Forecasting and Budgeting
I am surprised how many companies do not prepare annual forecasts or budgets. And many that do, simply add a blanket percentage multiplier (such as an increase of 10%) to prior year’s actual amounts. However, without applying the appropriate thought process to the forecast there is no way to explain any positive or negative variances. And, addressing variances is the catalyst for identifying issues and opportunities for the company. The forecast/budgeting process is an absolute necessity and critical for so many reasons:
o Sets the financial expectations for the next year
o Sets the goals/targets by department
o Projects the cash flow and need for additional funding
o Allows for the measurement of leadership performance
o Creates the initial goal necessary to reach the 3-5year strategic plan
o Helps the company identify issues and opportunities
Forecasting is so important and should be prepared in Q4 and completed prior to year end.
Although the process can seem daunting to start, I want to provide a few key suggestions that should help:
Divide the focus into three sections: Revenue, Direct Costs, and G&A. Each of these section has very different methods for calculating and forecasting future periods so its easier to work with them separately.
Whenever possible identify the key drivers for revenues and expenses such as number of units, sales price, direct costs, churn rate, conversion rates, days outstanding, production cycles etc.
Make sure to adjust for “one-offs” in both prior year and future periods. Account for known planned activities such as R&M and CAPEX activities. Make sure your proforma estimates are reasonable and attainable given the anticipated upcoming investment in revenue generation.
Prepare the forecast monthly and account for seasonality so that YTD variances to actual have meaning and can be used in measuring progress.
Costs that remain relatively consistent year over year should be adjusted for inflation but also add any known upcoming increases such as: published changes to minimum wage or utilities rates or contractual related increases.
Whenever possible, involve the department heads in providing departmental budgets. These can be integrated into the forecast and can also be used to measure their individual performances.
Once complete, review your forecast to make sure it looks reasonable. How does it compare to last year? If there are major differences, is there a logical explanation? Make sure to compare the target percentages (such as EBITDA) to make sure your forecast is in line with the Strategic Business Plan. If your forecast is below target then you most likely need to trim the G&A expenses if possible. Trimming Direct costs is difficult since, by definition, they are a function of Revenues and increasing Revenues can be problematic if there is no support for the increase. Any increase in Revenues should be thought through carefully because it may create unrealistic expectations or it may require a capital investment which will affect cash flow.
There is nothing worse than creating a forecast with unrealistic expectations. Performance bonuses will most likely be unattainable and any positive company improvements may be overshadowed by negative variances. If there is no logical explanation for correcting the variance, the ability to measure the performance of your team will be lost and you will lose the buy-in from your leadership team.
In practice a well constructed forecast can be compared to the companies actual performance monthly. Forecast to Actual variances can be identified and explained early so that any issues are discovered early and any victories are acknowledged and accelerated whenever possible.