The Basics of Budgeting and Forecasting
Planning is a key element in any business. In a nutshell, it is telling your business where you want it to go. There are two essential tools when creating a plan for your business: Budgets and Forecasts. In this article, we will look at the differences between these two tools and how you can use them to plan where you want your business to go.
In its most basic form, a budget is created based on where management wants the business to go. A forecast, on the other hand, is created to inform management on where the business is actually going. A budget is normally prepared once a year and contains goals for each area of the business. These are the goals management wants each business area to obtain for the upcoming year. A forecast, however, is prepared more frequently, either monthly or quarterly, and contains data on where the business is actually going, regardless of what the budget says. The forecast allows management to course-correct and take action based on the findings in the forecast.
Let’s say a business sets its budget for sales for the upcoming year at $500,000. This is the sales goal for the business. The entire management team understands $500,000 is the target for the year. However, on April 1st of that year, management creates a forecast for the rest of the year based on the first quarters’ (January - March) actual results and determines the business is forecasted to generate only $350,000 in sales for the entire year.
In this example, the intention was to get to $500,000 for the year. However, the reality is the forecast, based on 1st quarter results, now predicts the business will only get to $350,000 for the year. This information now allows management to take action. They may need to create a plan to increase their sales for the next nine months in order to hit their budget goal, or they may need to reduce production or staffing to save on expenses, since they are only going to generate $350,000 in sales.
A budget is created usually just once a year and is not adjusted during the year. Typically, any management performance evaluations are made against the budget for the year. This is everyone’s focus and target for the year. The forecast, on the other hand, is more of a rolling evaluation that is adjusted based on the actual circumstances that management finds the business in.
Types of Forecasts
A business can create as many forecasts as appropriate to get an accurate assessment of where the business is going in the short term. We will look at three of the more popular forecasts and see how they can be used as a guide for your business. These three forecasts are: Sales, Production, and Cash.
In order to accurately forecast the Production and Cash Forecasts we have to build a foundational forecast based on sales. It would be difficult to forecast production needs or cash flow without knowing what the forecast is for sales.
This forecast allows you to estimate where you think sales are actually going, not where you want them to go. You can further divide this forecast down to business unit and profit center. In order to derive at the sales forecast you must use sales history as well as any other known factors that might influence future sales. An example might be if you know that in the next quarter your business is releasing a highly anticipated product, you might increase your sales forecast based on the assumption sales will increase.
It is also advisable to forecast using two or three different scenarios. Forecasting the actual sales for the near future is nearly impossible as it is just your best estimate.
Knowing this you could create two or three different scenarios to see how your forecast will be impacted. For example, one scenario could be your base scenario, what your best guess is for sales, the second scenario could be your base minus 10%, and the third could be your base plus 10%. In other words, you are seeing what your forecast would also like on a worst case and best case scenario.
Production and/or Costs Forecast
All businesses incur some sort of costs; many of these costs are based on the sales of the business. For example, there will be likely more production costs on $100,000 worth of products produced than on $25,000. This is why the Sales forecast would need to be completed first. The Production forecast takes what is known from the Sales forecast and forecasts what the company will need to produce and the costs associated with that. There are other costs that will need to be forecasted as well such as staffing, raw materials purchases, and supplies, to name a few.
Understanding the forecasts for production and other costs can assist management with determining course-correcting actions. For example, it the production forecast calls for 15% less products to be produced then management can reduce staffing levels, raw materials, and supply purchases by 15% as well. As you can see, the budget is irrelevant in forecasting. Regardless of what you budgeted, what matters now is where your business is actually going in the near future.
Now that we have forecasted sales and costs, we have all the pieces of the puzzle needed to produce the cash forecast. Just like the other forecasts, management can use the cash forecast to take action. This forecast will let management know how much cash the business will have on hand in the coming weeks and months so that management can make appropriate decisions. They will now understand if they are able to meet their obligations such as accounts payable and payroll or if they have to borrow against their line of credit or raise cash using another method.
As you can see, by creating a budget your business will have a plan. The budget is based on the path you want your business to take. All visions, goals, and objectives of the business should be incorporated into the next several years’ worth of budgets. The forecast, on the other hand, is a guide to show you where you are actually headed, regardless if you wanted to be headed there or not. The forecast allows you to take action and course-correct so that you can get back on the path that you want your business to go.