In October we discussed strategic financial modeling as part of a broader look at modeling in general. Let’s now look into operating models.
Understand the Business
The importance of understanding one’s business and receiving input from throughout the organization—a notion we mentioned in the earlier post about strategic models—equally applies here. However, while the strategic model tends to be higher-level and broad stroked, the operating model should more granular. As such, building an operating financial model tends to be more challenging and more sensitive to changing assumptions. This goes to show that accurate modeling practices depends on accurate data sourcing and sound assumptions.
Operating Model Defines the Present Organizational State of a Business
An operating model essentially defines where an organization stands currently and how it will deliver the capabilities and financial outcomes that are required. In other words, it serves as the bridge between strategy (goals) and operations (execution) as it translates strategic planning into operational capabilities.
There are various ways to create and monitor operating models, including the three-statement modeling method, which outlines the Income Statement (IS), the Balance Sheet (BS) and the Statement of Cash Flow (SCF) of a business that detail historical financials by which to predict future direction. But to focus on just this method—or any other single method—in this article would be unfitting, as each business is different and may require a drastically different approach to building an operating model from another. Instead we will aim to provide a baseline of an operating model and describe these few elements that make up the model’s core: processes, governance, and organizational culture and values.
Process, Governance and Organizational Culture and Values
- Processes: Processes define the work that must be done to accomplish the value or service proposition. They outline key capabilities that the organization possesses.
- Governance: Governance outlines decision-making processes and distribution of authority. An operating model should clearly detail governance principles, which could help risk management and an appropriate alignment of interests.
- Organizational culture and values: Understanding the people who do the work and how they are organized is crucial. An operating model should capture the attributes and behaviors of an organization, as well as the values upheld, and provide perspective into how these elements apply to the individuals making up the business.
Operating Models Aren’t Just for Large Companies, Small Businesses Benefit
Operating models are not just for large companies. Small businesses and startups should have one in place, too, as it will provide a blueprint for how to take strategy to capabilities regardless of the scale of the business. Lacking a sound operating model could pose risks to an organization. Potential issues include operational inefficiencies, as employees allot resources in areas that are not in line with the strategic plan; unclear accountability; and further increased risk of operational sustainability due to the absence of clearly laid-out principles and processes.
To reiterate, an operating model must be detailed, but it should also be noted that a model not become too prescriptive to a point of losing flexibility. When done right, with a focus on the enterprise level, the model can serve as an effective tool for management to run scenario analyses to drive business strategies. A company that utilizes an operating model is more likely than one that lacks it to gain competitive advantages. A well-defined model could help improve operational efficiency and ultimately business performance, lead to better understanding of stakeholders, and improve risk management.