In this three-part series, our co-founder and CEO, and a former CFO, John Baule, discusses the different objectives between budgets and forecasts, and provides tips on how to approach each exercise effectively.
I was speaking with a partner from a private equity firm the other day. He made the comment that too often, his portfolio companies used the terms “budget” and “forecast”, interchangeably, creating confusion. This has always been one of my pet peeves as well. The reality is that while both budgets and forecasts are future-oriented, they are each distinct tools with unique objectives.
Budgeting is a collaborative tool used by management teams in conjunction with their boards (or corporate headquarters in the case of larger businesses) to ensure alignment on the broad investment decisions and objectives for the upcoming year. It’s a precise agreement on the annual targets, for which the management team will be held accountable.
A company’s budget takes revenue and expenses into consideration and dictates the issuance of resources that best suit overall objectives. Budgets should be done annually, and once established, they should remain unchanged.
Forecasting is a finance tool used by the management team to measure their year-to-date progress towards achieving the annual target established in the budget. A forecast reconsiders previous assumptions and incorporates the latest results in a full-year projection.
It is an iterative process that should be done regularly throughout the year with each iteration providing an updated snapshot of the full-year outlook. Effective monthly forecasting ensures that the management team is reacting in a concerted fashion to the latest available information and basing decisions on this updated viewpoint.
In a nutshell, the primary difference between a budget and forecast is, budgeting is a tool for setting goals; forecasting is a tool for achieving the goals you set.
To highlight the difference between a budget and forecast, consider a comparison to a weight-loss regime. First, you need to determine your target weight or measure of success. You may discuss it with your spouse, partner or medical professional before determining your goal to lose 30 pounds for a beach trip you have planned in 4 months.
With your target established, you start to add some detail to the plan. You do some calorie math and calculate that if you eliminate desserts and exercise for one hour, four days each week, you could lose two pounds a week and reach your goal — this is your budget.
Note these three characteristics of the budget: 1) You have successfully negotiated a target – lose 30 pounds in 15 weeks; 2) You have a broad plan to achieve it – no desserts, exercise four days a week for one hour; and 3) You have yet to lace on a running shoe or deny yourself a single donut.
This is where a lot of companies stop. Once they have completed the budget, they think they're done, as if the budget has been achieved just because it was built. The only aspect of a budget that endures is the target. Everything else starts changing as soon as the game begins.
Your weight-loss plan called for dessert elimination, but you didn't count on being invited to two birthday parties in week one. Refusing your piece of cake would be rude, and who can exercise after eating all of that cake, so you only worked out twice, not four times as planned.
At the end of week 1, you weigh yourself, and instead of losing the planned 2 pounds, you have gained 2 pounds. Now, you have only 14 weeks to lose 32 pounds, so you need to revise your plan to lose 2.3 pounds per week. You alter your original plan by adding one exercise session a week and eliminating cheese to increase your weekly loss to 2.3 pounds per week over the remaining 14 weeks of your program.
You also determine that you will weigh yourself at the end of each week and make additional adjustments to your plan based upon the updated results to ensure that you achieve your target — this is a forecasting process.
Note the three characteristics of the forecast: 1) You did not alter the original goals of the budget – to lose 30 pounds at the end of the 15 weeks; 2) Everything else in the original plan changed – pounds per week loss, number of weekly exercise sessions, allowable foods; and 3) Unlike the budget which is frozen in time as a document to your overall goal, the forecast will need to be updated regularly, if it is to be of value.
Let me give you a real-life example of how a budgeting process works in a company. I cut my teeth on budgeting when I was the Finance Director for the Asia Pacific region of Bristol-Myers Squibb, where the budget process was just a step short of armed combat. Corporate headquarters (the large-company equivalent of a Board) would gather assumptions from each business unit about market growth and potential, exchange rate trends, and other important planning factors.
They would then ignore all of this information and send targets based upon the amount of profit contribution they required from each unit to achieve the targets they had established with Wall Street analysts. One certainty was that the target received from Corporate was always higher than the target suggested by management.
The Asia Pacific management team usually greeted the arrival of the Corporate budget target with a day or two of wailing and teeth-gnashing and at least one night of commiserative drinking. And then, like dutiful corporate citizens, we began the process of building a detailed plan to achieve the target.
In building the budget to achieve the aggressive target, we were required to include the benefits of the many far-fetched income-generating programs that were part of major corporate initiatives. There were always productivity initiatives based upon a vague notion that every employee could do 10% more than they had in the prior year and vendors could be convinced to provide additional discounts if we just properly explained the rationale.
New product launches were assumed to be a blockbuster from day one. One year we included in our budget the savings in customs duties from shifting our source of milk powder (for infant formula) from New Zealand to China. Later that year, a team of employees was sent to North China, near Mongolia, to examine local dairy farms.
We learned two things from their report: 1) we would not be shifting to local Chinese milk, and 2) If you ever find yourself at a Mongolia/New Zealand cow racing event – bet on the Kiwi cow no matter the odds.
Keep in mind budgeting is a multiplayer game. Management always kept a few things in our back pocket, a few items not contemplated in the target that we knew would likely benefit us during the year. These might include expenses for employees we knew we would never hire, and accrued severance for employees we knew we would likely never fire.
Other back-pocket opportunities might include highly conservative estimates for bad debt and inventory reserves, potential insurance settlements, the possible elimination of 4th quarter advertising, or increasing distributor inventories; these were all potential budget gap-fillers to offset the impact of the inevitably under-delivering initiatives and enable us to achieve our assigned target. Management may have been dutiful, but we were not stupid.
A budget is more than a guiding principle for a company’s allocation of resources. I had the good fortune to work with many bright people at Bristol-Myers, seasoned veterans who understood the role of budgeting. These lessons have been reinforced by another twenty-budget season since then.
What I have learned is that a budget process is important for three reasons:
All of these things are documented in the annual budget, and once the budget is complete, it remains unchanged forever – a monument to hard choices made and a memorial of the targets a company will set out to achieve. At this point, it is important to realize, not a single second has ticked off of the annual game clock. Now that we have a budget, we need a tool to help us achieve it. We need a forecasting process.
From the minute you and your management team set foot on the playing field, you can be sure that nothing will go exactly as you planned in your budget. This makes a strong forecasting process essential to achieving your annual targets. Just like the weekly weigh-in, a forecast is a process for measuring a business’s results at defined intervals and determining the adjustments required to ensure that the annual goals are achieved.
A forecasting process is important for three reasons:
Imagine that an HR director submits a request in the middle of the year for a new HR analyst. The rationale stated on the request is that the position was “budgeted”.
Meanwhile, the CFO knows that the current forecast indicates that the company is projecting a 10% revenue shortfall for the year. Has the HR director considered this shortfall in deciding to proceed with the hire of the analyst? This is an example of a disconnected conversation – the HR director is operating with a “budget” framework, the CFO within the more informed context of the June forecast.
Here’s a simple analogy to illustrate this. You input a desired destination into Google Maps before setting off on a trip. Midway through your trip, you divert from the map to see the world’s largest ball of twine. Once this item is checked off your bucket list, you again set off for your original destination. In determining the direction to take, your original departure point, just like the budget, has been rendered meaningless;, you need to continue from where you are now, not from where you originally began. Similarly, your management team must begin their decision-making discussions with a common and current understanding of the company’s position.
The iterative nature of forecasting means that forecasts must be built at a level of detail and frequency that goes beyond that of the budget.
Consider the map example again. When you set off on a long journey, a simple direction like “head west” may be sufficient. As you near your final destination, however, you require increasingly precise directions e.g. which street do I turn on, etc.
Often the monthly phasing of budgets is little more than a guess. For example, you might assume that travel will be approximately $1.2M for the full year for which you are budgeting, and then simply straight-line the expense across the year.
When you are halfway through the year, however, and you have only spent a third of the annual travel budget, you will want to know whether this indicates that you have an upside against the full-year budget or just an intra-year phasing variance? The closer you get to your year-end, the more precise your forecasts will need to be.
Managing and tracking the increasingly precise changes to an iterative forecasting process can be greatly facilitated with budgeting and forecasting software. FutureView’s platform can help you manage your budgeting and forecasting process efficiently and with the level of precision you require to hit your target.
Our platform not only includes robust technology, but it incorporates tried and true methodologies developed through years of real-world finance experience. If you are ready to create a high-impact finance function and transform your Company, we'd love to speak with you.
--Check out the second blog post in this series where we provide tips on making your forecasting process effective, as well as examining some of the forecasting “buzzwords” that litter the forecasting landscape.