Budget Forecasting: What does it really mean?

Budget Forecasting: What does it really mean?
Contents

What’s the difference between budgeting and forecasting? 

Budgeting and forecasting are closely related management tools, but they are two distinct processes. Essentially, the budget is a target that the company would like to achieve, and the forecast estimates where the business is actually headed.

Budgets are generally static over a set period, so budgets can get left behind in a dynamic business environment. Forecasts, on the other hand, often account for current market dynamics to predict future outcomes.  

What is a budget?

Let’s start with where you’d like to take your business. A budget details the projected financial performance of your business over a period of time. This may be a monthly, quarterly, or annual budget. 

Your budget converts an operational plan into a set of financial outcomes that include revenue, expenditure, cash flow, and an investment plan. With a better understanding of income and expense sources, you can anticipate cash flows. 

Businesses use budgets as a yardstick to measure financial performance. Comparing actual to budgeted numbers offers clear insight into current progress. Armed with insight, managers can strategically adjust costs or change priorities. Budgets are central to the identification and allocation of financial resources in the business.

A budget is typically compiled annually for the fiscal year, meaning it can quickly become outdated, especially in a dynamic market. This is where the financial forecast comes in.

What is a forecast? 

A forecast uses historical data to estimate future financial results. Historical sales, expense trends, and future sales contracts help to inform forecasts.  Forecasts also account for relevant cost drivers and external factors, like changes in the business environment. 

Unlike budgets, forecasts are regularly updated. Updates may happen on a monthly or quarterly basis.

Forecasts are necessary for strategic planning and operational planning. Because of their relevance in both short-term and long-term plans, forecasts can address issues requiring immediate attention and plans that cover a span of years. Companies also use forecasts to improve cash flow management and determine capital requirements for business opportunities.

Key differences between a budget and a forecast

While budgeting and forecasting are intertwined, they have key differences. 

Time horizon: Budgets often cover a year, while forecasts can either be long-term or short-term. 

Preparation time: It can take three to six months to prepare a budget, while forecasts may only take one to four weeks.

External disclosure: Budgets are for management use only. Forecasts, at least for public companies, may require public disclosure.

Flexibility: Budgets require significant resources and are rarely updated. Forecasts are more flexible. Companies may revise forecasts multiple times to incorporate real-time information. 

Reliability: Budgets are only reliable if market conditions have not experienced major disruptions. Since forecasts use up-to-date numbers to predict business results, they stay relevant even if there are changes to the business climate.

Performance management: Companies use budgets as performance targets after managers analyze the variance from budget to actual. Forecasts project performance and serve as inputs for decision making as well as formulating budgets.

Does the budget or forecast come first?

Companies need to prepare budgets in advance, sometimes months before year-end. Budgets rely on assumptions, including forecasts, to prepare detailed financials.

Since forecasts serve as inputs in budget preparation, they are naturally done first.

How to create a budget

What should a budget include?

Once you cross the finish line, the last step in the budget process is to create budgeted financial statements. Key elements include: 

  • Revenue streams: All planned revenues with dollar amount and timing 
  • Fixed costs: Costs like rent, utilities, salaries, property taxes, insurance, etc. often unrelated to output
  • Variable costs: Include changing costs such as travel and entertainment, supplies, materials, and maintenance.

Step-by-step budgeting process

Building a budget is a careful, iterative process. A step-by-step approach is the best way to ensure that you cover all bases as you formulate your budget.

  1. Gather and review all the budget inputs. Tally revenue streams, fixed costs, variable expenses, and one-offs to avoid surprises.
  2. Review previous budgets. Analyze historical data to determine revenue and expense expectations for each month, understanding monthly and seasonal trends.  
  3. Consult with the team. Discuss departmental budgets with department heads to get buy-in from the entire team.
  4. Establish a capital expenditure plan. Consider necessary spending for required investments like infrastructure, property, and equipment over the budget period.
  5. Create budgeted financials. Use your budgeted requirements to prepare an income statement, balance sheet, and cash flow statement.
  6. Define metrics. Identify key performance metrics and ratios to evaluate actual results against the budget.
  7. Review and strategize. Look for strategic opportunities, for example, to discontinue non-core business activities, invest in technology to improve efficiency, or reduce debt.

How to create a forecast

Forecasts can serve different functions. They help create effective budgets and assist businesses in responding to market changes. Such operational and financial planning helps to keep numbers relevant over the budget period.

The most recent historical data is the main input into the forecast. 

Types of forecasts

  • Periodic forecasts: A forecast to the end of the budgeting period, typically the fiscal year. 
  • Rolling forecasts: Regular forecasts generated for a defined period that extends beyond the fiscal year. Rolling forecasts typically extend over a twelve-month period but may even go beyond that. You get consistent visibility over a set period.
    • For instance, a rolling 12-month forecast may initially start in January and end in December. At the end of the first quarter, the forecast rolls over to the next 12 months and would project numbers for April to March of next year. 

What should a forecast include?

Like a budget, a forecast should include the following:

  • Revenue forecasts: Revenue streams
  • Fixed costs: Salaries, rentals, insurance, and utilities, etc
  • Variable costs: T&E, materials, consumables, etc

Step by step forecasting process 

Financial forecasts include the following steps:

  1. Determine key focus areas. Define underlying assumptions and issues that will affect your forecast. This includes:
    • the metrics you are trying to forecast, such as the sales volume or gross revenues or the marketing expense,
    • current or expected regulatory requirements and other legal and political changes that could affect your forecast, and
    • the company’s financial forecasting policy.
  2. Set the forecast period. Typically, your forecast will take you to the end of the budget period.
  3. Populate your forecast template. Use the most recent updated numbers.
  4. Analyze trends. Compare the year-to-date actuals with historical data to determine the trends to the end of the period.
  5. Apply trend analysis to actuals. Use recent numbers with trends to come up with financial projections. Make modifications for known changes in the business environment before submitting your forecast.

Avoid these budgeting and forecasting pitfalls

The complexity of budget forecasts differs across businesses and industries. Challenges are nearly unavoidable, but understanding common pitfalls can prepare you for pending aggravation. 

  • Disconnected sources of data. Many companies face data silos, making it difficult to get useful and reliable information from different functions. Information gathering is also delayed since finance teams have to combine data across sources. These delays reduce the relevance of information and make collaboration harder.  
  • Manual creation in excel. Though many businesses use Excel for their budget forecast processes, spreadsheets are time-consuming and labor-intensive. Most managers are comfortable with Excel spreadsheets, but problems tend to compound and challenge growing businesses. Excel is susceptible to manual input errors, data corruption, formula errors, data integrity problems, and version control issues that could wipe out important information in an instant.  
  • Lack of communication and collaboration between stakeholders. Budget forecasting requires close collaboration across all stakeholders, including Sales, HR, Marketing, Product, and Operations, for instance. Without smarter department budgeting you might not see effective communication.
  • Misaligned motives. Most budgets have a bottom-up approach which allows department managers to set their budgets. Managers tend to set a low budget, so they are easier to achieve. On the other hand, setting a budget that’s too high will decrease employee morale. 
  • Inaccurate, unrealistic, or out-of-date assumptions. Budgets and forecasts have to be as grounded as possible. Rather than using optimistic revenue and sales figures, opt for achievable targets. On the expense side, include realistic spending even if it drags down the bottom line. If the market has changed too much, scrap historical data that would be of little to no use. 

Real-time budgeting to the rescue

Budgeting and forecasting keep your plans and company performance on track. A budget depicts what the company wants to achieve, and the forecast shows what they’re most likely to accomplish.

While forecasting is vital to long-term strategic objectives, the budget ensures financial resources for executing the operational plan. 

Reliable budgeting and forecasting take time and sustained effort across teams. No wonder 61% of small businesses don’t have a formal budget. 

While most software tools help to create budgets, enforcement is usually a different ball game. It’s essential to be able to compare actual to budgeted performance in real-time.

Enter Lola.com, which combines spend management software with corporate cards to keep businesses on budget. Lola allows you to create, allocate budgets (by individual, category, or vendor), and share them to all team members right from its user-friendly dashboard. Every transaction instantly maps to a budget, which enables all stakeholders access to up-to-date financials. Combined with real-time visibility into spend, budget-owners finally have the tools they need to manage their budget.

Get started for free today. 

Lola.com is the spend management solution that keeps you on budget.


About the Author: Anna Yen
Anna Yen, CFA, has nearly 2 decades of experience spanning financial markets, cryptocurrencies, and digital marketing. Currently she manages digital assets at FamilyFI, working to empower families with financial literacy.