Explaining Budgeting vs Forecasting
Budgeting and forecasting are two of the most important financial functions for a business of any size. Budgeting and forecasting are often linked together, as they should be, but they’re not the same.
Here’s a guide to help you determine the differences between the two and how each can help your business.
What Is Budgeting?
A budget is a detailed financial outline of what the business thinks will happen over a period of time (often a year) financially. The budget will include details about the company’s revenues, expenses, cash flow and financial position. This information should be available from your company’s financial reports. To learn more about financial reporting and to download free customizable financial statements, see our guide here.
Depending on the size of the company, there may be a budgeting process—often done later in the year—with input from the company’s various functional departments and profit centers, which should be managed by your head of finance.
In smaller companies, the budget might be done by the owner alone or with the help of a few key employees. The process and timeframe to complete the process are likely shorter in these cases.
Most budgets are static and set for the company’s fiscal year. However, some organizations use a continuous budget, adjusted during the year based on changing business conditions. While this can add accuracy, it also requires closer attention and may not necessarily yield a better outcome.
Budgets as a Tool
Ideally, a budget is used as a management tool to run the business. Actual financial results are compared to budgeted amounts, and variances are analyzed. If expenses in a certain area are higher than budget, then a company should determine if the overage is tied to additional business or just overspending.
Are revenues and profits on track with the budget? Did the company add additional revenue or lose business that was part of the budget? Reviewing the budget on a regular basis is a key tool in managing the business.
In some companies, the budget is used as a factor in awarding performance-based compensation.
Here are a few things to consider in making your budget a useful tool in managing your business:
- Start with a realistic cash-flow projection. Your revenue forecasts will drive this in part, but they may not fully materialize. It is better to be conservative here.
- Differentiate between essential expenses like electricity and internet, and your discretionary expenses that are not essential to running the company. These will vary from business to business.
- Build debt reduction, if you have any, into your budget.
- Try to incorporate cash reserves into your budget so any extra profits can serve as a cushion against a future downturn in business.
For a free customizable budget template, click here.
What Is Forecasting?
A forecast is a projection of what will happen at a higher level, generally key revenue items and overall expenses. Forecasts can be done over long-term and short-term time horizons. These can be done from top-down or bottom-up.
A longer-term forecast might look out over several years and feed a longer-term strategic business plan. Shorter-term forecasts are generally done for operational reasons. The revenue forecast will drive adjustments to head count, production planning and inventory levels for businesses that produce or distribute a physical product. A convincing forecast may also help determine the terms of bank loans.
Service and consulting organizations will generally use these forecasts to determine staffing levels.
Forecasts as a Tool
Forecasting is an important tool to help a company make necessary adjustments in spending and focus during the year as the business changes. For example, if a major customer will be reducing or adding to their volume of business with your company, this will have a major impact on operations and cash flow.
Here are a few things to consider when doing forecasts for your company:
- Consider using more than one forecast, perhaps three: one that reflects an optimistic outlook, one pessimistic and one most likely. This allows you to plan for growth but also to adjust in case some opportunities don’t materialize or happen slower than originally thought.
- Update your forecast on a regular basis. Things change, so don’t be caught off-guard.
- Involve key members of your team, such as managers from sales and operations. They are often closest to what is really happening. This will provide better information and keep these key managers involved in the process.