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A white paper for CFOs and Controllers Using CPM software to measure and manage business performance in volatile times

By Paul A. Sharman President Focused Management Information Inc.

Table of Contents Executive summary

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Introduction

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Changing circumstances

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Volatility and data

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What to measure

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The role of technology

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Integrated planning and reporting

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Informing decision making on-demand

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Longer term strategic uses of CPM

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Conclusion

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Calls to action

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Executive summary In this white paper, we will examine how technology’s rapid advancement has forced businesses to adapt in order to contribute value. Organizations can address this requirement to become more nimble by using new technology that delivers remarkably accurate data about their performance. We will look at the changing role of technology and investigate the business value of using Corporate Performance Management (CPM) software for integrated planning and reporting. We will explore CPM software’s pioneering ability to link financial and operational planning in a way that enables stakeholders across a company to make informed strategic decisions.

Introduction Business success or failure is and always has been the result of human beings making decisions about investments to capitalize on a perceived market opportunity. Opportunities are assessed in terms of factors such as potential for return, the economy, political stability, competitive considerations, financial capacity, and risk. Each of these factors is individually complex, and together they have been the subject of many thousands of books. Human endeavor is the essence of informed opportunism. In other words, accessing disciplined analysis of pertinent information about potential business choices before releasing funds to establish a business, and monitoring it thereafter as it operates, is fundamentally important. The quality of the decisions that people make is pretty important, too. In a pinch, people tend to make decisions whether or not they have correct information. All of us have made decisions at times even though we did not have all of the necessary data and facts. Sometimes we were lucky and other times not so. Generally, it is good practice to balance intuition and good ideas against the risk of failure. The availability of pertinent information in formulating almost any decision is good practice. 3

Changing circumstances Change is the normal state of business in today’s world; it is “increasingly going up not just in a linear slant, but almost exponentially.”* Technology, products, services, communications, and even the way in which business is transacted are all changing much faster than ever before. This has led to increasing levels of complexity and clarifies the need for sophisticated support mechanisms, principles, and practices in business, made all the more challenging by globalization, the speed at which change occurs, and the magnitude of unexpected changes and their potential business impact. Two other factors are important to consider in the context of business and change. The first is that the very premise of business value has shifted in the last fifty years since the concept of the Internet was first described. Today, more than 70% of the value of corporations listed on North American stock exchanges relates to intellectual capital (IC). IC is a derivative of knowledge and the way in which it is applied in order to achieve competitive advantage. Yet we all know that knowledge migrates at the press of a ‘send’ button, and in doing so market forces can reshape whole industries and redistribute wealth around the world. Data is inherently borderless, making the digital economy a global economy.* The second factor: corporate valuation methods are no longer premised on hard assets and return on investment, but now on the concept of discounted future cash flow and the creation of shareholder value. Under the new valuation standard, seemingly small changes to a business can leverage huge wealth impact. All of this adds up to a single word that describes today’s business context: volatile. Volatility summarizes the changing circumstances mentioned. This is the driving reason for the recent increased interest in Corporate Performance Management. * “Can you Handle an Exponential Rate of Change,” July 19, 2011. www.forbes.com/sites/johnkotter/2011/07/19/can-you-handle-an-exponential-rate-of-change * “BSA TechPost Executive Survey Shows the Benefits of Data Innovation Across the Whole Economy.” Espinel, Victoria. Data, Global Markets. December 10, 2014.

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Volatility and data Vertigo on Wall Street Volatile Dow plunges as much as 697 points, rises as much as 322, as panicky investors try to find their footing. By Alexandra Twin, CNNMoney.com senior writer, Last Updated: October 10, 2008: 6:53 PM ET

On October 10th, 2008, some weeks after the release of government bailout funds and a year after optimistic statements by global political leaders and even the International Monetary Fund, the Dow Jones Industrial Average experienced one of its largest one-day point drops in history and then partially recovered. Market and commodity prices around the world continued to bounce up and down for the next three years. Most people did not expect any of it. Such is the nature of volatility. The term volatility is most often used in reference to financial markets. However, in general business terms volatility describes the degree and frequency of fluctuation of external and internal parameters, which are relevant for companies and the patterns of which can be difficult to predict.* In order to diminish potential risk and volatility, business managers and their organizations have to prepare by having effective measurement and monitoring tools that act as early warning systems. They also need to prepare their organizations to be flexible and responsive in very short order. Finally, organizations are well advised to have reserves or cushions in order to build their resilience to risk. For example, since the 2008 credit market meltdown many companies have applied very conservative investment policies and built up significant cash reserves. Cash flow planning measurement has therefore become a very important measurement and management concern. * “Controlling in a Volatile Environment,” Andreas Aschenbrücker, Péter Horváth, and Uwe Michel. Cost Management November/December 2014.

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»» BSA/IPSOS Global Data Analytics Poll, November 2014, www.bsa.org/datasurvey

It also means that corporations need correct, reliable, and timely performance data. They need the ability to manipulate that data in order to perform financial and non-financial modeling and what-if analysis of their businesses in order to give managers information to consider when deciding on the best courses of action to pursue. This requires that organizations take advantage of significant changes in computing power by investing in data analytics and properly training staff to perform the work. Arguably, in a volatile, global digital economy where the predominant source of business value is intellectual capital and business choices can be leveraged into massive wealth impact on the basis of shareholder value, correct and timely information is the most valuable commodity on earth. CPM software provides the most effective and efficient mechanism with which to capture and communicate the information that is most valuable to business people at all levels of the organization.

What to measure In his 1986 business classic, Creating Shareholder Value, Alfred Rappaport provided the world’s managers and investors with practical tools needed to generate superior returns. The ultimate test of corporate strategy, the only reliable measure which has been embraced globally by publicly traded as well as privately held companies alike, is whether it creates economic value for shareholders. Rappaport identified “10 Principles for the Creation of Shareholder Value.”* One that is particularly informative to this paper is “#2: “Make strategic decisions that maximize expected value,” as defined by Shareholder Value Added (SVA) or free cash flow from operations. The idea is to motivate business managers to focus on future performance in order to provide financial return on shareholder capital that is greater than they would earn by investing in alternative options. * “Ten Ways to Create Shareholder Value.” Rappaport, Alfred, Harvard Business Review, September 2006, http://analystreports.som.yale.edu/internal/S2008/tenways.pdf

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The drivers of SVA are financial measures: • • • • • • •

The percentage annual sales growth rate Operating profit margin (before non-operating items such as interest payable and tax) Cash income tax rate (that excludes deferred tax) Incremental fixed capital investment rate Investment in working capital rate Planning horizon Cost of capital

Operating profit margin (before non-operating items such as interest payable and tax)

The percentage annual sales growth rate

Cost of capital

Cash income tax rate (that excludes deferred tax)

THE DRIVERS OF SHAREHOLDER VALUE ADDED ARE FINANCIAL MEASURES

Incremental fixed capital investment rate

Investment in working capital rate

Planning A decade later, in 1997, Rapport published an updated horizon version of Creating Shareholder Value. After a decade of downsizings frequently blamed on shareholder value decision making, the updated version presented a new and in-depth assessment of the rationale for shareholder value. Rappaport presented provocative new insights on shareholder value applications to: (1) business planning, (2) performance evaluation, (3) executive compensation, (4) mergers and acquisitions, (5) interpreting stock market signals, and (6) organizational implementation. Rappaport answered three management performance evaluation questions: (1) what is the most appropriate measure of performance? (2) What is the most appropriate target level of performance? and (3) How should rewards be linked to performance?*

In the context of volatility and creation of superior shareholder returns, new tools are available to provide managers with complete, current, and accurate information to help them make better decisions so they can deliver on strategic objectives. Specifically, we are referring to CPM software. To do so, all of an organization’s data relating to past, planned, current, and projected operations and financial performance is readily available and effectively communicated. Further, because the emphasis on creation of shareholder value prizes long term future returns, managers need the ability to respond to changes in circumstances and results on the fly by drilling down into performance data, identifying corrective actions, and undertaking what-if analysis to assess possible outcomes of alternative actions. Also, managers wish to prepare long term financial and operations performance simulations to ensure that preferred strategic directions, measures, goals, and actions will satisfy performance expectations. The shareholder value approach presented here has been widely embraced by publicly traded and privately held companies worldwide. Brilliant and incisive, this is the one book that should be required reading for managers and investors who want to stay on the cutting edge in a highly competitive global economy. * Creating Shareholder Value: A Guide for Managers and Investors. Rappaport, Alfred. Free Press, 1997.

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The role of technology In our global digital economy, where creation of shareholder value rules business thinking in order to leverage wealth from intellectual capital in a highly competitive environment, there is little room for error. There is always someone ready to step up to the challenge of doing things better. That leads to the understanding that the underpinning technology that facilitated the creation of shareholder value also provides the greatest mechanism with which to undertake measurement and management of all the processes involved in operating a business effectively and efficiently. Business software began as applications built to manage transaction processing to address specific business processing activities—billing, for example. Initially, such applications existed independently of each other, but gradually designers created ‘interfaces,’ and then data warehousing, so that information could be shared. Sharing data has led to the integration of applications in a way that allows information users and managers to possess accurate, consistent, and timely data. Coupled with the massive evolution of computing power, speed, storage capacity, and communications technology, the very premise of management principles, methods, and practices has changed. For example, double-entry bookkeeping methods were first described by Luca Pacioli in 1495 in times when the best tools available for humans to use, other than their personal memories, were paper and writing instruments. During the industrial revolution, bookkeepers provided rudimentary financial analysis by allocating revenue and cost to individual products to inform managers about which ones made or lost money. Hand operated comptometers made it possible to introduce early hand written versions of spreadsheets, but business decision making and commerce were slow in those days. That was helped significantly by deployment of the telephone. »» Portrait of Luca Pacioli, attributed to Jacopo de’ Barbari, www.en.wikipedia.org/wiki/Luca_Pacioli

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Although technology has improved dramatically, business people still generally apply rudimentary accounting practices, but that is changing. The modern day spreadsheet program, Microsoft Excel, remains the primary tool used by business people to conduct analysis, yet for the amount and detail of data involved, different versions of calculations, different perspectives, and business circumstances for which information is needed, new applications (and even principles) are required to provide better information to help managers make properly informed decisions. Those tools are now available and being deployed by early adopters of Corporate Performance Management software. Instead of spreadsheets, CPM employs data cubes that can work together to perform multi-dimensional, multi-attribute (financial and non-financial data), and multi-perspective analysis in a way that is completely aligned with the needs of business leaders and managers in their efforts to create shareholder value. Combined with »» Comptometer, circa 1950, www.wikimedia.org new communications technology, we have dramatically increased the speed of business decision making and commerce. Technology’s promise to generate shareholder value is being realized in a new form.

Integrated planning and reporting In the same way that available tools and technology have shaped management principles of double entry bookkeeping and manual spreadsheet analysis, so is modern Corporate Performance Management software shaping the way in which decision making is informed today. CPM opens the doors to fast, accurate, integrated planning, analysis, and reporting where data is collected from operating systems, databases, and accounting systems as well as from external sources of information such as commodity market data feeds and made available to all. Central to successful creation of shareholder value is effective planning. Planning involves strategy formulation, as well as the creation of strategic and operating plans, budgets, and forecasts—the performance of which is monitored by compliance and management reporting. Significant changes to management practices include driver based analysis, rolling forecasts, simulation modeling, and what-if analysis—all linked to aligned compensation and incentive systems.

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Integrated planning, analysis, and reporting as depicted in “The New CPM-enabled Planning Process“ has four major areas of information, including creation, analysis, and reporting stages which can be described simply as planning, performing, reporting, and adjustment. These stages are continuous and require constant vigilance in volatile times.

THE NEW CPM-ENABLED PLANNING PROCESS ROUGH CUT FINANCIAL PROJECTIONS PRIORITIZED RESOURCE MARKET ALLOCATONS PROJECTIONS MEASURES AND GOALS

STRATEGIC DIRECTIONS

STRATEGIC PLANNING = LONG TERM

PERSONNEL REQUIREMENTS

ANNUAL/ MULTI YEAR BUDGETS

PRODUCT AND MARKET FOCUS

PROCESSING VOLUMES

OPERATIONAL PLANNING = MID/SHORT

INCENTIVE SCHEMES

PERSONNEL PLANS

PLANT AND EQUIPMENT NEEDED TECHNOLOGY REQUIREMENTS

KPI

TOOLS

DATA SOURCE

ROLLING FORCASTS REVISED PROJECTIONS REVISED GOALS REVENUE COST/ PROFITABILITY

MARKET % & CUSTOMER SERVICE ORDERS & SALES ACHIEVED

MONITORING ACTUALS

OPERATIONS PERFORMANCE DATA

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DRIVER BASED COSTING

FINANCIAL RESULTS BALANCE SHEETS

ACTUAL KPI

CASH FLOW

Planning involves a series of steps that begin with strategy formulation, the purpose of which is for business leaders to determine and reach agreement on a variety of important matters such as corporate vision, mission, strategic directions, strategic actions, measures, and goals. The primary purpose of strategy formulation is to make decisions about how to prioritize resource allocation to business operations. This is documented in a corporate strategic plan. The strategic plan is used as the basis upon which operating plans and budgets are developed. CPM is used to a) inform strategy formulation, b) to compile plans regarding how to implement strategy, c) to produce reports that show how well the organization has executed its strategy, d) to analyze those reports in order to provide insight on variances, and e) conduct what-if analysis and simulation modeling, which in turn feeds back into strategy review and planning. Part of business planning engages operating managers in preparing non financial plans on many topics, including sales, marketing and promotion, distribution, workforce, production and service delivery, inventory management, freight, return goods servicing, and many others depending on the nature of the business. Based on operational plans, finance staff develops financial plans and statements that outline department expenses, profits and losses, the balance sheet, cash flows, product line profitability, capital expenditures, and others. The outcome of planning is the provision of critical information to corporate executives, operating managers, and employees at every level about what resources they will be allocated to work with and what performance is expected of them. Hence, planning establishes a complete set of measurements and goals that influence how employees at every level of the organization are expected to behave and perform. Plan information is prepared and maintained in CPM data cubes, and then it is communicated to managers through a variety of communications systems, including BI, the CPM software itself, Microsoft SharePoint, and Microsoft Office. As plans are executed and the work of the corporation is performed, CPM software automatically captures results from operating systems and other sources of data. CPM software automatically provides comprehensive comparisons between planned and actual performance and delivers reports on financial and non financial results to managers and executives at every level throughout the corporation using the same methods as for plan data, including BI dashboards and formatted financial statements. At the same time, companies meet government compliance reporting requirements automatically with the minimum involvement of managers and staff. This means that CPM software fulfills a multitude of different analytical and reporting functions simultaneously.

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One of them can be described as integrated financial planning, which refers to the continuous updating of data from operating systems and operational information CPM cubes to financial information cubes. This integration facilitates the updating of financial information on a current basis. Before CPM, organizations tended to depend on comprehensive status reporting only on a monthly basis. Although it is unlikely that a corporation would want to move to a daily financial close because of the need to perform accruals, it is entirely feasible to prepare daily and even more frequent reports of key financial and non financial indicators. In addition, managers at all levels have access to both leading and lagging indicators that are most important to their individual roles and responsibilities. This allows managers to not only access current data but also to assess the need to improve problematic situations on a much more current basis than has ever been possible.

Informing decision making on-demand In the end, Corporate Performance Management is all about helping people make informed decisions. Being informed does not mean that they will prove to be right, because decision makers have to interpret what is in front of them. Yet CPM software provides decision makers the opportunity to examine relevant information, formulate questions, and drill down into the data to find out what is really going on. The data will provide actual performance information compared to plan expectations, relative to allowable standards, and over the longer term to determine if there are emerging trends. After all that, decision makers can ask analysts to perform what-if analysis and create longer term simulation exercises to determine if/which corrective actions will improve performance outcomes.

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A really critical aspect of CPM reporting and analysis relates to the way in which decision makers can customize the types of reports they receive in order to satisfy their particular interests. For example, more senior executives will be interested to know how well the organization is doing against broader, organization-level performance measures and goals such as free cash produced and availability for dividend payout in comparison to statements made to investors and the analyst community. In the event that the company experiences a miss on free cash, the executive would likely ask operations and finance executives to use CPM to examine what happened, to perform variance analysis, and to prepare what-if analyses and projections to assess recovery options and their potential time frames. Such analysis will lead to management taking actions such as launching unplanned promotional campaigns to boost revenue or perhaps to reduce costs. Other decision makers will have their own interests relative to their roles. Here are some examples: A sales manager may wish to monitor the number of sales and marketing measures in comparison to sales plans, budgets, and forecasts. Depending on the information they receive, sales managers may well be interested in using CPM to confirm their understanding of marketing and promotion campaign expenditures by territory. They may also wish to get information about promotional and new products being introduced by competitors in each sales territory. Based on what she/he learns, a decision may be made to change sales representative territory assignments, to conduct training on how competitive products are less effective than their own, or change promotional spending by territory. A sales manager might conclude that circumstances in the market are changing, perhaps because the economy is in decline and that short to medium term sales targets will be missed. Further, a reduction in the number of sales staff may be warranted for the following year. Accordingly, the sales manager notifies the Controller, who initiates a forecast update on the fly to determine the magnitude of earnings and cash impact so that the executive team can discuss their options and give instructions to sales and other key operating managers.

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One example comes from the case of Myriad Genetics. This organization used CPM software to react adeptly to external market conditions, which change particularly fast in the developing field of genetics. In May of 2013, Angelina Jolie announced that she had undergone a preventive double mastectomy after genetic testing indicated that she had an 87% risk of developing breast cancer from a defective BRCA1 gene. Myriad Genetics developed the test. Public interest developed virtually overnight. The company used CPM software to revise their budgets and forecasts within 1 week of completing their previous versions, and they developed these redrafts with ease.* A production manager might be interested in monitoring work force hours in comparison to hourly production output and quality reports. This would enable the company to assess operating efficiency and effectiveness on a current basis and to confirm whether the organization can meet their revenue targets and customer satisfaction goals. If not, the production manager might choose to increase the workforce to provide additional support to a specific line that has some sort of processing challenge, for example. The Treasurer might be monitoring cash deposits versus payment commitments on a daily basis. Should they encounter a shortfall in daily cash receipts as a result of a customer being unexpectedly late in making a payment, the Treasurer may decide to draw on a line of credit for a short period. He would advise the Controller so that he could process a cash flow and profit and loss impact assessment. Regardless of one’s role and responsibilities, CPM software provides relevant information for all decision makers about what is expected of them and how they are doing. CPM will also allow decision makers to test a variety of assumptions and potential decision outcomes in order to evolve their thinking and inform their decisions.

Longer term strategic uses of CPM With a focus on long term creation of shareholder value, executives and board members together need to make informed estimates about a number of strategic questions. They will use the information to update the organization’s strategic plan. Some of the questions that are typically addressed in the strategic planning process are: •

What existing and new products/services will we offer (or not offer)?



What criteria will we use to evaluate new product opportunities?



What existing and new customer groups will we serve (and not serve)?



What criteria will we use to evaluate a new market opportunity?

* Prophix Software: Myriad Genetics In-Depth Profile. Online, 2013. resource.prophix.com/en-casestudy/Myriad%20Genetics%20-%20In-Depth%20Profile%20(Final).pdf

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What factors (price and/or quality aspects) is meaningful to our customers?



In which of our current product-market areas will we place the greatest emphasis (resources and attention)?



In what new product or market areas will we place the greatest emphasis?



What financial and non financial measures will we use to assess the viability of the strategy?

Q1

Q2

Q3

What existing and new products/services will we offer (or not offer)?

What criteria will we use to evaluate new product opportunities?

What existing and new customer groups will we serve (and not serve)?

Q4

Q5

Q6

What criteria will we use to evaluate a new market opportunity?

What factors (price and/or quality aspects) is meaningful to our customers?

In which of our current product-market areas will we place the greatest emphasis (resources and attention)?

Q7

Q8

Q9

In what new product or market areas will we place the greatest emphasis?

What financial and non financial measures will we use to assess the viability of the strategy?

How does our strategy implementation plan ensure that?

A

B

C

Departmental goals, design, and management support the strategy?

Process goals, design, and management support the strategy?

Positional/people goals, design, and management support the strategy?

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How does our strategy implementation plan ensure that: Departmental goals, design, and management support the strategy? • Process goals, design, and management support the strategy? • •

Positional/people goals, design, and management support the strategy?

To answer questions such as #3, “What existing and new products/services will we offer (or not offer)?”

»» Customer profitability analysis comparing traditional to activity cost driver overhead allocations using Corporate Performance Management software

companies can use CPM software to calculate product profitability using different forms of cost allocation. For example, with CPM it is easy to allocate overhead costs to a product’s cost using a traditional volume variable denominator. Alternatively, overhead cost pools can be broken down into a number of homogenous activity cost pools in order to apply more sensitive ‘activity’ cost drivers, which are known to yield highly superior projections of future profits. Companies can compare results from calculations using both traditional cost allocations and more correct activity cost drivers to determine if there is a significant difference in product profitability and whether overall corporate profitability might be improved by abandoning poorly performing products. In order to undertake multi-year projections, operations data cubes are used to prepare forecasts of all major inputs to the plan based on history and then to extrapolate the data into the future based on a series of assumptions. Assumptions would consider factors like the availability of services and products from suppliers, workforce pay expectations, availability of qualified team members, and information about new products to be introduced. 16

They would also assess external factors such as expected competitor strategies regarding new products to be introduced, marketing actions and pricing, anticipated legislative changes, commodity pricing, economic outlook in major markets, inflation, and exchange rates. And the list goes on! All of this information can be collected within CPM data cubes using work flow routines and automated compilation of the data. There is no need for finance staff to capture information manually or transpose it from spreadsheets into other systems. This leaves finance staff with the time to perform multi-year simulations using cost driver assumptions to flex major profit and loss and balance sheet line items over the strategic horizon.

»» Multi-year financial projection using CPM

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Conclusion Never before has such comprehensive, timely, and reliable information been available to managers and leaders at all levels of an organization as is now possible with Corporate Performance Management software. By automating compliance reporting and what was previously labor intensive data management and analytical work that required specialized attention by professionals, CPM software has moved the emphasis from necessary but non value adding work to the all important work of creating value. The wonder of modern technology and communications now allows managers and leaders to get up to speed with the knowledge age in which we live. It used to be said that managers, dependant on compliance reporting, were running their organizations as if they were looking in the ‘rear view mirror.’ Thankfully, we now have principles, practices, and the technical ability to run our organizations while looking through the windshield. Keeping your organization’s competitive advantage in our volatile knowledge age depends on having the right tools to do the job. In the knowledge age, leaders who fail to ensure they have up to date, reliable, high quality information about matters critical to their businesses place themselves, their companies, customers, employees, investors, and suppliers at greater risk than is necessary. Leaders have the option to fuel their businesses with good information and focus their employees on making the best informed decisions possible while providing them with the ability to ensure that they perform forward looking, value creating work. CPM software enables competitive businesses and success driven people to achieve their vision.

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Calls to action •

Identify the types of business decisions key to increasing shareholder value



Identify the gaps in information that are preventing you from making the types of business decisions that are key to increasing shareholder value



Quantify the likely costs that were incurred in the last 12 months as a result of not having the information required to make decisions that increase shareholder value



Identify variations in financial and/or operational performance that you consider acceptable



Evaluate whether your processes for monitoring the variations in financial and/or operational performance are well documented and followed



Quantify how many strategic opportunities you believe have been lost in the last quarter



Determine if your processes and tools for generating forward-looking insights, future scenarios, and recommendations have produced quantifiable benefits



Compare your organization’s track record (over the last 24-36 months) of consistently creating greater shareholder value versus that of your closest competitors.



Review and evaluate the tools your finance team uses to conduct ‘what if’ analysis and simulation modelling to support long-term planning.



Identify the quantifiable benefits that your organization, your team, and you could achieve if the time required to collect, analyze, and make sense of financial and operational information was cut by 30 to 50%.



Identify the benefits that your organization, your team, and you could achieve by accessing your most critical business information on a smartphone or tablet.



Create a high level ‘wish list’ of the qualities and functionalities of a solution that would increase your organization’s ability to conduct long-term forecasts by providing more complete/accurate financial and operational information.



Conduct a review of independent analyst reports (e.g., from Gartner, Aberdeen, Forrester) about Corporate Performance Management software designed to improve your ability to plan, forecast, and budget with greater confidence.

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A white paper for CFOs and Controllers By Paul A. Sharman President, Focused Management Information Inc. Focused Management Information Inc. Phone: 905 320 7467 Email: [email protected] www.focusedmanagement.com