Budgeting and Forecasting – What It Is and Why Do It!

Last year, as part of a financial forum, I sat on a panel to discuss budgeting and forecasting methods with a room full of head financial managers of their businesses. I was surprised at the number of businesses that do not have a formal process in place to do an annual budget. In fact, there was a high amount of resistance to developing a budget.

Some of the reasons given were as follows:

Having a Fortune 500 background early in my career, I was indoctrinated with the belief that a formal budgeting process and forecasting were vital to the company’s financial and operating health. In fact, in public companies it is a requirement, because of that important quarterly and annual Earnings Per Share projection. A budget enables the CEO to tell the analysts and stockholders why they hit the projection or not and then forecast future earnings based on revised conditions. Shouldn’t the owner of a private business also have this ability?

Let’s define what a budget is and why every company should develop one that includes both revenue and expenses. My definition of a budget is as follows:

It is the formal business plan that is developed using historical information and adjusted for the future business environment. It is the operational and financial outcome of the plans/goals that you have set for the next year. The budget is typically finalized in the months before a company’s new fiscal year starts. If possible, it should include all P&L items and, on separate schedules, any required capital expenditures. A company budgets annually and reviews periodically (preferable monthly).

There are many reasons to create a budget.

Among them are:

1. It is the formal document that formalizes and memorializes your intentions for the direction of the company over a period time. In other words, it is the course charted by company leadership to arrive at a specific destination.
2. It is an educational tool for the company’s managers, helping them to discover the key operational and financial drivers of the business.
3. It is a communications tool to keep everyone in the organization working towards the same goal.
4. It provides the basis to grade the actual performance of your company against planned goals.
5. It is a tool for cash flow forecasting.
6. Though not many executives outside the auditing function might think of using a budget this way, it can also be used for fraud detection. For instance, comparing actual expense numbers to the budget can reveal unusual expenditures, which can be flagged for investigation. For example, the travel budget has been developed using a schedule of planned trips by month during the year. Credit cards by managers are utilized for all travel transactions. Through variance analysis of actual versus budget, the month’s travel expenses are found to be twice the budgeted amount in one of the company’s divisions. The company policy is that all expense categories with more than a 20% variance receive a line item audit. It is found that a manager’s credit card has been used for unauthorized travel. Without a budget number to compare against, the unauthorized travel might never have been discovered.
7. It can be presented to the bank for financing purposes.
8. It reinforces the appearance to financial partners, vendors, and outside investors that the business is sophisticated and “on top” of business matters.
9. It provides a roadmap for cash requirements during the budget period. Knowing the cash requirements means knowing better when financing might need to be secured, and it can also help you adjust payables schedules and plan for capital expenditures.

It is not difficult to create a budget. It can be as simple or detailed as you like. Of course, the more detail, the longer the budget takes to complete. The two key components of any P&L budget are revenue and expenses.

Revenue

I would guess every company in our industry creates, at the very least, an equipment revenue budget as the result of the assigned quotas for the sales representatives. Some other components of the revenue budget would be service/supply income, leasing/rental income, solutions income, etcetera.

Expenses – Fixed and Variable

Fixed expenses are often referred to as overhead items and would include things like utilities, rent, and general and administrative expenses. These are all consistent from month to month, regardless of the revenue volume.

Marketing/advertising expenses can also be considered fixed if the company has identified an amount they want to spend for the budgeted period. These expenses can be budgeted evenly through the period, or, if there are known large expenditures in certain periods (for instance, if it is known that half of the advertising budget will be spent in the first quarter), I would budget those items when they are expected to occur for cash flow purposes.

Variable expenses fluctuate from month to month as the result of revenue volume changes. For example, the costs associated with equipment sales fluctuate in direct proportion to the amount of equipment sold. Other variable expenses would be parts and supply costs, etc.

After the P&L budget is completed, you should be able to identify the cash provided from operations for each month. This will help with planning any anticipated capital expenditures and the financing required (if any). The capital expenditure budget should be on a separate schedule and budgeted for the month in which the capital expenditure is required.

At Thermocopy we use the budget for comparisons to actual as part of our monthly management meeting. We have identified the key performance metrics that determine the health of the company and review them monthly. Each manager is expected to explain why there are variances, both favorable and unfavorable, from the budgeted number. If the variance is unfavorable, what plan is being implemented to bring the number in line with the budget.

These items are all discussed in a very non-threatening manner, and the more a company does this, the less threatening the review becomes. The review is a great communications tool and helps the managers understand the challenges in other departments. It provides a forum to bring all hands on-deck to help solve problems and to celebrate victories. Forecasting is also part of this meeting.

A forecast is the expectation of what is happening in your business for the rest of the budgeted period. It should be prepared monthly or quarterly and is a combination of the actual results to that point and the future expectations. I mentioned before that each manager in our monthly managers’ meeting is expected to present the plan for the rest of the year. Things change, that is a given. It would be like wearing blinders if you did not revise the budget numbers in a changing environment, and the forecast allows you do exactly that.

Here is a real-life example of using a forecast to deal with an unexpected change. The end of one of our major account contracts ($2,000,000 of equipment revenue) was set to end on August 31, 2016. I had budgeted the implementation period to be June through August if we were awarded the contract again. We were awarded the contract in July, but the company required an extension of the old contract to the end of the year. Wearing blinders would have been using the original budget numbers for the rest of the year and not recognizing that $2,000,000 and all the resulting cash flow was not going to occur. Fortunately, we had a contract in hand and the lease revenue for the additional months. The changes were all considered in the forecast. As the result of the reviews in the managers’ meetings, all departments knew what operational resources were not required until the end of the year and how the revenue and cash forecasts were changed.

In conclusion, I believe that a budget should be developed for every business, no matter how large or small. There really is no excuse not to have a full P&L budget of some sort. Used correctly, it can lead to higher profits, provide a framework for financial decisions, and ensure that all teams are working toward the same goal.