Budgeting and forecasting are both important financial management tools used by businesses to plan for the future, but they serve different purposes. Here’s a comparison between the two:
- Purpose: Budgeting is a process of allocating resources to achieve specific business goals over a defined period, typically one year. The goal of budgeting is to create a plan for how the business will spend its money in the coming year. Forecasting, on the other hand, is a process of predicting future financial outcomes based on past and current trends. The goal of forecasting is to estimate future revenue, expenses, and cash flows.
- Time frame: Budgeting is typically done on an annual basis, while forecasting can be done on a shorter or longer time frame. Forecasts may cover a shorter time period, such as a quarter or a month, or a longer time period, such as three to five years.
- Detail: Budgeting requires more detail than forecasting. Budgets typically include specific line items for revenue and expenses, with each item broken down by category and subcategory. Forecasts, on the other hand, may be more high-level and focus on overall revenue and expense projections.
- Flexibility: Budgets are more rigid than forecasts because they are based on a specific set of assumptions and targets. Forecasts, on the other hand, are more flexible because they can be adjusted as circumstances change.
- Use: Budgets are used to set performance targets and to monitor progress against those targets. Forecasts are used to identify potential risks and opportunities and to inform strategic decision-making.
Budgeting vs. Forecasting
However, they each function differently and have distinct roles in financial planning. Understanding the process for each will help entrepreneurs prepare their business for growth and weather the down times.
What is budgeting?
Budgeting is the process of setting your financial goals for a specific period, often for one year. Budgets serve as road maps that guide the company’s direction.
A basic business budget would express annual financial goals such as:
- Debt reduction
- Sales volume
Budgets are set at the beginning of the year to put forth the ideal direction of the company. At the end of the period, business owners can compare the budget to actual results to see which goals were achieved.
What is forecasting?
Financial forecasting refers to using your company’s past performance data and assumptions to predict future results. These projected outcomes (forecasts) can be for the long or short term. They’re usually updated regularly, sometimes in real time.
For instance, a business owner might update sales volume, cash flow, and revenue forecasts every quarter. They can use information from Q1 sales to inform and adjust their predictions for Q2 and onward.
Business forecasts are based on estimates of future performance metrics, including:
- Revenue growth rate
- Conversion rates
- Sales volume
These estimates are typically based on assumptions around your existing data. For instance, if you are estimating future sales volume, you can start with last year’s volume. Then, you make an assumption about what it will do in the next year: increase, decrease, or stay the same.
Budgeting vs. forecasting difference
In business, the budget outlines the direction the management wants the company to go in, while the financial forecasts are used to track progress toward the goals defined in the budget.
Furthermore, budgets are often set for a single period, such as a year. Financial forecasts, on the other hand, can be used for various periods (annually, quarterly, monthly) and are updated regularly.
However, budgeting and forecasting usually work together. Typically, management will start by creating an annual budget based on business goals for the year. Then, they can use financial forecasts to visualize different scenarios for achieving their budget goals.
Your budget is your goal, and your forecasts are your road maps for reaching that goal.
Let’s say you have an annual budget goal of increasing revenue by 10%. There are a few different ways to achieve that — you could increase sales to your existing market, target a new market, or raise prices.
You can create forecasts for different tactics to see how well you would need to perform to reach the 10% revenue increase. Then, as the year progresses, forecasts serve as a way to monitor progress and see if the company is on track.
For example, you may want to increase revenue by 2.5% each quarter to meet the goal of 10% annual growth. But at the end of Q1, you’ve only increased revenue by 2%. You can adjust your forecasts to see that, at the current rate, you’ll only reach 8% growth. To achieve your original goal of 10% growth, you now need to average 2.7% growth in Q2 through Q4.
Planning vs. budgeting vs. forecasting
In addition to budgeting and forecasting, management also uses planning to keep the organization moving in the right direction. A business plan typically outlines the company’s overall vision and goals for a longer time frame (such as 3-5 years).
A basic business plan will include information about your company’s key information and strategies, such as:
- Description of products or services
- Definition of target customer
- Industry and competitive analysis
- Relative strengths and weaknesses
- Threats and opportunities
- Marketing strategies
- Financial planning (including budgets)
The business plan is the big picture, while a budget focuses on specific financial objectives for a period of time. From there, forecasting tells you how well you’re tracking along with your budget.
Budgeting vs. forecasting examples
Businesses use budgets to determine how to meet goals, such as increased profit. For instance, you can increase profit by generating more revenue, reducing costs, or both. If your plan relies on more revenue, then you should project higher revenue in your budget.
Once the budget is set, financial forecasts can be created and updated to help management see if they’re on track to achieve their goals.
Say a SaaS company made $3m in revenue last year. This year, its budget includes a goal to increase revenue by 20%, bringing it to $3.6m.
Here’s what a sample budget for the upcoming year might look like:
In this budget template, you’ll see the total revenue goal of $3.6m, plus details about smaller goals in different services (e.g., basic tier vs. premium tier).
The budget also outlines goals for operating expenses, which add up to $2.8m. If you meet both revenue and expenses targets, your operating income will be $0.2m.
The “Actual” column stays blank until the year-end when you review performance. Filling in those numbers will allow you to see whether you achieved your target.
After you have a budget in place, say you want to create a forecast and find out whether it’s feasible to reach $3.6m in revenue.
To forecast this year’s revenue, gather information about your previous performance and make assumptions.
Let’s say that by the end of last year, your revenue was increasing at a rate of 2% month-over-month (MoM), and in your last month, you made $250k in revenue.
If you assume that this growth rate will continue in the next year, then your financial forecast would be as follows:
Projected monthly revenue based on 2% MoM growth rate
This forecast tells you that if you keep the same 2% MoM revenue growth, you’ll achieve a total revenue of $3.42m, falling short of your $3.6m goal.
Your management team can use this information to see that you’ll need more than 2% MoM growth. Using forecasts to help with decision-making, you can look at different strategies for increasing that growth rate, such as:
- Increasing prices
- Improving sales conversion rates
- Generating more leads at the top of the sales funnel
Since forecasts are updated regularly, these initial projections aren’t set in stone. Say that in March and April you experience 3% MoM growth instead of your predicted 2%.
You can update the remaining predictions (May through December) to reflect 3% MoM growth and see what that does to your total revenue projection.
The forecasting process above relies on the straight-line method, which assumes your company’s historical growth rate will stay the same.
There are several financial forecasting methods, and each may give different results.
Here are three additional financial modeling techniques commonly used to predict business performance:
- Moving average method: Uses an average (or weighted average) of the previous period to predict the next to provide a rolling forecast. For instance, it may use the last three months’ average revenue to predict the next month’s revenue.
- Simple linear regression (SLR): Predicts financial performance based on a related variable. For instance, a utility company may use temperature data to predict revenue from electric usage.
- Multiple linear regression (MLR): Predicts financial performance based on multiple related variables. For example, a shipping company may use gas prices and interest rates together to project expenditures for a future period.
If you want to explore more complex forecasting methods (such as regression), then using sales forecasting software can streamline and automate the process.
Tips for improving budgets and forecasts
Here are some best practices that can help you get the most out of your budgeting and financial processes.
Create a budget
According to a survey by Clutch, only 54% of small businesses created an official budget in 2021 — meaning many entrepreneurs don’t have an outline for annual financial goals.
If you don’t have a designated chief financial officer (CFO), you can use a business budget template to get started or work with a financial consultant to create one.
Use accurate data
Forecasts are only as good as the information you input. If you’re using incorrect data in your forecasts, you won’t get much value from them.
Be careful of manual data entry errors and typos. Double-check inputs and update data often so you have the most recent information.
You can also use accounting and bookkeeping software to automate data tracking and reduce the chances of human error.
Learn from previous forecasts
Tom Miller, CMO of strength sports publication Fitness Volt, recommends business leaders “reduce errors systematically by determining where past projections went wrong.”
For instance, let’s say you’re a SaaS company that launched a new premium pricing tier. You assumed this tier would have the same conversion rate as your basic tier. But in reality, the conversion rate was lower because the cost was higher and the product was new.
This assumption may have led to overestimated revenue projections.
To correct it, you can explore a couple different revenue scenarios, including ones based on more conservative assumptions. This way, you’ll be able to understand what happens to your budget even if you fall short of ideal performance.
Improving your ability to make financial assumptions over time will help you create more accurate projections.
Consider qualitative data
Small businesses and startups that don’t have much historical data to use in forecasts can look at qualitative data such as surveys or research reports.
For instance, if you haven’t launched your product yet, you can survey customers to estimate how many people would buy and at what price. That information can be used in revenue and sales forecasting.
Do your research
Your company doesn’t exist in a vacuum. When making budgets and creating forecasts, don’t ignore what’s happening in the economy and your industry.
Walter Lappert, president of drone company Triad Drones notes, “Always do your market research and err on the side of overestimating variable costs.”
You can’t always predict when market conditions like supply chain problems or inflation will result in a rise in costs. So, you want to avoid relying solely on best-case scenario forecasts. Instead, use conservative estimates to give yourself financial buffers.
In summary, budgeting and forecasting are both important financial management tools, but they serve different purposes. Budgeting is focused on allocating resources to achieve specific goals, while forecasting is focused on predicting future financial outcomes. Both tools are essential for effective financial management, and businesses should use them in tandem to achieve their financial goals.
Images and Content source HubSpot