For any enterprise, being able to accurately assess the probability of meeting financial commitments is a crucial aspect of both short- and long-term planning. It’s no simple task, however, as overconfidence and other behavioral biases can lead even experienced managers to err in their estimates, with serious consequences to those who rely on those expectations.
Meeting commitments and managing risk are central themes of the business simulations provided by TRI Corporation, which offers corporate financial education and experiential leadership programs. TRI’s recent study of 117 teams that participated in these simulations sheds light on the challenges inherent in the estimation process.
In a TRI business simulation, teams of four to eight participants are given the task of turning around a hypothetical business in the wake of missed commitments by a previous management team.
In one example shown in TRI’s report on its study, the simulation began midyear 2012. The teams were given a net-income target range set by the CFO of $15-20 million for 2013. Probability assessments were gathered twice during 2013. The team was first allowed to become familiar with all aspects of the simulation in the third and fourth quarters of 2012, to eliminate any bias related to the learning curve.
The initial assessment occurred after the teams completed their budget commitments for 2013 and the second took place at midyear, at which point teams had access to the first two quarters of actual results. Conducted anonymously in the form of an individual participant survey, the assessments addressed two issues: whether actual net income would meet or exceed plans; and the individual’s assessment of the probability of net income meeting or exceeding plans.
The collected data were later segmented by various classifications, grouping those that:
- Did meet and/or exceed commitments;
- Did not meet commitments, but did beat the historical average; and
- Came in below the historical average
The study revealed that greater divergence in opinion among team members early in the estimating process can result in more accurate assessments. Divergence later in the process, on the other hand, can weaken the team environment and lead to an inability to deliver on commitments.
More specifically, the two groups that did not meet their commitments exhibited a significantly increased divergence of opinion in the second assessment. For the group that came in below the historical average, the average probability of an accurate assessment declined significantly at midyear. That is troubling, says TRI president Thomas Conine, as it can set up a dysfunctional team environment that can negatively affect decision-making and lead to business losses. The message for managers is to watch shifts in probability, as declines by midyear can signal trouble for the entire year.
It’s worth reading the full report, which provides a wealth of insights that will help managers reduce bias and avoid common pitfalls with the goal of improving the accuracy of their estimates and, ultimately, meeting their commitments.