We often hear different terms used to describe forward-looking versions of a company’s financial statements. People frequently use these terms interchangeably, with some having a deeper understanding of the nuances in terminology than others. Forward-looking financial documents may include budgets, projections, forecasts, and pro forma financials. All of these represent hypothetical situations–that is, they are estimates or educated guesses (or occasionally just wishful thinking) about what may happen in the future. But the differences are important.
In a recent post, we covered the fundamental distinctions between forecasts and projections. There are some subtle but relevant differences there. It’s especially helpful to understand those differences when speaking with investors, regulators, or other key stakeholders.
Budgeting and forecasting, likewise, are somewhat different. In this case, though, the distinctions are not quite as subtle, although you may be tempted sometimes to muddy the waters by mixing the two. In fact, the combination of budgeting and forecasting can sometimes be a useful approach, which is why there has been so much interest lately in budget forecasting.
Before we dive into that, let’s explore the fundamentals of budgeting and forecasting.
What Is a Budget?
A budget is a financial plan for a specific period of time, typically covering one complete fiscal year. Generally speaking, budgets represent an unfolding financial reality that a company’s managers hope will come to pass, or to put a more optimistic spin on it, the budget represents management’s plans and intentions.
There are a number of different methodologies for developing a budget. Historically, the most common approach has been to use last year’s budget numbers (or actual performance) as a starting point, then to make adjustments upward or downward to individual line items based on changing business conditions and any change in the strategic direction of the business. The process often involves adjustments to planned sales revenue based on past trends and future plans. Nevertheless, as a budget, it tends to emphasize intentions over expectations.
There are several other approaches to budgeting that have also garnered considerable attention lately. These include zero-based budgeting, driver based budgeting, and activity-based budgeting. Each of these has distinct advantages and disadvantages. In the past, a key concern about several of these methods has been the amount of time and effort required to build a bottom-up budget every year. With the powerful planning and budgeting software available today, though, the balance has shifted for many people in favor of these more sophisticated methods.
The CFO's Guide to Zero-Based BudgetingAccess Resource
What is a Forecast?
Whereas budgeting is about what management intends and hopes for, forecasting is about what management actually expects to happen. In other words, forecasting leans slightly further toward realism then budgeting does. There should be little or no wishful thinking involved in a forecast.
Just like budgets, forecasts may cover variable time periods, often spanning an entire year or more. It is common, however, for forecasts to address more focused time frames, such as the next quarter or six months. It is also more common for them to be limited in scope–for example, attempting to predict sales revenue for the coming quarter or for specific seasonal peak periods.
As such, forecasts tend to be somewhat quicker and easier to prepare. Because they tend not to be used as performance benchmarks for employees, they do not require as much back-and-forth negotiation as budgets do. Budgets tend to be internal documents, intended for planning and assessment. Projections, on the other hand, can serve as management tools, but for many companies they are also disclosed publicly, especially in the case of publicly traded corporations where such disclosures are legally required.
So What Exactly is “Budget Forecasting”?
Now that you understand the differences between budgeting and forecasting, you are naturally left with the question “What is budget forecasting?” In fact, you will not find many formal definitions of the term. Perhaps it is most useful to describe budget forecasting as a kind of hybrid document that combines elements of both budgets and forecasts.
In fact, this is a process that most business managers engaged in at one time or another, simply because it can be useful in understanding how the business is likely to perform over the entire duration of the budget cycle, based on a combination of year-to-date results, plans for the remainder of the year (that is, the remaining budget), and expectations for the remainder of the year (that is, a forecast).
A variation on this approach is sometimes referred to as “reforecasting” or “budget flexing.” These terms generally apply to situations in which a significant event has occurred, resulting in a substantial deviation from budget. The onset of the COVID pandemic in 2020 represents a perfect example of the kind of situation that would call for reforecasting. As businesses were shut down and demand shifted abruptly for various goods and services, virtually every company in the world experienced significant, unexpected change to their annual budget. Other examples might include the emergence of a new competitor, the development of a new technology that supplants a company’s product, or external conditions that lead to an abrupt change in market demand.
Budget forecasting is a bit different from reforecasting in the sense that it does not necessarily imply a sudden and unexpected material change to the business. For some, this takes the form of budget vs. actual reports alongside projections for the remainder of the fiscal year. If you expect material changes, or if management is considering key decisions that could impact the financials, then it can also be useful to incorporate projections that map out potential outcomes of different scenarios under consideration.
Many companies get started with budget forecasting by combining information from various sources in spreadsheets, often by copying and pasting static information from their ERP system, from budget spreadsheets, and combining that with formulas that predict likely future outcomes. Unfortunately, that can be a slow, tedious process, and it is prone to error.
Because the manual approach takes so much time and effort, budget forecasting in many organizations does not get updated as often as it should be. When the finance department has powerful budgeting and planning tools at its disposal, though, updating the budget forecast with near-real-time information is possible in mere seconds, with complete accuracy, and no additional effort.
At insightsoftware, we provide powerful budgeting and planning tools, along with near-real-time reporting capabilities that integrate with over 140 different ERP applications. If your organization is seeking better, faster, more accurate and flexible ways of planning and budgeting. To get started with budget forecasting, you can download our free template today.
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Title: Budget Forecasting: What It Is and How To Do It
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Published Date: Wed, 02 Feb 2022 14:56:30 +0000