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In the first installment of this series, we defined the processes of “budgeting” and “forecasting”, and drew a sharp distinction between the purposes of each process. To recap, budgeting is a tool for driving decisions and setting goals, while forecasting is a tool a company should use to measure its progress against the goals established during the budgeting process.
In this installment, I would like to take a deeper dive into the forecasting process. While a budget is a process that a company generally undertakes once a year, forecasting is a process you will repeat regularly; therefore, putting thought into its mechanics will yield meaningful efficiencies. Also, to frame the discussion, I'm focusing on the monthly forecasting of full-year financial statements that correspond with the monthly accounting close.
There are specific elements of a business that may require more frequent forecasting. For example, certain businesses may require weekly sales forecasts and production plans may be updated daily for some manufacturing businesses. These forecasts can be incorporated into the regular P&L forecast.
The primary purpose of a forecast is to incorporate new information into the ongoing pursuit of your established budget goals. Since most companies close their books monthly, it stands to reason that you should update your annual forecast every month as well. If you are not going to take advantage of the additional information provided by each monthly close, then it begs the question of why bother to close the books each month in the first place?
A monthly updated forecast that accumulates the input of all functional leaders is an excellent tool to drive ongoing management conversations. When you sit down at your weekly management meeting, every member of the team is starting from a common view of the Company scoreboard. This scoreboard provides a context for the team to have meaningful discussions on alternatives and required course corrections.
During the early stages of the recent pandemic in March and April of 2020, companies that had a robust monthly forecasting process were better able to make rapid decisions than those who were still starting from the often obsolete 2020 budget that they had prepared at the end of 2019.
Given the greater precision required as you navigate to your full-year target, a Company should forecast at a level of detail that is equal to or exceeds the budget. For example, if you budgeted $1M for a new CRM, and then in June you signed a $1.2M annual subscription with a vendor, your forecast should be at the vendor level and adjusted for the monthly expense amount. If you have a strategic investment or large spend, I advocate forecasting on an employee-by-employee level and vendor-by-vendor level.
The more detail you include in your monthly forecasting, the more meaningful your monthly variance analysis will be. Think of your forecast as a scientific experiment. A well-designed experiment will yield better observations and will enable a company to improve its forecasting accuracy over time.
If we take this science comparison a bit further, the only reason a scientist conducts an experiment is to generate actionable observations. Similarly, a forecast is only useful if it results in a meaningful analysis that enables the company to improve performance in the future. If a forecast is not built at a detailed level, it will not yield actionable insights. Consider an example.
Assume that your marketing department forecasts spending of $200k in the upcoming month under the summary line item “marketing expense”. When the month concludes, actual spending is $190k, $10k less than the forecasted amount. At the “Marketing expense” line level, this seems like a favorable variance to the forecast, but is it really? What if marketing decided to eliminate advertising in the month and instead spent the entire $190k on company coffee mugs and t-shirts for employees?
This would not be considered positive by most CFO’s. If, on the other hand, marketing had forecast at a detailed level, a more detailed variance analysis would better indicate whether they had accomplished what was intended in the forecast.
To yield actionable insights, forecasting must be done at a sufficiently detailed level.
My preferred method of forecasting is what we refer to as Accountability-based Forecasting (ABF). With this forecasting method, the prime focus of the forecast is enabling budget owners to track progress against the annual target they committed to in the budget.
In our FutureView platform, we use a 1+11, 2+10 cadence to indicate the number of months of actual and forecasted months. So, after closing the books for February, for example, a company would complete the 2+10 forecast, after the March close, the 3+9, and so on until the year is complete. This approach provides a Company with a laser focus on the goals that they established in the budget.
Several other FP&A platform providers advocate for “rolling forecasts” in lieu of an annual budgeting process. Instead of going through a budget process each year, they operate the company by perpetually forecasting the next 12-24 months. There is nothing wrong with expanding the forecast beyond the months encompassed in the most recent budget, and the FutureView platform can easily accommodate this.
However, I do not think a rolling forecast is a substitute for a robust annual budgeting process. As we discussed in the first part of this series, budgeting and forecasting are unique processes with different outputs.
Relying solely on rolling forecasts, you lose the forced decision-making and the process of target negotiation that is yielded from the conclusive annual budget process. In theory, you could use a rolling forecast to drive decisions and discuss targets for the next twelve months, but in reality, it is a little too easy to punt tough choices to the next month. The perpetual nature of the rolling forecast works against it – there is never a clear point of conclusion. Budgets force companies to make tough choices, the essence of strategy.
The second reason that I favor an integrated budgeting and accountability-based forecasting process is less tangible. I think perpetual forecasting, to some extent, denies the seasonal nature of the human psyche towards achievement. Most great endeavors begin with an established goal followed by a journey to accomplishment that includes windfalls and setbacks.
The business cycle needs to provide ample time for management teams to recognize and adjust to these fluctuations — a single month or quarter is probably not sufficient. Marathoners can adjust to a poor mile, but sprinters cannot make a mistake.
I have seen many situations where the organizational pressure generated by an annual budget pushes a company to accomplish things it did not think it could. As the year progresses and the company has less time to achieve its annual target, management's choices get increasingly creative and bold.
There is a reason why so many of the truly transcendent sports performances occur in the ninth-inning, fourth quarter or last lap. The same holds true for sales and other departments of a company. Conversely, one could argue that too much pressure generates poor behaviors, which is why thoughtful discussions around the budget (and a good system of internal controls) are critical.
When the pressure is on to deliver, the cream rises to the top, and your best team members find a way to deliver when it matters most. Having a monthly accountability-based forecasting process ensures everyone is up to speed on what must be done to hit their intended targets.
Finding the right balance in these things is always messy, but that intersection is where tremendous achievements occur. Identifying that intersection is indicative of a mature finance function that can provide clear and actionable insight for strategic discussions to grow the company.
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An accountability-based forecasting (ABF) approach integrated with a robust annual budgeting process allows budget owners to have a view of what constitutes success concerning revenues and expenses. They are then responsible for and must monitor their ongoing performance against their goals. It also provides a framework for management collaboration as budget owners make course adjustments in their respective functions.
A long-ago boss used to say “make the month, make the quarter, make the year”. I think he had it exactly right. You establish big goals once a year and then you deliver against those goals one month at a time, making adjustments and course corrections during every step of the journey, while never losing sight of your desired end-point. This is how great companies operate and succeed year after year.
If you are looking for solutions to manage a detailed and decision-based budget process integrated with an accountability-based forecasting process so that you achieve your goals and become a great company, our FutureView Systems platform might be for you. Schedule a free demo of our Platform to see our accountability-based forecasting approach in action and make your finance function organizationally impactful.
-- Check out the third blog post in this series, where we dive deeper into variance analysis and reveal what it takes to develop ideal budgets and forecasts.
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