Modern business enterprises use a number of tools or functions to arrive at finance-related business decisions and goals. Budgeting and Forecasting are two of the financial planning functions, that are often linked within a business, but are technically not the same.
This article is aimed at understanding the differences between these two functions, and how each of them can contribute to a successful business.
A company budget is a quantified estimate of what the company wants to achieve within a stipulated period, usually a year or even 6 months. Detailed aspects of a budget include the financial goals, financial position, and cash flow targets that the company management wants to achieve within the budget year. At the end of the budget period, the actual financial results of the company are compared to the budget estimation to calculate the deviations from the expected results.
Financial forecasting, on the other hand, is an estimation of the company’s financial future based on the historical financial data. Typically, forecasting is limited to the company’s major revenues, and does not include cash flow targets or financial goals. Forecasting is a more short-term activity, and is updated on the monthly or quarterly basis.
In short, the budget is the plan of the path which the company business wants to follow, while the forecast is an indication of where the business is heading.
Budget planning and execution serves the following purposes:
• Implement any change in the performance-related employee compensation, depending on the budge-to-actual conversion.
• Implement changes in business overspending (or underspending) in certain company functions. The company management can determine if additional business expenses are linked to generation of additional revenues, or it is simply overspending.
• Identify redundant expenses that are not essential to the operation of the business.
• To implement a more realistic budget in the future, which is more in line with the company growth and market.
Forecasting, on the other hand, serves the following purposes:
• Achieve short-term goals such as staffing requirements, inventory levels, and production plan.
• Can be used as a tool to create more accurate company budgets.
• Determine the term and conditions of bank loans for the company.
• Make necessary changes in the company spending during the year, depending on the short-term cash flow and market dynamics. For example, if your customer is upgrading or downsizing their business, this can have a significant impact on your projected cash flow and operations.
The process of budgeting can depend on the size of the company. In larger and well-established companies, budgeting is typically done once a year by the company’s top-level management, with inputs from the functional heads and managers. In smaller companies, budgeting is usually planned by the company owner, along with a few key staff members. While most company budgets do not change over the year, company in more dynamic markets can opt for a continuous budgeting process, in order to adapt to changing business environments.
On the other hand, forecasting can be done for a long-term and short-term duration. A long-term forecast can be for several years, and devise a robust business strategy plan. Short-term forecasts, which are for a quarter or 6 months, is done at an operational level. Forecasting is done by involving department heads of all key revenue-generating functions of the company, including sales, marketing, and operations. This is because functional heads are more in tune in daily operations and can provide better information for accurate forecasting.
Depending on the effectiveness, budgeting and forecasting do have a few limitations.
Limitations of budgeting include:
• Unreasonable levels of targets that are just not achievable.
• Dynamic changes in market conditions that makes the budget estimates simply unachievable or obsolete in a short duration.
Limitations of forecasting include:
• Lack of deviation analysis tools that can measure the forecasts against the actual results.
• Forecasting, without any operational input, will be inaccurate and unachievable.
Which is better?
While technically, budgeting and forecasting are separate functions, they are not completely independent of each other. Effective forecasting technique can contribute to the development of an accurate budge.
In today’s dynamic business environment where companies need to be flexible to adapt to the changing customer and business needs, forecasting is a more effective tool that allows businesses to implement immediate changes in their plans. Budgeting techniques will prove to be insufficient in rapidly-evolving business environments. To keep its relevance in such a scenario, budgeting practices may need to be updated a couple of times each year, rather than keeping it as an yearly exercise.
Companies are also following the approach of a 12-month rolling forecast that is updated every quarter. This significantly reduces management time, and is a more realistic reflection of the business growth in each of the 4 quarters of the fiscal year.