Predictive Accounting Article
Predictive Accounting Article
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Predictive Accounting Article

by James A. Brimson, Predictive Management Institute

Consider the rise of pro forma reporting. Many organizations are reporting pro forma financial results to the investment community. These pro forma reports highlight the decreasing relevance of financial reporting. Pro forma statements are not audited and often disregard financial standards (such as GAAP). Yet the investment community closely follows these pronouncements. Why? It is obvious that both private organizations and the investment community recognize the limitations of financial reporting as a forward looking tool and seek alternative sources of information to fill this void.

Everyone would agree that the past has already happened and reporting systems cannot change history. External users of financial information and managers are far more concerned about what will happen than what did happen. The investor (Wall Street) community best illustrates the need for forward looking information. Investors are primarily concerned with what are the expected financial results. No value is given to an organization's performance once the actual results are released. Organizations that miss their projected earnings forecast, either too high or too low, are severely punished with lower stock prices.

Financial executives have several options available to overcome this information deficit. The first option is to depend on the management accounting system to provide the forward looking information. This option is increasingly difficult in today's competitive environment. Accounting is considered an overhead function that has been slashed to a minimum level at many organizations. Thus countless organizations do not have the necessary resources to maintain a separate and robust management accounting system. Another problem is that data created from separate sources tends to confuse management. It raises questions such as what data is correct?

The second option is to expand financial accounting to become more forward-looking. This option requires the accounting community to create a single financial database that supports both fiduciary and forward-looking requirements. This goal can be accomplished by adding process information to today's cost element accounting databases. Enter predictive accounting.

Predictive accounting projects future financial performance using a statistical understanding of an organization's processes. Predictive accounting seeks to understand the future. It is not tarot cards. It is based on the observation that much of an organization's work is repeatable. The work steps of these activities have been well thought out and provide an "invisible hand" that guide's daily work.

Predictive accounting uses process maps to understand the sequence of activities. At any point in time, say the last day of the month, an organization knows the actual events that have occurred as of that date. The process map identifies the upcoming events that will follow. These upcoming events are then translated into predictive financial statements using resource consumption activity standards and statistical probabilities.

The fourth financial statement: a process statement

Predictive accounting proposes to expand the three required financial statements (income statement, balance sheet and cash flow statement) to include a Process Performance Statement. The process statement evaluates the capability of every process to create value. The statement evaluates the elements of work (processes). Some processes create future value such as research and development, new product development, and marketing. Other processes create current period value such as procurement, financial management and operations, sales, and personnel. The value created depends on the effectiveness (ability to achieve an outcome), the efficiency (ability to churn positive cash flow), the stability (six sigma compliance) of those processes and the storehouse of value previously created. A sample process statement is displayed in Table 1. 1.

Process Performance Statement (Table 1.1)

                                                              Amount Strategic Measure/                                       Process                 Value
                                                              (000's)  Value Creation             Value Target Velocity Variation Inventory

Sales                                                 $40,000


Raw Materials                                      9,000


Understand markets/customers        280 Revenue per customer       $4 $5       ----        1.3              $5,700

Develop vision and strategy            110  Shareholder value              +2%        +5%   ----          2.1                  800

Design products and services

Research& Development                       600 Average revenue/patent  $11,240 $15,000 ----         1.1                    250

Introduce new product/service               250  Revenue/new product      $10,040$15,000  -----       1.3                 200

Refine existing products/services          400 Target cost achievement          88% 98%   ----     1.4         32,000

Market and Sell

Market products                                     860  Revenue per lead                    $0.1  $0.15   ----     2.0                   750

Sell products/services to relevant     1,250  % contacts sold                      45%   60%   3.8 weeks  0.8            18,000 
customer segments

Process customer orders                         320  Accurate& on-time              92%  100%  5.5days    2.4

Produce/deliver (manufacturing/service org)

Procure materials                                   1,500  Target time/quality/price  84%  100%   25 days   2.3

Convert resources/inputs into             18,300  Target time/quality/price 74%   100%  14.4 days 1.5              1,400

Deliver products                                          380  Target time/quality/price 88%100%    5 days   2.6

Invoice and service customers

Bill the customer                                          220  On time payment                  82% 98%  35 days 2.0

Provide after-sales service                       150  $ per existing customer        $1.5 $1.0     ----     2.5

Respond to customer inquiries                   90  $ per existing customer           $0.9     $0.3     ----    0.8

Develop and manage human resources

Manage deployment of personnel           240  Average length employment 5.2 years 10 years  ----  1.7

Develop and train employees                   150  Improvement rate                      4%    10%       ----    2.3

Ensure employee well-being                    120  Employee turnover                   7.5%  2.0%     ----     2.2 
and satisfaction

Manage information resources

Manage information storage/retrieval     480  Targeted service level               62% 100%  ---- 1.4

Manage facilities/network operations     310 Targeted service level               87% 100%    ---- 1.9   

Facilitate info sharing/communication     290  Targeted service level               93% 100%    ---- 2.1  

Manage financial and physical resources

Process finance/accounting                     490  $ per sales invoice                     $1.30 $0.75  ---- 2.1

Develop budget                                             260  Financial estimate accuracy    93% 100%  ---- 1.4

Conduct internal audits                           140  Significant audit exceptions 3 0   ---- 2.0

Manage the tax function                          150 Effective tax rate                       27% 30%    ---- 2.1

Execute environmental management  100  Targeted environmental                                             1.4  (1,000) 

Manage external relationships                 90  Cost of capital                                                             1.9   500

Manage improvement and change      130   Improvement rate                                                 ----  1.3

Net Profit                                                    $3,340

There are several essential elements of the process statement that make it forward looking. To begin with, the process statement is organized by process. Processes are how an organization converts resources into products and services to meet customer needs. There is no better way to understand an organization's ability to create value than to assess how effectively and efficiently they carry out their work.

The second part of the process statement records the current and targeted process outcomes. Each process exists to deliver an outcome. An organization must explicitly identify the desired process outcome. This requires a thorough understanding of how each individual process outcome will achieve the organization-wide strategic goals.

An organization's value creation potential depends on how well an organization executes their processes to bring about the desired outcomes. Highly effective processes (minimal gap between the target and the actual outcome achieved) can be relied on to deliver future value. Highly ineffective processes cause business events to spiral out of hand creating self-induced crises that reduce value creation.

The third section of the process statement communicates process velocity. Process velocity measures the speed with which the process converts resources into cash. Economic Value thinking has taught us that free cash flow equates to shareholder value. Take for example, the procurement process. A perfect process velocity will reduce work in process to zero meaning that the required material is delivered directly to the requester--exactly when required, with perfect quality along with the proper quantity. Any deviation to these requirements necessitates the need for working capital (less free cash flow) to be tied up in financing the raw material inventory.

Organizations that have streamlined their processes to improve process velocity will create more free cash flow and thus value than those that have slower process velocity. The inevitable conclusion is that organizations with effective processes are better positioned to create free cash and thus have a greater value creation potential.

The fourth section of the process statement is the Six Sigma segment. The standard deviation of each process is displayed. A high standard deviation, with a value over 2 or 3, indicates a stable and predictable process. A 6.0 standard deviation is referred to as Six Sigma and is the objective of many leading organizations. A low standard deviation indicates an unstable and unpredictable process.

The less a process varies the greater its predictability. The better the predictability, the greater the value creation potential of an organization.

The fifth and final part of the process statement is the value inventory. The value inventory represents the storehouse of value created from past and current operations. Every process creates or destroys value. The inventory of value is the unrealized value that is available for future operations. The total value of all processes approximates the organization's overall value.

An organization that has created a storehouse of unrealized value is in a strong position to prosper in the future. An organization must carefully balance the short-term performance results with making investment in future value.

Predictability and the accountant

Repeatability equates to predictability. An accountant does not come to work in the morning wondering how they should process a customer receivable. The procedures have been established, the information systems and work area are in place and the accounts receivable (AR) accountants have been trained. The workers would not have it any other way. Establishing a routine work environment is vital to the sense of security of a worker. Exceptions to the routine cause tension and anxiety.

Predictive accounting develops statistical probabilities of the future financial and non financial results by understanding the organization's processes and the conditions under which the process operates. Actual process results are comprised of two primary components:

Actual cost = (Standard resource consumption +/; process variation)

The above equation demonstrates that actual cost is predictable when process variation has been methodically reduced to a low level (approaches zero). Conversely, actual cost is unpredictable where process variation remains high. The distinction between predictability and unpredictability is important because prediction is the essence of making a profit. Predictability enables organizations to shape their future. Managers can anticipate events and thus put themselves in a position to act. Unpredictability will repeatedly undermine management efforts to achieve strategic objectives. It is difficult for management to shape the future when they are constantly responding to crises caused by unpredictable processes. It becomes an adventure every time an unstable process is executed. Preemptive action, rather than reactive action, keeps profits up.

An important element of predictive accounting is to ensure action is initiated at the earliest possible point but no earlier. Action taken too late is costly to the organization will have wasted time and resources needlessly by ignoring early warning signals. It is equally serious to take action too quickly. Changing the process will only disrupt performance and create problems that did not exist prior to the change.

Predictive accounting relies on Statistical Process Control (SPC) to provide the information needed to trigger action. Action is required where the predicted results are not within statistical limits of actual results. The root cause of the problem must be identified and the process improved in order to reduce its variation.

The key to predictive accounting is to focus management on the future rather than the past. An executive needs to know of problems before they become variances on financial reports that must be explained. Predictive accounting provides management with an "early warning" signal of an impending performance problem. Timely signals enable managers to take proactive corrective action aimed at altering potentially undesirable results. This goal is feasible because predictive costs are potentially changeable (as is not the case with historical reporting).

Process Management Foundation

The tools that make up predictive accounting already are in use at leading companies Six Sigma, root cause analysis, ISO 9000, balanced scorecard, lean enterprise, activity based costing and process mapping. All of these tools and techniques concentrate on the process they measure and improve process performance. However, these techniques remain a collection of independent process management tools. Little or no work has done to integrate these tools into a comprehensive management system. In particular, financial accounting has done little to evaluate the relevance of processes (activity costing) to financial reporting. This flies in the face of the extensive use of process information to manage an organization.

Predictive accounting provides a framework for institutionalizing the use of process tools into a comprehensive management system. The framework provides managers with data needed to identify opportunities and problems as a continuous process that is built into the management system. It cannot and must not allow processes to be managed as a series of one-time exercises. Instead management must continuously analyze the root causes once a warning signal has been detected. Most importantly, the process must be improved and new solutions implemented.

Predictive Accounting

The concepts that underpin predictive accounting are very simple future cost and performance is the consequence of certain events that have already occurred. These events become the basis to:

  • Understand and project the workflow of the upcoming activities that will follow,
  • Understand activity standards employed to project cost using the process resource consumption rate (standard cost),
  • Understand process variation to constantly reduce process variation, and to use control charts to measure whether a process is in control.




























Events have a sequence certain events precede and other events follow. Each activity (work step) requites certain input before it can begin and a certain output before it can allow the next step to start. To illustrate the dependence amongst events, consider a procurement business process (Figure 1.1).

  Text Box: Figure 1.1 Procurement Process


The process map portrays the sequence of events in a procurement process (Figure 1.1). The process is executed every time a purchase order is placed an event that takes place dozens of times in a single day. If you were to plot the procurement process on a time phased graph (see Figure 1.2), each time a purchase order was placed, you could project when all upcoming activities in the procurement process are anticipated to occur. During any month, you would find each purchase order in a different state of completion depending on when the process was initiated. Of even more interest, you could statistically predict how much work was to be accomplished during the upcoming month. The necessity for the upcoming activities has already been set in motion by earlier events the placing of a purchase order. Predictability does not depend first and foremost on forecasting rather it depends on an understanding of the sequence of events (Figure 1.2) and the statistical probability of the resulting financial impact.




Resource consumption standards

The resource consumption standards are based on the average amount of resources consumed in processing one unit of output. Every activity has finite time duration and requires a finite expenditure of resources. An activity cost should include all traceable that is, where a cause and effect relationship can be established resources and shared services. Table 1.1 illustrates a resource activity standard.

  Text Box: Table 1.1 Activity Resource Standard

Text Box: Activity:  Collect past due invoices
Performance measure		Dales Sales Outstanding	32 days
Resources consumed:		Collection clerk		12 minutes	
				PC workstation		12 minutes	
				AR software		1 past due invoice	
				Facilities		100 square feet	
Outputs consumed:		# of past due invoices	10,000 per year 
Cost of resources consumed: 	AR clerk		$12.50 per hour for 1/5 hour		$2.50
				PC workstation		$3,000 cost; 3 year life;
							    $1,000 /  (120,000 min per year) x 12	  0.10
				AR software		1 invoice * $0.05 / invoice			  0.05
				Facilities		$14.00 per square foot per year;
							    $1,400 /  (120,000 min per year) x 12	  0.14
Cost per past due invoice processed					$2.79
Note:	The $0.05 per invoice was derived from the shared service accounting system.

Process variation analysis

Each primary activity must be assessed to determine its process variation. First, the assessment should compute the actual amount of process variation. Second, the work group should determine the root cause problems that explain why a process varies. Third, management must act on the information. Minimizing cost variation is an important goal of predictive accounting. There is a direct correlation between cost variation and process variation.

The first step is to determine the amount of process variation. Process variation identifies the gap between the current process performance and its potential performance. The gap indicates the value creation potential of each process. For instance, assume a sales order taking process currently is capable of entering 150,000 orders per year. However, by eliminating all the root cause problems, the potential capacity could increase to 250,000 orders per year. This gap of 100,000 orders per year represents a tremendous opportunity for productivity improvement.

One simple technique to rapidly approximate the amount of process variation is called the ideal process method. The method begins with the actual average activity time derived from the resource consumption standard. The work group then determines how long it takes to perform the activity when there are no problems the activity is completed without a hitch. This value is labeled the ideal activity time. The ideal activity time is determined by observation or it originates from the experience of the work group. It is unnecessary to perform a more rigorous analysis to set the ideal time since the purpose of this method is to compute a quick and approximate estimate of process variation. This method is summarized below:

Process Variation = Standard activity time ; Ideal activity time

Need for objective and verifiable information

But before accountants are ready to embrace predictive accounting, they want to ensure the projected results are based on facts and "hard" numbers. Accountants do not like subjectivity. They avoid, when possible, external forecasts and projections. Predictive accounting must meet the immutable criteria of objectivity and verifiability.

It does! Predictive accounting relies on hard facts derived from process mapping. It relies on the hard facts that underlie statistical analysis. Consider that predictive accounting use some of the most interesting of these "hard" facts to project future financial performance:

  • The sequence to the order and timing of activities. Organizations create process maps to understand and document the order and timing of activities in their business processes.
  • The repeatability of activities. Repeatability equates to predictability.
  • The degree to which a process is in control. Predictability is highest when the process remains within the acceptable variation limits and there is neither an obvious trend nor any long sequence of points above or below the average process performance.
  • The significant few problems on which management must focus. The root causes of process variation follow Pareto's 80/20 rule 20 percent of a process's problems will cause 80 percent of a process's variation. Thus, there are a small handful of root cause problems that account for the majority of process variation.

The four "hard facts" stated above form the touchstone of the predictive accounting revolution. Consider the implications. If there is a set sequence to processes and its component activities are repeatable, then the results of a process are predictable within statistical limits. The constant attention to and improvement of the factors that cause process variation will improve the statistical probability of achieving the predicted performance results. Root cause analysis simplifies the process by identifying the significant few problems that need to be fixed. As the problems are resolved over time, management reaps twofold benefits: First, performance improves. Second, management will become more confident in using process data to predict future performance results.


Under predictive accounting, the accounting profession is poised to take one of its most significant leaps forward by increasing the relevancy of reported financial information. Accounting information will focus on managing upcoming events rather than merely reporting past history.

Predictive accounting becomes even more provocative when one considers that it is built from existing proven process techniques such as standard costing, Six Sigma, control charts, activity based cost and balanced scorecards. What predictive accounting adds to these tools is a foundation that integrates these elements into a process framework. Of chief impetus is the convergence of process knowledge and information technology that has enabled management to advance the process model. A process framework creates a powerful synergy by joining these potent but independent techniques. Predictive accounting meets the important criteria of any accounting system, it is relevant and reliable. To be relevant, the accounting should have predictive value, feedback value, and be timely. Clearly predictive accounting exceeds historical accounting based on these criteria. To be reliable, the system must be verifiable, valid and objective. Predictive accounting is at least as reliable as historical accounting systems since it uses the same general ledger and operational data.

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