and optimize strategic decisions across the business. As businesses face increasingly rapid and variable change, being able to define interrelationships accurately and quickly will be increasingly critical.