Big Ideas

Budget & Forecast Essentials

Budgeting & forecasting for success

04 March 2019

Budgeting and forecasting are an important part of a successful business planning process. We live, work and play in a fast-moving world and the complexity this brings ensures that budgeting & forecasting are daunting tasks. Daunting, but well worth the effort.

 

What is the difference between a budget and a forecast?

These are similar tools that are best used together but there are some subtle and important differences. 

The differences 

A budget is set for a fixed period of time and illustrates the plan – or where you want to go. It is tightly linked to strategy and sets the businesses expectations for revenue, gross profit, expenses, net profit, capital expenditure and debt.  For reporting purposes, the budget is compared to actual results so that the reader can see how the business has performed against the set plan. The key benefits are that the process will help you to set expectations, uncover inefficiencies, agree key performance indicators (KPI’s), and visualise how you will achieve your strategy.  

Forecasting uses up to date financial and non-financial information in order to project where your business will actually go depending on the various factors that influence your business. As time moves on, this gives us an early warning signal of a divergence from your plan (or budget) and assists in making decisions to either recover a gap or to return increasingly better results. 

The similarities

Both a budget and a forecast are completely dependent on sound assumptions. The more accurate you can be when making decisions, the more effective you’ll be in achieving your plans.  

In 2019, we have access to better and more detailed data and we can make use of technology that enables more effective use of the data. With good communication and a structured process, budgeting and forecasting can be done quicker and more accurately than in in the past.  

 

Budgeting processes

 We are often asked – how do you prepare a budget?

The best answer is that the process needs to be tailored to the business. Some examples of the choices are:

Top down v bottom up process

This is as it sounds – from the top, or from the team.  

A top down approach is driven by business owners or top-level management. They will develop a high-level budget and then ask the different business units or cost centres to develop plans and numbers that fit within that. A bottom up approach is the opposite, the business units will recommend a budget to the top level for approval.

Each has advantages and disadvantages

A top down approach can save time and is less of a disturbance to people working in your business but it can cause the team to feel alienated or aloof from the overall plan. The lost opportunity could be missing out on valuable input from key people that have a solid understanding of the day-to-day.

 A bottom up budget process is more inclusive and can bring an important feel for reality, especially where we explore and drill down on the drivers of revenue and expenditure. An inclusive approach can be big plus in terms of culture and buy-in to strategy. On the other hand, the budgeting process can be quite involved, time consuming and, at times, frustrating!

In our experience, we’ve seen both methods go well and both not so well. The key elements driving success are: leadership, focusing on the underlying drivers, thoughtful communication, and rigorous testing of assumptions. 

  

Enhance your budget

If you’ve ever used the budgeting tool in your accounting software you’ve probably noticed a few handy functions that allow you to spread costs evenly, increase or decrease in increments, or adjust based on percentages. These are handy but should not be used without purpose.

We often see people using these tools to create a quick budget based on pure guesswork and then later making decisions based on deviations from their guess. This is far from ideal! Here are a few pointers that you can use to bring that guesswork closer to reality:

 1. Look at history

 Learn from your mistakes. If you went through a budgeting process last year, review the assumptions you made and see where you can improve – why make the same mistake twice? Document everything, you won’t regret it. 

 Your historical information can also give you a guide on the timing of revenue and expense (think seasons, large annual subscriptions etc.) and is useful for trend analysis.  

 Some commentators will tell you that history is not the best guide or basis for assumptions towards the future because of rapid change, disruption, and the next cliché. Looking forwards is important but much can be learned from the past – so make sure you learn your lessons. 

2. Identify the underlying drivers

Start with revenue. What are the drivers of your revenue? For example, these might be: number of leads, conversion rate, average sale. You should be able to map these out along with known (already sold) sales to provide a revenue target. 

Make sure you test underlying data that gave you these drivers. Does your sales team agree with the number of leads, or conversion rate? Does your finance team agree with the ave. sale amount? 

 Next work out your cost of sales / direct costs. What does it cost you to sell $1 of revenue? 

 If you sell goods, then you’ll need to work out how many units you need to produce to meet the revenue target. What will it cost to produce these? Do you have enough labour, materials, manufacturing capacity? Can you produce the required amount and if not, what changes are required? 

 If you sell services, then your direct costs will likely be labour and software. Here, you’ll need to work out the mix of employees and freelancers required to deliver on the revenue target and identify the costs related to the necessary tools that are required. 

 With both of the above, how does the resulting margin compare to history or to expectation? Test out your assumptions with your operations team or against known industry benchmarks. 

 3. Operating expenditure (OPEX)

 Some of these costs may be fixed and will not vary based on revenue numbers, head count etc. Others will change and are variable depending on revenue, number of employees, overall strategy (geography for example). 

 There are probably some obvious examples in your business that you can tie back to the earlier identified drivers of revenue. For example, if your revenue is driven by a number of leads, conversion rate, average sale type equation then you had best check in with your marketing team to understand the cost of generating those leads, and with your sales team to understand what support they need to execute on the conversion rate. 

 This is an opportunity to review your expenses line by line. Are you paying for subscriptions that you don’t use? Is this the best supplier? Have you tested the market to ensure you are not paying over the odds? Does the supplier align with your values?

 4. Assets & capital expenditure (CAPEX)

 If your budget ends at net profit then you are only half done. By ‘capex’ we refer to expenditure on assets, or on higher value items that deliver value to your business for years to come. Don’t forget these! They are true costs of doing business and successful businesses plan their capital expenditure with the same effort as their operational expenditure. 

 An example of capital expenditure is the purchase of a vehicle. The fuel for the vehicle is operational expenditure, whilst the vehicle itself is an asset or capital expenditure. Another example is your website. The cost of hosting the website is OPEX, whilst the cost of developing a website is CAPEX. 

 5. What else?

 Other points that are worth including in your process are debt repayments, owner drawings or dividends, and income tax payments. 

 We often see budgets that do not include owner remuneration. Assuming that you would like to be paid for your role in the business, you should factor this in! Likewise, tax is a true cost so once you understand the profitability you should allow for tax and the timing of payments.

 

Next steps

A new financial year is upon us and now is the time to ensure you’ve robust numbers in place to support your future plans. Better business decisions require access to relevant and key information on a timely basis and if the info at hand is future focussed it is all the more powerful. 

If you need help with your budgeting or reporting processes, call us today.  

 

Further reading and acknowledgements 

 

Acuity magazine recently released this article. We’ve used it as a reference for our notes and the article is well worth a look for more information. 

(c) Chartered Accountants Australia and New Zealand. Contact Chartered Accountants Australia and New Zealand for permission to reproduce this article. 

 

 

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