Why Build a Model?

CVP analysis is very crude. We know that business performance has many drivers and that success is measured, and indeed depends upon the management of, cash flow, assets, liabilities and investment. A spreadsheet sensitivity model is an essential tool in developing effective plans and making good commercial decisions.

My approach is to develop a model that makes not only financial sense but which also makes explicit the key drivers of business performance. It is these drivers that control the model; a change to a driver, such as the conversion rate for a salesperson, will immediately be reflected in the financial statements. When such a change is made, it should prompt the question:

“And what will make this happen?”

The model pushes us to:

identify the drivers of the drivers

The conversion rate of a salesperson depends upon their skills, which in turn depend upon experience and training. Therefore, we may build into our model a link between investment in training and conversion rates. If you can’t make the link, why do the training?

The depth and breadth of your analysis will depend upon your business. There will always be a danger of analysis-paralysis where the quest for the perfect model becomes all-consuming. But this is true of almost any endeavour.

There will also be those who denigrate modelling on the basis that the predicted results will almost never be correct. My response to this is:

“So blind ignorance is a better option?”

Modelling requires you to think more deeply about your business. This in itself is of great value. In the oft-quoted words of Dwight D Eisehower:

“Plans are nothing; planning is everything.”

The plan or model is a means to an end, not an end in itself.

To build a model requires you to think deeply about what drives financial performance; to construct a theory of how to be successful. Actual results may show you to be wrong in a number of respects. However, because you have been explicit in your thinking it is easier to learn from experience and adapt your model for the future. The interaction between your theory and your experience will lead you to success. As Immanuel Kant said:

“Experience without theory is blind, but theory without experience is mere intellectual play.”

Furthermore, variance analysis will direct your attention towards specific areas.

To summarize, the spreadsheet model:

  • helps in building an understanding of what drives business success
  • enables you to compare reality with theory
  • provides a means of quickly gauging the impact of your proposed actions on projected financial statements
  • allows the creation of multiple scenarios and exposes potential risks
  • supports business cases
  • assists in the development and justification of budgets

To obtain these benefits it helps if you follow a number of principles in developing your spreadsheet model. The first principle concerns the structure of the spreadsheet and that’s what we’ll look at next.