Budgeting vs Forecasting: What Really Matters – Week #40 of The Financial Operating System®

Chapter 25, “Budgeting vs Forecasting: What Really Matters,” explores the distinction between budgets and forecasts and highlights their roles in effective financial management.

Key Points:

1. The Limitations of Budgets:

   • Budgets are often static plans created at the start of the year, representing a snapshot of expectations for revenue, expenses, and profit.
   • While budgets provide a baseline, they can become irrelevant as business circumstances evolve, such as unexpected growth opportunities, customer losses, or economic shifts.
   • Businesses sometimes struggle with rigid adherence to budgets, and this rigidity can create tension when mid-year reality deviates from expectations at the beginning of the year.
   • Questions like “Is this expense in the budget?” can lead to confusion if the budget doesn’t align with current financial realities.

2. The Importance of Forecasting:

   • Forecasting is a dynamic process that provides updated predictions based on the latest financial and operational data. 
   • Unlike budgets, forecasts evolve over the course of the year to reflect the current state of the business.
   • A rolling 12-month forecast, updated monthly, provides a better tool for decision-making by aligning current conditions with future financial goals.

3. Metrics-Based Decision-Making:

   • The chapter emphasizes using performance metrics (e.g., Labor Value Multiple, Pre-Labor Gross Margin) rather than rigid budget dollars to guide spending decisions.
   • This ensures decisions are tied to achieving desired profit margins and operational efficiency, regardless of whether they were included in the initial budget.

4. Practical Applications:

   • Forecasting helps address questions like whether to hire a new employee by evaluating real-time financial metrics.
   • Budgets remain useful for evaluating performance against the budget, while it is forecast metrics that should drive mid-year decisions.

5. Mindset Shift:

   • The chapter advocates shifting from a mindset of “spending budgeted amounts” to “managing resources as needed to meet financial targets.”
   • Budgets are not a license to spend money. Budgets are an annual revenue and profit target to hit, and spending decisions are made to support achieving revenue and profit targets.

Practical Recommendations

1. Integrating Metrics into Decision-Making:

   • Shift focus from rigid budgets to performance metrics that guide spending decisions based on profitability and ROI.
   • For example, metrics like Labor Value Multiple (LVM), gross profit margin, or revenue growth rates provide dynamic insight into whether additional expenses or hires are justified or costs need to be cut.

2. Creating a Rolling Forecast:

   • Use a rolling 12-month forecast updated monthly to replace static, annual-only budgeting practices. Start with your original annual budget as a baseline and regularly update it with actual results and revised projections for the remaining months.

3. Real-Time Decision-Making:

   • Avoid focusing solely on whether a line item is in the budget. Instead, evaluate whether the decision aligns with metrics targets.
   • For example, consider hiring decisions by assessing metrics like utilization, LVM, revenue growth, and operating profit margin.

4. Tracking and Accountability:

   • Implement systems to monitor and compare actual results against both budgets and forecasts.
   • Use the insights from these comparisons to iterate and improve future financial planning processes.

Practical Example

A decision to hire a customer service representative demonstrates the difference between budgeting and forecasting:

• Budget-Based Approach:

  • If the budget approved the hire at the beginning of the year, the hire might proceed, even if current revenues don’t support the expense.

• Forecast-Based Approach:

  • If current revenue trends show slower-than-expected growth, the forecast might indicate the hire should be delayed until revenues justify it.

Takeaway:

Budgeting reflects annual targets and provides an annual plan to hit those targets. As a static document, potentially updated mid-year, it lacks flexibility. Forecasting allows for real-time adjustments and decision-making aligned with current conditions in a dynamic business environment. Budgets remain important for strategic planning but should be supplemented with a regularly updated forecast metrics to use real-time insights to guide decisions.

This chapter focuses on the differences between budgeting and forecasting, the challenges business owners face when interpreting and applying these tools, and practical approaches to align them for effective financial management.

Next Step:

Business owners can self-implement The Financial Operating System. Chapters are available to download at smartbooks.com/resources or you can buy the whole book from Amazon (the marketing firm version or the general business version).

If you would like assistance with implementation or would like to accelerate results for your business, please contact author Cal Wilder at cwilder@smartbooks.com or book a free consultation with our team directly using this calendar link.