Replacing Budgets with Forecasts? Expect These Benefits

Most companies today prepare some sort of financial budget. Budgets can be built at a very high level (Sales, cost of sales and expenses), or built-in detail (sales detail by type, expenses by department, capital spending, projects). Some companies also budget the Balance Sheet to be able to prepare budgeted cashflow statements.

Company budget preparation runs the gamut from the executive team determining the budget and disseminating it down to the troops (aka top down, or centralized) or letting each department manager build a budget for their area of responsibility and consolidating each department budget up to the company level (aka bottom up or decentralized). Throw in other methods such as zero-based budgeting or percentage increase/decrease, and you can see how confusing and time consuming the budget process can be.

Sadly, after all of this work, a static budget is pretty much obsolete within the first month or two of the new accounting year, making the return on the company’s budget preparation time and resource investment minimal at best.

At the end of the day, a successful budget is one which meets three objectives:

• Projects revenue accurately
• Helps control expenses
• Assists the company in maximizing profit
• Keeps company personnel aligned with the company’s goals

With an annual (or even semi-annual) static budget cycle, this is almost an impossible task.

The goal of this post is to provide information in support of the idea that a rolling forecast may be a better way to go. Whether you use a forecast or budget, be sure that the process helps maximize the bottom line, aligns with your company’s capabilities, prevailing company culture and provides the best return on your time and resources investment.

This post discusses some best practices that can help improve the budget process as well as, some “pit-falls” which often result in a less than optimal result.

What is a Rolling Forecast?

A rolling forecast is a financial projection which is periodically adjusted (usually monthly) based on actual business results and other factors.

Rolling forecasts are supported using a number of different tools such as ERP budget functionality, advanced report writers, a standalone forecasting application or even excel spreadsheets. If possible, use a tool that integrates with your ERP, to be able to easily import and export budget, forecast and actual information to/from the ERP.

Rolling forecasts can be based on different calendarization methods. Some forecasts are based on the accounting year (calendar or fiscal). For example, in a calendar year accounting environment, a forecast takes effect in the second period (February) and is re-forecasted until the end of the accounting year (December).

Forecasts can also be built looking forward a specified number of periods regardless of the accounting year. For example, a forecast may look forward for the next twelve periods. In this environment, a forecast can span two different accounting years. A forward looking forecast for the next eighteen periods can span three accounting years.

When considering a forward-looking strategy, be sure of the following:

• Ensure your budgeting or forecasting tools can handle the process.
• Keep the process simple in the beginning.
• Start by addressing critical performance factors such as sales, cost of sales and expenses.
• Don’t overextend yourself with specific headcount tracking, project, Balance Sheet or cashflow forecasting unless absolutely necessary.
• Continue to improve the process until you reach your forecasting goals.
• Stay within your company’s capabilities and be sure to get value commensurate to the level of effort expended.

“My first job out of college was with the publishing division of a major entertainment company.

The Financial Planning department prepared an annual calendar year budget. The budget was re-forecasted monthly. In addition to the forecast, a mid-month estimate was prepared for each month. Each of these submissions were supported with a detailed narrative explaining the re-forecast changes as well as, budget and forecast variances to actual results.

As each forecast was submitted, the Corporate Finance people would review the forecast and variance explanations, then ask additional questions which needed to be responded to. The same process was completed each period.

Personally, I never understood the value of this level of detail or the wisdom of making sales and operations people into financial planners but, the process worked for the company.

My point here is that, while the process worked for a larger company, it would certainly overwhelm a small or medium sized company and in my opinion would be of dubious value.

So, remember, keep it simple and stay within your capabilities.”

Forecast Benefits

Data Timelines and Increased Project Accuracy

As we discussed in the introduction section, a static budget is pretty much obsolete within the first month or two of the new accounting year. Once a material actual to budget variance is encountered, the budget is no longer an accurate projector of future performance.

Using a rolling forecast (annual or forward looking) addresses this issue. In a rolling forecast, each period’s budget or forecast value is replaced with actual values at the end of each period. For example, an April forecast, at the end of the March period (in a calendar-based accounting year), budget and forecast values for January through March are replaced with actual results. April through December periods would be the original budget or re-forecasted values.

When the April forecast is completed, the full year forecast includes January-March actuals and an April to December forecast or re-forecast.

It’s pretty easy to see how the forecast is a much more accurate predictor of future performance.

Fixes Expense Responsibility and Accountability

I was an Accounting Manager for several years. I can tell you that there is nothing more frustrating than being responsible for the financial performance of a department without having a hand in the budgeting or forecasting process.

Many times, a budget is completed by senior management and finalized based on internal company politics. It may also be prepared using a percent change, rather than a zero-based method. The final product is then pushed down to the troops.

Most of the time this budget or forecasting style results in unfavorable performance as the year rolls out. After a lot of drama, the end result remains the same as actual results rarely conform to these simplistic or unrealistic budgets or forecasts. Remember, just wishing doesn’t make it so!

I once worked in a retail company which was in the middle of a major store growth initiative. As each new store location was considered, the budgets prepared were massaged to satisfy the ego of the different executive team members. Sales volumes were exaggerated to show a high level of sales and gross margin per square foot. Store headcount and operating expenses were budgeted, then adjusted downward to support an arbitrary profit level. As the stores opened and began operations, I’ll bet you can guess how they performed versus the budgets and how the store managers accountable for store performance fared. I’ll bet you can also guess how successful the initiative was in the end.

Holding department managers accountable to budget performance in these environments is fruitless. If financial performance is a part of a manager’s bonus or annual review, unnecessary turnover will occur.

On the other hand, if you really want to hold department managers accountable, give them a hand in the budget and forecast processes. I’m not advocating that department managers dictate the company’s financials or should be given everything they ask for. What I am saying though, is get them involved in the process and ensure that they understand each budget and forecast line item.

Assist them in modifying department operations to align with the budget and forecast dollars allocated to the department. Make sure that everyone is on the same page.

Increased Ability to Assess Business Fluctuations

So you’ve prepared an annual budget and the first quarter sales volume fell short of, or exceeded budget expectations. If you don’t reflect actual performance to budget (sales, cost of sales and some operating expenses) the budget is no longer an accurate projector of financial performance.

There are basically 2 options to handle this situation:

• You can make some notes, rough calculations and advise various departments to “tighten up a little” on their spending (if needed) and not revise the budget.
• Or you can revise the budget through forecasting, to reflect the expected financial performance and make informed decisions.

This is where a forecast outperforms a budget every time. Forecasting allows the company to clearly understand sales performance effects on the sales, cost of sales and expense lines. Since YTD actuals replace the budget values for the same periods, and future periods can be re-forecast, sales, cost of sales and expense impacts resulting from the variance, is easily determined.

Use a rolling forecast to adjust sales, cost of sales and expense lines accordingly. For example, if the sales variance is timing related, re-forecast sales in the future periods. If the variance extends throughout the remaining forecast periods re-forecast that as well. Of course, adjust cost of sales and other related operating expenses (e.g. credit card fees, shipping and commissions) can be re-forecast based on sales changes.

Build a Looking Forward Environment

One problem with an annual budget or a static calendar year forecast is that the users tend to focus on only the current year and may give little thought as to how their operations can be affected by performance beyond the current year.

Using a forward-looking forecast method, cuts through these issues. For example, if you use a forward-looking period of 12 or 18 months, you automatically challenge your managers to look forward more than one accounting year. So, if they make a forecast decision in the current period, and if the forecast process is done correctly, the effect of the decision is rolled out to the future periods over a longer time horizon. By having to forecast future periods over a longer time horizon, and possibly across multiple accounting years, the user is forced to think ahead both financially and strategically.

Forecasting over a longer time horizon also allows the company to be sure that the forecast decisions align with the company’s longer-term goals and objectives.

Improved Financial Reporting

Most companies create some type of monthly financial reporting package. The package includes Income Statement reports which compare current period and year to date actual results against budgets and the prior year.

The reports are usually built at the company level and by department. A typical Income Statement example is displayed below:

The financial package is a major undertaking for the Accounting department and usually occurs monthly. Unfortunately, just as in the budget preparation process, the reporting package ceases to be an effective analysis tool as soon as there is a material variance between the actual results and the budget.

Try using the rolling forecast rather than, or in addition to the budget, in the monthly reporting package. Remember, in a forecast the actual results for each prior period have replaced the applicable budget or forecast values, and the future periods forecast reflects current thinking based on the most up to date information.

In my mind’s eye this results in a superior tool to use in assessing company performance. Compare the forecast to the actuals and original budget to gain some performance perspective and analyze the source of any material variances. Once you buy-in to a monthly rolling forecast concept, completing a monthly actual vs. budget only reporting package becomes an exercise of questionable value.

Conclusion

At this point, you may or may not have decided if a rolling forecast process is the way to go. No matter which method you choose, remember that some type of financial planning process is an important part of a well-run company.

Successful financial planning needs to:

• Project revenue accurately
• Help control expenses
• Assist the company in maximizing profit
• Keeping personnel aligned with company objectives

Stay within your company’s capabilities and be sure to get the most value from your level of effort.