Budgeting vs. Forecasting: What's the Difference between the Two?
Budgeting and forecasting are critical in planning for the future of a business. While the concepts are used interchangeably, they have striking differences.
Simply put, forecasting provides the bigger picture regarding what the company wants to achieve in the future.
Conversely, budgeting quantifies those expectations within a shorter period, usually one year. This article will explain budgeting vs. forecasting in detail.
What is Budgeting?
Budgeting is the process of preparing a company’s expected financial activities for a specific period. It outlines its projected cash flow, estimated revenues, and expenses, as well as expected debt reduction.
It prepares a detailed and holistic report that can be used to compare actual results. Since budgets are prepared at the beginning of the year, they must be re-evaluated periodically to streamline them to the existing market conditions.
Who Prepares Budgets?
Company executives play a significant role in preparing a budget. They use information from managers and individual department heads to draft budget proposals.
The premise is to address a range of factors, including projecting the sale or purchase of fixed assets like machinery or building a new factory, among others.
They must also plan for ongoing economic problems, cash needs, and revenue shortfalls which are critical in determining a company’s financial health.
Benefits of Budgeting
Beyond the financial and accounting dimension, budgeting has many ramifications in a business:
- Aids in planning: The budgeting process takes management away from the day-to-day management of a company and requires it to make long-term goals.
- Creates yardsticks for evaluating performance: Budgets provide information for superiors to assess employee performance. Employees exceeding set yardsticks are rewarded.
- Facilitates communication among departments: Budgeting calls for companies to establish clear plans and expectations. As a result, department heads and managers have a common language that provides clarity.
- Prioritization of cash allocation: With a limited amount of cash available, budgeting compels managers to prioritize assets most worth investing.
- Profitability analysis: The numerous day-to-day operations can cause companies to lose sight of the most profitable areas of a company. A well-structured budget points out the aspects of a business that make the most money and which ones don’t.
Budgeting methods establish a framework from which to prepare budgets. There are four ways of preparing budgets:
- Incremental budgeting: It’s the simplest way of preparing budgets as it involves adding or subtracting a set percentage from previous figures to obtain the current year’s budget
- Activity-based budgeting: This method focuses on the results the company plans to achieve and working backwards to determine the activity level required to achieve the desired effect
- Zero-based budgeting: It is a more flexible budgeting method that involves a line-by-line justification of purchases, sales, and other activities. The objective is to cut back on spending
- Value proposition budgeting: The premise for using this method is to ensure every item in the budget provides value. It’s used along with other budgeting methods like activity-based budgeting
How to Prepare a Budget
Budgeting begins with reflecting on past income and expenses. The process is easier for people who have been in business for a long time because they understand market trends and patterns.
However, small business owners who just started need to research costs and trends affecting their business to develop accurate budget estimates. Here’s a simple guide on how to do it:
Step 1: Evaluate your revenue over the past year to determine the amount of money your business is making monthly.
Step 2: Subtract the fixed costs (rent, debt repayment, taxes, insurance etc.). Fixed costs happen regularly when operating a business.
Step 3: Identify variable expenses. These are expenses that change depending on production or activity level. They include marketing costs, owner’s salary, office supplies, utilities, to mention a few.
Step 4: Set aside an emergency fund to cater to unexpected costs. These costs arise when you least expect them and can disrupt your budget if no money is allocated for such expenses.
Step 5: Examine planned capital expenditures like purchasing furniture, computers, machinery, and other such items. It may be tempting to hold off such investments but can improve the quality of products, delivery time, and increase output, which can significantly impact revenue.
Step 6: Review the profit and loss statement for the last 1-2 years to identify and remove unnecessary expenses. Then make changes in gross margins, market conditions, one-time investments and the revenue you anticipate the following year. Factor in how changes in some areas affect others.
Step 7: Incorporate the budget into the system. You can divide the budget by 12 months and use it to evaluate the following year’s monthly revenue and expenditures. Every time you prepare monthly statements for the month, compare them to the budget to understand how close your projections are.
What is Forecasting?
Forecasting is the process of predicting a company’s future financial outcomes based on historical data and trends.
Beyond directly looking at factors affecting the business, forecasting incorporates social and political aspects likely to disrupt your market.
Companies use forecasting as a planning tool to guard against future uncertainties. As such, forecasting takes a long-term approach when estimating figures rather than a short-term one as in budgeting.
However, some businesses make short-term forecasts for operational reasons. Forecasts are also more flexible than budgets because they factor in the ambiguity of a business’s market.
Who Prepares Forecasts?
Accountants are tasked with the responsibility of forecasting with the help of the managers. They can access both internal and external data and use computer software programs to make more accurate forecasts.
While juniors in various departments can also forecast, there’s a risk of overestimating or underestimating figures.
Benefits of Forecasting
Forecasting is a valuable business tool because it helps businesses make informed decisions and adopt a proactive approach instead of reactive in adversity. Forecasting also:
- Helps companies determine how to allocate resources for a future period
- Helps anticipate market changes
- Is a tool for measuring growth
- Allows businesses to recognize growth opportunities and assess their potential
- Enables companies to set reasonable goals based on current and historical data
Forecasting techniques are classified into two categories:
- Qualitative forecasting
- Quantitative forecasting
Businesses use this type when developing short-term forecasts with a limited scope. The estimates rely on expert opinions and hardly require elaborate statistics.
Their reliance on personal judgment makes the predictions inaccurate and a little biased. Examples of models that use this forecasting approach include polls, market research, and surveys. Businesses using qualitative forecasting may rely on:
- Salesforce estimates
- Execute opinion
- Customer expectations
It involves the use of mathematical models and large amounts of statistical data to predict the future. Quantitative forecasting uses methods such as:
- Regression analysis
- Time series analysis
- Economic models
How Small Businesses Can Forecast
Making short-term and long-term forecasts is critical to setting business objectives and measuring growth.
Forecasting requires an evaluation of past and present data to envision the company’s financial trajectory. We’ll highlight a simple example of how to make a sales forecast:
Step 1: Define the goals of the forecast: In this case, it may be to increase the customer base by a certain margin, annual revenue, or introduce the number of product lines depending on the stage of the organization.
Step 2: Choose a suitable forecasting method, i.e., quantitative or qualitative.
Step 3: Study the company’s average sales cycle on a weekly, monthly, and quarterly basis to establish accurate forecasts based on the velocity of the business.
Step 4: Gather information from other departments like Finance, HR, and marketing. It facilitates transparency throughout the process, and every team member understands what the sales forecast is about.
Step 5: Analyze historical data and reports. The premise is to look at specific metrics (conversion rates, sales activity data, sales linearity etc.) to understand the company’s past performance and identify areas that need improvement.
Step 6: Identify trends affecting sales performance. Some seasons impact a company’s sales performance negatively or positively. The forecast should reflect such booms or downturns to enable the company to prepare a solid plan.
Step 7: Review the process, checking every step, making modifications, and present it to the board or other company executives.
Key Differences Between Forecasting and Budgeting
This analysis shows the differences between budgeting vs. forecasting and confirms that they are different concepts. Here’s a summary of their differences:
- Budgets outline plans management wants to take, while forecasting is a report that illustrates whether the company is meeting the budgeted goals
- Budgeting is prepared for short-term purposes, while forecasting incorporates long-term and short-term goals
- Budgeting is done once a year, while forecasting is done regularly to ensure appropriate measures are undertaken
- Budgeting is a broad analysis of the company’s costs, cash flows, revenues, and profits, while forecasting adopts a narrower analysis dealing with revenues and expenses
It’s important to understand the differences between budgeting vs. forecasting, as both form an integral part of a company’s short-term and long-term decision making.
Without budgets, a business may not have a clear direction of what it is doing or going.
Also, if forecasting isn’t done, there’s a risk of overlooking some trends and making wrong decisions that may impact the business.
The entire process can be overwhelming for a small business, hence the need to hire one of our experts to help you make accurate estimates for your business.