It’s that time of year. The leaves are falling and the temperature is dropping. For those of us whose companies operate on a calendar year basis, that also means it is budgeting season.
While there have been many technological enhancements over the years that profess to simplify and accelerate the budgeting process, it is still generally an arduous task that causes us to painstakingly examine every aspect of our business. We put in the work, ask tough questions, and have spirited debates with our teams. The effort is worth it. I have found that there are very few meaningful shortcuts to an accurate and complete budget. It is an iterative process that may involve company owners, boards, or even investors.
The Benefits of Forecasting
Given that the budget is often a massive undertaking involving managers throughout the company, it is therefore disappointing, while not entirely unexpected, that in February you will hear comments about changing the budget. A manager missed something; the macro environment has changed; a large customer failed to renew in January. Not surprisingly, those calls for a budget revision are decidedly about reducing revenue or increasing expenses. I have yet to have someone ask me to tack on additional revenue after the budget is approved.
So, what do you do when your vice president of sales or business unit leader calls for a budget revision? While it may depend on the reason and time of year, in most cases, you do not revise the budget. It is likely the budget took many hours to prepare. Additionally, that budget was approved by the board after lengthy discussions and negotiations. The budget is the projected one-year financial result of the company’s strategic plan.
While both external and internal factors are certainly at play, the company expects to perform at or reasonably close to the budget as it executes its plan. In many cases, performance relative to the budget drives incentive compensation, staffing decisions, and many other decisions and outcomes. Moving the goalposts during the game is not a good idea.
The calls for a budget revision, however, provide the CFO the opportunity to teach the team about the benefits of forecasting. Unlike the budget, the forecast can and should be updated often. This is a living, breathing work product that includes the most current and accurate data you can access. Have you lost or acquired a major customer? Amend the forecast. You were opportunistic and able to acquire a competitor? Amend the forecast. The bank unexpectedly called your loan and you will need to materially trim expenditures? Amend the forecast. The forecast should tell you where you will likely end the year. The budget ideally would tell you the same but is only as good as when it was compiled and approved.
In many cases, performance relative to the budget drives incentive compensation, staffing decisions, and many other decisions and outcomes. Moving the goalposts during the game is not a good idea.
It is important to recognize that when creating the budget, you used your best knowledge at the time. The forecast, however, should always be up to date. It may be less detailed but it will be detailed enough to accurately capture revenue, EBITDA, cash flow, and other important metrics. While the forecast will presumably be more accurate than the budget, it will not address the situation where a budget shortfall is impacting incentive compensation tied to company goals as defined in the budget. That is a different conversation that could lead to the resetting of goals or comparing actual results to the forecast.
So, you now have a budget and a forecast. Which one should you report against? Both. In addition, you will want to compare your actual results to prior-year results. The budget is still relevant and variance analysis will be instructive in determining where you were off base so you can improve the budget process next year. Maybe you had some faulty assumptions. You might have missed a price escalation clause buried in a supply contract. Your industry may be facing new regulatory hurdles and the cost of compliance was difficult to predict.
The greater the complexity, the greater the chance of missing something. This happens more frequently than we’d like to admit but it is an inherent part of the budgeting process and will undoubtedly improve future outcomes.
As a finance leader, you need to drive a process that allows other company leaders, investors, and boards to see where you are headed. Without accurate data, course corrections are challenging to accomplish.
While a rigorous budget process shines a light on new initiatives and long-term goals, while also providing the guardrails for the coming year, sometimes facts on the ground change and you need to understand that and respond accordingly. If the changes are material, that response should include an accurate and sufficiently detailed forecast. Running a business is challenging. Attempting it with limited visibility will mute its successes and may even hasten its demise.
Michael Paull, CPA, is CFO of The Ahola Corporation.