Budgeting and forecasting are two terms that are often confused. Both budgets and forecasts are internally generated forward-looking predictions about the financial performance of the business. One source of confusion is the similarity of the methodologies used to prepare a budget and a forecast. However, each works towards a different objective and they also have subtle nuances in how they are created. These nuances are important for any management accountant to understand when preparing both budgets and forecasts for an organization.
Before listing some key points of difference between budgeting and forecasting, let’s understand how accountants form financial projections of the four key elements of an income statement – revenue, gross margin, overhead and profitability.
Key elements of income statement
The starting point for a forward-looking forecast or budget is revenue. This is the logical place to begin, not because it is the first line on an income statement, but because the revenue will drive the scale of activity needed in the rest of the business. Said another way, a change in revenue will cause the activity level of the business to change, which is the best predictor for changes to expenditure. For example; if revenue increases the business will recruit new employees and spend more money on salaries. If revenue decreases, the business may need to consider letting some employees go and subsequently it may save on salary costs.
Predicting revenue is easier for some organizations than for others. Some corporations hold secure contracts which provide security over their future income for many months. Examples include security companies, IT service providers and construction companies. Other types of businesses have highly insecure income which can fluctuate widely and present a real challenge to forecasters. Retailers, manufacturers of weather-dependent products or businesses exposed to strong obsolescence risks will experience this level of uncertainty.
2. Gross margin:
Gross profit is the profit made from deducting direct costs (such as materials, direct labor) from revenues. When expressed as a percentage of revenue, this gives gross margin.
Due to the laws of economics, gross margin tends to remain stable in a reasonably competitive environment. That is to say; any increases or decreases in direct costs are normally passed onto customers in the form of a higher or lower price. However, many of the best economics books clearly state that this will not occur in scenarios involving monopolies or monopsonies.
This dynamic results in the gross margin percentage remaining relatively static month-on-month.
This hands forecasters a useful shortcut in predicting direct costs. Rather than forming a detailed cost estimate from the aggregation of various salary and material costs, they can apply the gross margin to the forecasted revenue figure to derive a direct cost. For example, consider that the gross margin of a business historically hovers at approximately 20%. If forecasted revenue is £10m, then forecasted gross profit would be £2m, which means direct costs must account for £8m. The £8m can be quickly calculated as a balancing figure.
Overheads are easier to predict than direct costs because they tend to remain fixed in the short term, and they only increase as a result of strategic decisions. As a reminder, overheads are the expenditure on indirect costs which don’t directly produce a product or service. They include administrative costs and support departments such as finance, payroll, debt collection and the canteen.
Known changes to these support services can be specifically factored into an overhead projection, but otherwise, it is usually appropriate to forecast overheads at their current level unless information suggests otherwise.
The ultimate output of financial performance projections is the forecasted profit figure. This is of particular interest to the board of directors, as senior management is incentivized and rewarded on the basis of the bottom-line performance of a business. If profits increase ahead of initial expectations, both chief executive officer (CEO) and chief financial officer (CFO) of an organization can normally expect to be awarded a generous bonus.
Setting the personal incentives of management aside, the profitability of a company is the strongest indicator of its financial health and its ability to continue to grow into the future. A profitable business is able to recruit new talent, invest in new products and provide opportunities for internal promotion to existing employees. Therefore, it is the most crucial element of all financial projections contained in forecasts and budgets.
Definitions and meanings
A budget is a projection of the desired financial performance of a business over a coming financial period. A budget is prepared, reviewed and approved before it is accepted as the official budgeted figure. It usually covers an entire financial year.
The budget result is used as the official comparison against actual performance throughout the entire budgeted period within an organization. As a result, the budget is often the basis for performance-related bonuses for senior employees. For example, a cost center leader may be awarded a fixed $10,000 bonus if the profit of their division exceeds the budgeted figure.
The budget is not re-visited or re-assessed during the financial period, except in extreme circumstances. If variances between the actual performance and budgeted performance persist, then these are understood and explained by the management accounting team, to help management understand the drivers of underperformance or outperformance.
If a department falls below budget in the first quarter of a year, they have the opportunity to turn this around and return to the black by the end of the financial period.
Budgeting isn’t just a corporate activity; governments and charities also prepare detailed budgets each year to establish how they will spend the funding, grants or donations they expect to receive. A budget that reveals a deficit for the year (i.e., more expenses than income) will generate an internal debate over how this shortfall can be covered.
Forecasting is the general practice of preparing any financial projection into the future. Forecasts are as varied and disparate as the needs and whims of senior management. A forecast could:
- Focus entirely on revenue, to the exclusion of costs or profit
- Look 5 years into the future
- Be modelled under numerous hypothetical scenarios, such as with or without a new acquisition.
Forecasting requires an analytical mindset. The best forecasts utilize a thorough knowledge of the causal link between income and cost in a specific business. The economics of every business model is different, and this will lead to numerous forecasting approaches such as top-down or bottom-up approaches which we’ll expand on later in this article.
Difference between budgeting and forecasting
Six key points of difference between budgeting and forecasting are as follows:
Budgeting is a practice of projecting an entity’s financial performance in terms of revenues, costs and cash flows etc. that the entity wants to achieve during a certain forthcoming period whereas forecasting is an estimate of what an entity will actually achieve within a specific future period.
2. Time horizon
Budgets tend to cover an entire financial period, which is typically one year in length.
Forecasts can cover a wide range of time horizons. They could include a cash flow forecast showing incomings and outgoings over the next month or could cover revenues over a 5 year period. A forecast is a scientific attempt to produce a reasonable answer about any future eventuality on the mind of senior management.
Budgets are adjusted/revisited only when the management observes some significant changes in one or more core assumptions on the basis of which they were originally prepared. This makes budgets more static in nature. Forecasts, on the other hand, are often frequently adjusted to incorporate the latest data and impact of economic changes.
Once a budget is approved by the chief financial officer of an organization, it will usually remain in place for the entire budgeted period. It represents the ‘original target or aspiration’ for where management hoped a result would land.
A forecast, in contrast, may be revised frequently as circumstances change, to provide the latest view of an outcome. For example, despite having a 12-month budget in place, a company may choose to produce an updated forecast each month through a financial year, to predict where the companies result will actually land relative to the original budget.
The budget is, therefore, a vehicle used to hold management and employees to account against a target. A forecast is an exercise to allow management to remain in touch with the most likely future outcome.
5. Top-down versus bottom-up
Budgets are primarily set to ensure that each part of a business understands what result they need to deliver in order for the organization as a whole to meet the growth ambitions which it has externally communicated to investors. Therefore, the budget process is inherently top-down in the sense that the chief financial officer may reject a budget and demand changes if he believes a divisional budget is not sufficiently challenging or falls short of the growth needed.
Forecasting is a search for the latest reality and therefore such strategic direction is not as useful as the information is in the hands of employees in charge of delivering the result. It may involve crowd-sourcing the expectations of hundreds of employees in order to aggregate a prediction that uses knowledge from those best placed to foresee an outcome.
6. Tactical or strategic tools
Budgets work as tactical tools because they help entities in managing their operations for a specific period whereas forecasts work as strategic tools because entities use them for planning both short as well as long-term growth of their business.
Conclusion – budgeting vs forecasting
A budget is an aspirational projection for a full financial period, which can then be used to hold management to account for any future underperformance.
A forecast is a financial projection produced to give the most accurate estimate possible, so that management can make informed decisions about the business.