Strategies for Budgeting and Forecasting Due to Extraordinary Events
At any point in time during a year a business may need to revise their annual budget or forecasting models and processes.
The Differences Between Budgeting and Forecasting
Budgeting is a planning process that is done on an annual basis to help the executive management team define what they want the business to achieve during the coming year. Annual budgets are used to create a baseline expectation for a business’s performance in the year ahead. The business’s actual performance is then compared to the budget during the year. The annual budget should include a written business plan on how the expected business’s results, both financial and operational, will be achieved by functional areas, including goals and objectives by department.
An annual budget is a single plan that is fixed for the fiscal year, with all the scenario planning taking place in the time period before the start of the annual budget period. Often there is limited flexibility built into budget models as more thought is often given to annual numbers, such as revenue, gross margin and payroll, after which historical data points are used to spread the numbers out over the budget period. Often annual budget numbers are predetermined and then engineered into the annual budget.
Forecasting is a projection process that is based on more current data, which allows the executive management team to anticipate the business’s activities on a shorter time period horizon, such as the next month or quarter’s results. Forecasting models should use the exact same financial framework as the annual budget, but with current data variables providing updated results. Forecasting is often done at the executive level of a business to help guide executive thinking on changes or improvements that need to take place now for the business to succeed.
The forecasting process often focuses on changing limited data points, with the primary focus of forecasting being on what revenue levels will be achieved in the coming month or quarter and what related variable expenses need to be adjusted up and down. Examples: Cost of goods sold changes with revenue, but rents remain the same.
Both budgets and forecasting models need to include all three financial statements: The Income Statement, the Balance Sheet and the Statement of Cash Flows! Executive management needs to be able to consider changes to the balance sheet, such as, accounts receivable growing if credit terms are changed, capital equipment purchases and use of loan facilities. The projected changes in the income statement and balance sheet activity will then be reflected in the statement of cash flows.
Business Environment Undergoes Unexpected Major Changes
In times of dramatic change, both negative and positive, budgets may need to be completely revised for the remainder of the fiscal year and both the budgeting and forecasting process may need to become much more dynamic. During times of major change and uncertainty, the re-budgeting and forecasting process should become an integral part of the executive short-term and long-term thought process and action plans for the business. For executive decision making the ability to have better visibility on fiscal scenario planning and operational actions becomes of key importance for both re-budgeting and forecasting.
Scenario Planning Using Probabilities
Scenario planning using probability in the re-budgeting and forecasting process is simply having several different versions of the budget and forecast that shows several different potential outcomes based on input variables. Executive may use a best case, most likely case and worst-case scenario plans to help with their thought process. This type of scenario planning is relatively easy to achieve by changing just a few data point, such as revenue, inventory levels and payroll. Though this type of scenario planning is useful, they may miss more important data points that need to be adjusted on a more granular level.
Scenario Planning Using Probabilities and Weighting Values
Scenario planning that uses both probabilities and weighting values will be able to provide executives with greater insight and focus related to potential business outcomes during the re-budget and forecast process.
The process of weighting values takes the re-budgeting and forecasting of best case, most likely case and worst-case scenarios probability planning to the next level during times of dramatic change as well as during the annual budgeting process.
Weighting values is the process of taking data points and weighting these data points with projected outcome separately. Here is an example of how a model could use weighting values for revenue.
The business has three distinct product lines – A, B and C, which total a 100% of the business with the revenue breakdown for year and for each month being:
Product A’s Revenue Product B’s Revenue Product C’s Revenue
Month 1 to 12 40% 35% 25%
Let us say there is a major unplanned change to the business’s revenue projections due to a large increase in raw material costs that has forced the business to increase the sales price of all its products dramatically. Executives believe the increase in sales price will changed the business’s customers’ buying habits. Due to the increase in sales price, executives now believe that the business’s revenue mix needs to have weighted values by month as follows:
Product A’s Revenue Product B’s Revenue Product C’s Revenue
Month 1 to 3 40% 35% 25%
Month 4 to 7 20% 30% 50%
Month 8 to 10 10% 40% 50%
Month 11 to 12 15% 40% 45%
These changes in the revenue product mix by time period will result in more inventory of product A due to lack of sell through and product A has the highest cost per unit inventory. The business will need to quickly increase inventory levels of product C, customers that purchase product C typically take 30 days longer to pay their outstanding invoices and product C has the lowest gross margin of the three product lines. Executives believe that these changes will cause overall revenues to decline and even with the sales price increases gross margin will be lower.
Therefore, it becomes critical for executives to be able to see the effects of the sales price increases, product mix changes to revenue, gross margin, inventory levels and cash usage due to increases in accounts receivable and inventory over the various time periods. This allows executives to see the changes and the resulting effects to the income statement, the balance sheet and the statement of cash flows.
Conclusion
Scenario planning that uses probabilities and weighting values is an analytical tool that can be done in Excel spreadsheets and updated quickly. It is also recommended that re-budgeting and forecasting use variable expense (COGS, shipping and handling, office supplies) formulas based on revenue which will recalculate every time there is a change made to revenue, while fixed expenses (rent, month equipment lease expenses, security and cleaning services) remain flat.
In any scenario planning that uses both probabilities and weighting values modeling, cash flow analysis is imperative to keep a business functioning and solvent. When doing scenario analysis using probabilities and weighting values executives must avoid thinking that when the business environment begins to improve that the business is experiencing growth versus recovering from the recently experienced economic decline.
It is hard to overstate the importance for re-budgeting and forecasting scenario planning using probabilities and weighting values in times of unpredictable business environments and how it will help executives make better business decisions.
The Siburg Company is a consulting firm that specializes in strategic planning, mergers and acquisitions and financial and operational systems during both challenging economic and business growth environments.