A corporate planning model is an integrated business planning model in which marketing and production models are linked to the financial model. More specifically, a corporate model is a description, explanation, and interrelation of the functional areas of a firm (accounting, finance, marketing, production, and others) expressed in terms of a set of mathematical and logical relationships so as to produce a variety of reports including financial statements. The ultimate goals of a corporate planning model are to improve quality of planning and decision making, reduce the decision risk, and, more important, influence or even shape the future environment favorably. Today more and more companies are using, developing, or experimenting with some form of corporate planning model. This is due primarily to development of planning and modeling software packages that make it possible to develop the model without much knowledge of computer coding or programming. For the accountant and financial analyst, the attractive features of corporate modeling are the formulation of budgets, budgetary planning and control, and financial analyses that can be used to support management decision making.
However, corporate modeling involves much more than the generation of financial statements and budgets. Depending on the structure and breadth of the modeling activity, a variety of capabilities, uses, and analyses are available. What is “Corporate Planning Model”? How is it developed? How is it Applied? What Types of Analyses available? Let’s overview and find the answers out through this post. Follow on…
Benefits Derived from the Corporate Planning Models
Benefits that can be derived from corporate planning models include the following:
- The ability to explore more alternatives
- Better-quality decision making
- More effective planning
- A better understanding of the business
- Faster decision making
- More timely information
- More accurate forecasts
- Cost savings
Who Uses the Corporate Planning Models and When?
- Financial Planners and Budget Analysts – Using a corporate planning model, financial managers are able to generate pro-forma financial statements and financial ratios. These are the basic tools for budgeting and profit planning. The model will enable them to perform risk analysis and “what if” experiments.
- Corporate Planners and Strategists – In the face of uncertainty about the future, management is particularly interested in determining the best possible course of action under given circumstances. The model is used as a tool to help minimize risk and uncertainty and develop the best course of action for the company. For example, using corporate planning models, a firm can examine the effects of proposed mergers and acquisitions with more certainty and estimate the potential profits from new markets with more confidence.
How Is Corporate Planning Models Developed?
Corporate planning models can be categorized according to two approaches:
- Simulation models – are attempts to represent mathematically either the operations of the company or conditions in the external economic environment. By adjusting the values of controllable variables and assumed external conditions, the future implications of present decision making can be estimated. Probabilistic simulation models incorporate probability estimates into the forecast sequence, whereas deterministic models do not.
- Optimization models – are intended to identify the best decision, given specific constraints.
The advent of corporate simulation languages enables analysts with little programming experience to write modeling programs in an English-like programming languagefor example, IFPS, SIMPLAN, or XSIM. In addition, a number of spreadsheet programs, such as Lotus 1-2-3 and Excel, are also available for use by corporate planning modelers. Since 1979, nearly every Fortune 1000 company has used corporate simulation models. Increasingly, small- and medium-sized firms are introducing this analytical tool.
A majority of corporate models in use are recursive and/or simultaneous models. In recursive models, each equation can be solved one at a time by substituting the solution values of the preceding equations into the right-hand side of the next equation.
An example of a recursive-type financial model is:
(1) SALES = A – B*PRICE + C*ADV
(2) REVENUE = SALES*PRICE
(3) CGS = 0.70*REVENUE
(4) GM = SALES – COGS
(5) OE = $10,000 + 0.2*SALES
(6) EBT = GM – OE
(7) TAX = 0.46*EBT
(8) EAT = EBT – TAX
In this example, the selling price (PRICE) and advertising expenses (ADV) are given. A, B, and C are parameters to be estimated; and:
- Sales = Sales volume in Units
- Revenue = Sales revenue
- COGS = Cost of Goods Sold
- GM = Gross Margin
- OE = Operating Expenses
- EBT = Earning Before Taxes
- Tax = Income Tax
- EAT = Earning After Tax
Simultaneous models are frequently found in econometric models that require a higher level of computation methods, such as matrix inversion.
An example of this type of financial model is presented below:
(1) INT = 0.10*DEBT
(2) EARN = REVENUE – COGS – OE – INT – TAX – DIV
(3) DEBT = DEBT(- 1) + BOW
(4) CASH = CASH(- 1) + CC + BOW + EARN – CD – LP
(5) BOW = MBAL – CASH
Earnings (EARN) in Eq. (2) are defined as sales revenue minus COGS, OE, interest expense (INT), TAX,-and dividend payment (DIV). Note that INT is a percentage interest rate on total debt in Eq. (1). Total debt in Eq. (3) is equal to the previous period’s debt [DEBT(- 1)] plus new borrowings (BOW). New debt is the difference between a minimum cash balance (MBAL) minus cash. Finally, the ending cash balance in Eq. (5) is defined as the sum of the beginning balance [CASH(- 1)], cash collection, new borrowings, and earnings, minus cash disbursements and loan payments on the existing debt (LP). Even though the model presented here is simple, it is still simultaneous that is, it requires the use of a method capable of solving simultaneous equations.
How Is “Corporate Planning Models” Used and Applied?
Generally speaking, a corporate model can be used to:
- Simulate an alternative strategy by evaluating its impact on profits
- Help establish corporate and division goals
- Measure the interactive effect on segments within the firm
- Help management better understand the business and its functional relationships and help improve decision-making ability
- Link the firm’s goals and strategies to its master budgets
- Assess critically the assumptions underlying environmental constraints
Types of Analysis
Management’s choice of one type of corporate model over another depends on the types of analysis the company wishes to perform. There are typically three types of model investigations:
- The first type of investigation seeks to answer ”what is“ or “what has been“ questions for example, what is or has been the firm’s profit when the price of raw material is $12.50? Thus, the model examines such relationships as the relationship between variables of the firm and external macroeconomic variables such as GNP or inflation. The goal of this type of model investigation is to obtain a specific answer based on the stipulated relationship.
- The second type of investigation is based on simulation or sensitivity analysis and focuses on “what if“ questions. This analysis often takes the following form: “What happens under a given set of assumptions if the decision variable(s) is (are) changed in a prescribed manner?” For example, “What will happen to the company’s cash flow and net income if it initiates a reduction in price of 10 percent and an increase in advertising budget of 25 percent?”
- The third type of question that can be addressed with corporate planning modeling takes the following form: “What has to be done in order to achieve a particular objective?” This type of analysis is often called “goal seeking,” and usually requires the use of optimization models such as linear programming and goal programming.
Typical Questions Addressed Via Corporate Modeling
The following is a list of questions addressed by corporate modeling:
- What are the effects of different pricing policies?
- What is the effect of different interest rates and current exchange rates on the income statement and balance sheet of the firm?
- What will be the demand for the end products of the firm at various locations and at different times?
- What is and will be the unit contribution margin for certain production, transportation, and sales allocations?
- What are the absence and turnover rates of the employees of the firm, and what effects will they have?
- What is the effect of advertising and distribution expenditures on sales?
- What marketing strategies can and should the firm follow?
- What do price-demand or supply relations on the output or input side of the firm look like? What are the effects of price/cost changes on sales?
- How do certain states of the national or world economy influence sales of the firm on the one side and purchase price of production factors on the other?
- What is the nature of the conditions that must be fulfilled if the total sales of the firm at a certain time are supposed to be higher than a certain budget value?
- Should the firm produce and sell a certain product, purchase and sell the product, or not get involved at all?
- In what range will the return on investment on various projects and units lie?
- How will the income statement, the balance sheet, and the cash flow statement develop for several operating divisions? What will their contributions be?
- What effects with respect to the financial position of the firm could an acquisition or merger with another firm have?