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Mining Company Case Study: Introduction (continued)

These outputs were selected for the model because NPV greater than zero is a key project
acceptance hurdle and IRR is the discount rate at which an investment’s NPV equals zero and is
thus another way of understanding the project’s minimum acceptance criteria, especially as it
regards the cost of project funding. Similarly, the profitability index is attractive when it exceeds a
ratio of 1.0. The payback period and discounted payback period show how long it takes to recoup
the initial investment in terms of actual dollars and present value dollars respectively. Together,
these measures are often used to evaluate capital budgeting projects because each provides a
different piece of information for making accept or reject decisions. Since each method has its
own strengths and weaknesses, using the outputs together can provide the best information in
total. However, the mining company considers NPV to be the metric of most value because it
shows by how much the project will increase shareholder wealth. Each of these metrics is
discussed in more detail in Part II, Domain B. The final model output, the expected life of the mine,
is a key output critical for understanding whether the mine will have sufficient resources to be a
profitable long-term investment. It is calculated using the reserve estimates and the amount
extracted per year.

Other important outputs to be produced using a set of pro forma financial statements (not shown
in this case study) for the entire organization include the following:
• For the financing question, a key output is the external financing required; interest expense
will be an input to the profitability analysis so this will require an iterative model. (See Part II,
Domain C, for an example unrelated to this case study.)
• Another output is the marginal (additional) profit to the organization generated by the mine for
each of the first three years of the project. (See Part II, Domain B, for an example of financial
statement projections unrelated to this case study.)

Finally, while also not specifically addressed in this case study, often an output of a potential
investment analysis is the comparison of a project against competing alternatives for
organizational funds. The outputs of the financial model could be directly compared to other
potential projects of similar risk or they could be risk-adjusted so as to compare apples to apples.
Risk-adjusted comparisons are discussed in Part II, Domain B.

Topic 2: Define Key Inputs and Input-to-Output

Logic
With an understanding of the desired outputs for the model, the
FP&A professional can then begin to define the inputs and the
input-to-output logic needed to produce the outputs. Inputs come in
many forms.

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These may include:

• Value drivers (or business drivers) and related key performance
indicators
• Historical data or seed data that can help establish trends
• Proxies and assumptions that take the place of missing data or
predict what conditions will be like during the analysis period
(Note that proxies and assumptions are discussed in later
topics.)

Specifying inputs and input-to-output logic often revolves around a

study of value drivers related to the end product. Value drivers are
discussed in Part I, Domain A, Chapter 3, “Organization.” After
introducing some types of inputs, the discussion here therefore
addresses how value drivers and KPIs are used to help define both
inputs and the logical flow of inputs to outputs. Afterward, there is
a discussion of how to construct high-level flowcharts and
flowcharts of more detailed calculation processes for models.

Specify Inputs
When deciding what inputs to specify in the model, the first question to
ask is, “What critical factors do we need to know about the situation and
the future that will drive the outputs?” This is a brainstorming process
of listing all critical factors and then separating them into direct inputs,
contextual inputs and derived inputs.

Direct Inputs
Direct inputs are those inputs or drivers entered directly in the model
and used as inputs to calculations. Direct inputs can be variables,
constants or semi-variables.

Variables
Variables are data that can assume any one of a set of values as needed
or expected in the model. Variables can be based on value drivers, the
most up-to-date historical data or assumptions.

Variables will form the majority of direct inputs to a model, especially

when generating projections into the future. Variables are used as inputs

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for assumptions, for example, when historical data are not available.
Even when historical data are available, how the input will behave
going into the future could vary and so a variable direct input is usually
necessary.

FP&A professionals could start with a long list of potential variables,

which can then be reviewed to determine which are really constants or
semi-variables and also which are better as contextual or derived inputs
(all discussed below).

Constants
Constants, also called the “givens” in a model, are values that are not
expected to change in the model and are used for stable relationships.
Constants could be assumptions, historical data, internal policies or facts
(e.g., five workdays per week).

Constants are typically easy to collect because by definition they do not

change frequently, if at all. Constants are still modeled as direct inputs
because calculations should not contain hard-coded values and the
values might also differ the next time the model is used.

One example of constants are internal policies. Internal policies are

those strategic or operational values set by organizational policy.
Examples include minimum cash balances, working capital, weighted
average cost of capital, depreciation schedules, capital expenditures,
dividend payout policy, operating and financial leverage, relevant
marketing or manufacturing decisions, management’s attitude toward
taking risk (risk appetite), or management’s preference for debt versus
equity.

Semi-Variables
Semi-variables (or step variables) are inputs that are used for
relationships that are stable over a given relative range and then step up
or down to a new stable level once the range is exceeded.

Semi-variables require modeling the relevant range or ranges for the

model, perhaps as separate input fields. For example, say that one

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employee can produce between a relevant range of 0 and 100 parts per
week. If 150 parts are needed per week, an additional employee would
be needed and number of employees might be an input field. Note that if
the relevant range will not be exceeded within the model (e.g., that
range is considered reasonable), these inputs can be treated as constants,
but some data validation might be needed so the range is not
inadvertently exceeded.

Contextual Inputs
Contextual inputs (contextual drivers or indirect inputs) are those
inputs or drivers that are not used in the model directly but may help
determine model logic or may be used in descriptive summaries to
provide support for scenarios or conclusions and recommendations.
Contextual inputs should be removed from the list of direct inputs and
put on the assumptions tab or elsewhere.

Derived Inputs
Derived inputs are the outputs of calculations in a model that are used
as inputs to different calculations in the model. The more models make
use of derived inputs, the more flexible they are, because derived inputs
and the calculations they are based upon leverage the interrelationships
between elements. Derived inputs are discussed further in Chapter 3,
Topic 3.

The determination of which inputs should be direct, contextual or

derived often starts with a study of value drivers and their related key
performance indicators. In this way, the inputs and the input-to-output
logic are often developed simultaneously.

Specify Value Drivers and Related KPIs

Value drivers, or business drivers, are factors that affect the
organization’s ability to generate economic value. Activities meant to
influence value drivers are often measured using key performance
indicators. A key performance indicator (KPI) is a metric that
indicates the level of performance required to achieve a defined
objective in a certain activity.

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As discussed in Part I, Domain A, Chapter 3, “Organization,” a financial

value metric such as net profit margin is driven by financial value
drivers such as sales revenue, and each of these drivers is driven in turn
by a number of operational value drivers, one of which might be direct
sales volume. Direct sales volume is in turn driven by one or more
tactics such as new account development, which might be measured by
the KPI “number of new accounts.”

Purpose of Identifying Value Drivers and KPIs

Identifying value drivers and KPIs is a high-level, top-down effort that
can help frame the big picture and clarify the purpose of the end product
prior to getting into the details of the model. Studying value drivers
helps the FP&A professional to understand the financial and economic
relationships between inputs and helps to construct the logical flows and
high-level model process flowchart logic.

Understanding the key value drivers for a particular end product and
how the business opportunity impacts the drivers will help the FP&A
professional and decision makers understand how a project will
maximize a business opportunity or improve business operations so that
recommendations will have relevance for decision makers. Another
benefit of studying value drivers is that it helps to identify potential
project or operational risks and opportunities. These risks and
opportunities can be listed in a risks and opportunities (R&O) analysis
for possible inclusion in scenarios, as is discussed in Chapter 3, Topic 2.

Value drivers can also be used to generate derived inputs using the
known relationships between the drivers and other information that is
unknown when making a projection. For example, when building a set
of pro forma financial statements, drivers of revenue will give you your
revenue for the model, drivers of expenses will give you your expenses,
drivers of capital expenditures will give you your capital expenditures,
and so on.

Value drivers that cannot be used as direct or derived inputs are often
still valuable as contextual inputs. These drivers might be addressed as
considerations or constraints within the overall logic of the model.

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External Value Drivers and Related KPIs

External value drivers and their related KPIs are factors outside the control
of the organization that are likely to have an influence on the end product.
As defined and described in Part I, Domain A, Chapter 5, external drivers
are sometimes considered in the following macroenvironment categories,
which is sometimes called a PESTLE analysis:
• Political
• Economic
• Social
• Technological
• Legal
• Environmental

Considering each of these areas in turn can ensure that no important

external factors are ignored in the model. See Part I, Domain A, for
specific examples of macroenvironment drivers in each of these categories.

External drivers can also be specific to an organization, business unit or

product decision:
• Market growth
• Overall market size
• Customer needs and expectations
• Loan covenants
• Competitor actions such as their offerings, marketplace positioning
strategies and anticipated responses to the organization’s actions

Organization-specific external drivers can help provide subtle distinctions

in how variable interrelationships should be interpreted. For example,
understanding where a company or product is at in terms of its life cycle
will influence how its free cash flow should be interpreted. A new
company or one experiencing strong growth may have significant negative
free cash flow, and this is a normal consequence of its life cycle stage.

External drivers specific to a particular business question could include

impact on the environment or a local community, availability of suitable
land and infrastructure, useful life or maintenance costs for technology and

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equipment, or local market costs for services such as construction. Also,

some macroenvironment factors can be drilled down to relevant specifics,
such as the impact of a specific regulatory approval process on a product
release or the inflation rate of the raw materials used in a product.

Selected external drivers and KPIs are therefore specific to the

organization and the end product. Take, for example, a chain of mall-based
retail clothing stores that markets to a niche market segment:
• End product. Increase mall retail space foot traffic.
• External drivers of foot traffic. Unemployment levels and disposable
income for niche demographic, mall foot traffic, ratio of vacant to
occupied spaces in mall, seasonality, rate of change in clothing trends,
etc.
• KPIs. Number of persons entering store, ratio of walk-ins to sales.

Another example is for a hotel chain:

• End product. Maximize hotel revenues.
• External drivers of hotel revenue. Unemployment rates, disposable
income, travel budgets for organizations, gas prices, regional events,
regional situation (e.g., political or social strife), etc.
• KPIs. Occupancy rate, price realization, etc.

Internal Value Drivers and Related KPIs

Internal value drivers and related KPIs are drivers and metrics that the
organization can influence or control. Many internal value drivers and
KPIs will be ones that the organization has previously determined are
vital to the organization’s business model and strategy. When these
exist, FP&A professionals should select an appropriate subset that
relates to the end product or business question. When decision makers
are already measuring and managing success using these drivers and
KPIs, it will be straightforward to show how the planning or analysis
results are pertinent to the audience and how they impact the
organization’s strategic or tactical goals.

Newer organizations or organizations that have not engaged in formal

strategic planning may not have a set of clearly identified drivers and

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KPIs, in which case the FP&A professional may need to consult with
internal experts to develop them for the end product.

Like external value drivers, internal value drivers and related KPIs
will be specific to the organization and end product. The prior
example of a mall retail clothing store is continued for internal
drivers:
• End product. Increase mall retail space foot traffic.
• Internal drivers of foot traffic. Choice of malls for stores, store
location in mall, store layout, shelf layout, product mix,
advertising, number of salespersons, training of salespersons, etc.
• KPIs. Number of persons entering store, ratio of walk-ins to
sales, etc.

Internal drivers for the hotel chain example follow:

• End product. Maximize hotel revenues.
• Internal drivers of hotel revenue. Location, customer
experience, frequent stay programs, coordination with convention
space, up-selling initiatives, availability of ancillary services, etc.
• KPIs. Occupancy rate, price realization, ancillary services paid,
customer complaints, satisfaction with complaint resolution, etc.

Differentiating Between Direct and Contextual Inputs

The process of selecting which inputs or value drivers will be direct (or
derived) inputs and which will be contextual inputs involves only
deciding what is necessary and sufficient to produce the end product.
Necessary is a criterion that will help restrict key inputs to what is
feasible to model within scope and deadline constraints. Sufficient is a
criterion that will help ensure that the set of inputs as a whole can
answer the business question, including any scenarios that need to be
developed.

Other selection criteria include driver volatility and prediction

usefulness. Volatility relates to the frequency and size of swings in
variations. Volatile drivers often still need to be explicitly included in
the model if they are critical to understanding the issue. They may

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require more assumptions, and you should understand that these

assumptions become quickly less reliable the farther into the future they
are projected. Prediction usefulness refers to how predictable a driver
has been in the past in forecasting correlated events. Drivers with poor
correlation might be excluded.

The variables selected may start out broadly in the first iterations and
then may be narrowed or changed as the understanding of the end
product and available information evolves.

Document the Logical Flow of Inputs to Outputs

The logical flow of inputs to outputs uses logical arguments to
show the overall factors and drivers that come into play in a
complex model. More detailed flowcharts show how the inputs lead
to calculations and the results of those calculations become inputs
to other calculations, and so on, until the final outputs are
generated.

The purposes of producing a logical flow of inputs to outputs are

to:
• Ensure that all relevant considerations and major components
of the model are accounted for
• Show cause and effect
• Make the design and documentation transparent
• Provide a method of checking for logic errors or model auditing
• Enable presentations of high-level model logic to interested
parties

For example, for a revenue projection model the purpose of the

flowchart is to show where the money is coming in, how things tie
together and what factors influence each revenue stream.

Flowcharts can be created using an automated flowcharting tool

such as Microsoft Visio, but they can also be created manually in
an Excel worksheet tab or in a PowerPoint slide show.

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High-Level Logic Flowcharts

High-level logic flowcharts are a top-down method of showing all
of the major influences on a given model output. They are
especially vital for complex models with many drivers and
influencing factors. These flowcharts are top-down because they
start from a major output and branch into more and more specific
drivers. A common way of presenting this information is a value
driver tree. (See Part I, Domain A, Chapter 3, for an overview of
value driver trees). These high-level flowcharts do not indicate the
specific calculations but instead provide a way to check that all
considerations and constraints are accounted for. Exhibit II.A.1-2
on the next page shows an extract of an example of the logic for
free cash flow (FCF) resulting from a utility company’s economic
assistance customers (EACs). Note that some of the specific drivers
or inputs on the right could be further broken down into additional
levels of detail. Note also that F( ) denotes “function of” in the
chart.

Detail-Level Process Flows

For specific portions of a complex model or for a simple model, an
additional level of detail can be mapped out to help with design. At
this higher level of detail the inputs, calculations and outputs (ICO) of
a model can be shown. This type of process flow should visually
differentiate between the inputs, derived inputs, calculations and
outputs.

Detail-level model process flows may be constructed in many ways. A

simple model may require only simple mathematical arguments such
as plus, minus, multiply and divide, or it could list financial functions
to perform such as Excel worksheet functions. Other detail-level
model flowcharts will use standard flowchart methodology (i.e.,
symbols such as boxes for processes and diamonds for decision points
with arrows between processes). In this case, the mathematical
operators and calculations to perform might be specified within the
flowchart boxes, or they might be omitted to keep the chart simple, as
is often needed when a detail-level flowchart must still show many
complex interactions between elements.

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Exhibit II.A.1-2 – Illustrative FCF Driver Flowchart for Economic Assistance Customers

Exhibit II.A.1-3 on the next page shows a process flow produced on a

worksheet tab, which ensures that it is easily accessible within the model.
The chart shows how an organization selling products for families with
newborns estimates their revenue based on the new customers gained and
the number of existing customers retained after accounting for churn

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(lost customers). Note that the exhibit differentiates between direct

inputs, derived inputs and outputs, while the calculations are all shown
using operator symbols (plus, times, and equals).

Exhibit II.A.1-3 – Revenue Projections of Simple Model

Transparency and Continued Relevance

Model logic and flow development throughout this iterative process
should be very open and transparent. Documenting as you go is the only
way to keep this process transparent. Clearly documenting the logical
flow using a basic flowchart is a best practice.

It is important to keep the flowchart up-to-date so that decision makers

can understand conceptually how the model works. Only when they
understand the model’s logic and assumptions will they be in a position
to apply their expertise rather than blindly relying on a black box (or
rejecting the model outright). From the FP&A professional’s
perspective, a useful flowchart will improve formal presentations and
make justifying the methods used to arrive at the results more obvious
and visual. Flowcharts will also be valuable for future model users and
auditors so they can trace the model’s process.

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Formal Review of Inputs and Logical Flows

Large, complex projects may have a formal review step to validate the
inputs to be used and the logic of the model for quality assurance
purposes. Such reviews may occur at various development stages.

Mining Company Case Study

The Inputs
The following direct inputs are planned for the Panama mine purchase analysis model. The first
two fields sum to the initial year investment cost. The next field is the discount rate, or the cost of
funds used for present value calculations. The copper reserves and extraction per year fields are
listed in metric tons, and together they dictate the expected life of the mine. The copper base
price field is the average historical price of copper in the initial year. The copper price growth rate
is a compounded growth rate to apply to the copper base price in the first year and to the prior
year’s calculated copper price for subsequent years. The retirement obligation is the cost of
closing the mine and any necessary environmental remediation. The cash expenses field is an
assumption that the expenses can be estimated as a certain percentage of revenue. Depreciable
assets, asset salvage value and depreciation period are to be used to estimate straight-line
depreciation for the model as a simplifying assumption since the real assets will be depreciated at
different rates. The income tax rate is also a simplifying assumption because it omits
consideration of tax deductions, deferred taxes and so on that would be used to arrive at a more
realistic effective tax rate. Note that all amounts listed in millions are entered in whole dollars but
are formatted to display in millions. Finally, note that the values entered in the input fields so far
could be test data or early assumptions at this point.

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Mining Company Case Study (continued)

High-Level Flow
The following flowchart shows a value driver tree for calculating the net present value as of the terminal
year of the Panama mine. This flowchart shows that NPV requires knowing the terminal year of the
mine, which is variable based on the amount of copper reserves and the extraction per year.
Therefore, the model will need to calculate NPV for each year and then look up the NPV for the
terminal year. The NPV calculation is primarily determined using the present value of the after-tax cash
flows based on the discount rate, plus the initial cost. The retirement obligation is deducted only in the
final year. Note that F() denotes “function of” in the flowchart.

Detail-Level Flow
The detail-level flow below shows the direct inputs, the derived inputs, the outputs and the calculations
(math operators and Excel worksheet functions, e.g., PV, IRR) the analyst plans on using.

Starting from the top, the copper base price is used as the Year 0 copper price. Thereafter, the prior-
year copper price times one plus the growth rate is used to create compounding growth in average
annual copper prices. The copper price per MT for the given year is multiplied by the amount of MTs of
copper extracted per year to find the base revenue per year. Then the cash expenses assumption is
used to calculate the cash expenses for the given year. The third item required to calculate the income
before tax per year is the depreciation per year, which is a function of the depreciable assets, salvage
value and depreciation period. Income before tax per year is multiplied by the tax rate to calculate the
income taxes, which are subtracted from the income before tax to find the income after tax.
Depreciation is added back at this point to find the after-tax cash flow per year, and this amount is used
to calculate the IRR for each year of the mine.

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Mining Company Case Study (continued)

In cell A30, the after-tax cash flow per year is added as cumulative sums. An IF Statement and MAX
function in Excel is used to find the payback period. The discounted payback period is also
calculated starting with after-tax cash flow, but a present value (PV) function is used to calculate the
cumulative discounted cash flow for each year. Net present value is calculated using an NPV
function, which should equal the discounted cash flow per year less the first-year cash expenses
and/or capital. NPV divided by the first-year cash expenses equals the profitability index ratio.

Starting in cell H6, the copper reserves divided by the extraction per year equals the estimated life of
mine. Since the final year of the project is variable, this model calculates the other outputs for each
potential terminal year. Therefore, a LOOKUP function will be used to match the terminal year of the
mine to a project year field within the calculations and then return that year’s outputs for IRR, NPV
and profitability index. The payback period outputs are found using an array function to return the
minimum payback period that is greater than zero. (See Part II, Domain C, for more information.)

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