Forecasting and budgeting

Last updated: 10.11.2016

The series aims to describe the fundamental aspects of forecasting and budgeting - planning process, the difference between forecast and budget and description of the basic types of budgets (fixed vs. flexible, static vs. continuous, incremental vs. zero-based budget and top-down or bottom-up budgeting process).

A significant part of the series consists of variance analysis, a description of planning techniques (e.g. time series) and responsibility centers.

This series logically follows our article series Strategic planning.

 

 



Forecast

Forecast is a quantified prediction of the results that are expected to be achieved by the company in the future.

 

The difference between budget and forecast is:

  • budget shows what the entity aims to achieve (target)
  • forecast shows prediction what is likely to be achieved


Budget

Budget is a quantified operational plan for the upcoming accounting period/s. It is financial plan which works as a kind of target.

 

The difference between budget and forecast is:

  • budget shows what the entity aims to achieve (target)
  • forecast shows prediction what is likely to be achieved

 


Types of budgets

According to the updates for the changed level of activity (usually sales volume):

 

According to the updates for the past/new periods:

According to the level which prepares the overall budgeted figures:

 

According to preparation technique:



Fixed budget

Fixed budget is a budget that is not flexed with the changed production/sales volume or other significant variable.  The variances between budget and actual are therefore usually great. But in practice, fixed budgets are used more widely than flexible budgets.

 

Fixed budget is useful mainly when:

  • the budget serves as a target
  • there are not substantial changes in production/sales volume over time
  • costs are largely fixed (which is nowadays often the case)

 

Fixed budgets are not very appropriate for evaluating the performance of responsibility centers.

 

The opposite term to fixed budget is flexible budget.


Flexible budget

Flexible budget is a budget that changes with the changed production/sales volume or other significant variable.  Budgeted sales/revenues and variable costs are therefore flexed with the actual activity level, but fixed costs usually remain unchanged. Flexible budget shows how the financial plan/target would look like if actual (not planned) sales/production volume were used. The variances between budget and actual are therefore usually much lower than with fixed budgets. The condition of using this approach is splitting of all costs into variable and fixed components.

 

Therefore, flexible budgets are a kind of sensitivity analysis.

 

Flexible budget is useful mainly when/during

  • the budget does not serve as a target
  • there are substantial changes in production/sales volume
  • costs are largely variable
  • evaluating the performance of responsibility centers (25)

 

In practice, flexible budgets are used less often than fixed budgets mainly because:

  • they are available with significant time delay (25) as actual volumes must be known
  • budgets usually serve as fixed targets
  • the proportion of fixed costs on total costs is still increasing
  • it may be difficult to split semi-variable costs into variable and fixed components (25) or the result of doing so would be misleading

 

The opposite term to flexible budget is fixed (or static) budget. (25)



Rolling budget / Continuous budget

Rolling (continuous) budget is budget, which is continuously updated by:

  • deducting the figures for periods that have passed
  • adding the “missing” future period figures

 

For example

if the original budget covered the period January – December 20x1 and January 20x1 is now over. January data will then be deducted and instead, January 20x2 will be included to the budget.

 

Advantages of rolling budget

  • full-year budget is always available
  • budgets are regularly updated and are therefore not out of date

 

Disadvantages of rolling budget

  • time-consuming preparation
  • updated budgets do not agree with the entity´s fiscal year
  • many companies prepare their budgets in detail only for the immediately forthcoming year, but only general figures are prepared for the further periods, i.e. detailed budget for the newly covered period must be prepared anyway
  • generally, if the changed circumstances are not updated as well, it provides no substantial benefit

Static budget

Term static budget refers to budget that is not updated, either in terms of rolling of periods (months) and the changed conditions and circumstances. It is therefore both an opposite of rolling budget or synonym to flexible budget.

 

Static budget is useful mainly when

  • the budget serves as a fixed target
  • there are not substantial changes over time

 

Static budgets are not very appropriate

for evaluating the performance of responsibility centers. (24)



Top-down budgeting / Imposed budgeting

If this style of budgeting is used, budgets are prepared from top-down direction, i.e. senior management sets the high-level budget (often just basic numbers) without collecting detailed information from operating staff. This total general target is then broken down into detailed budget.

The process is reversed to bottom-up budgeting.

The advantages and disadvantages of top-down budgeting can be derived from those described in term bottom-up budgeting


Bottom-up budgeting / Participative budgeting

If this style of budgeting is used, budgets are prepared from bottom-up, i.e. operating staff collects the detailed information from various departments/functions/other sources. Process usually has a budget coordinator – e.g. controller who aggregates/consolidates these lower-level budgets into the master budget which then is passed for management approval.

The process is thus reversed to top-down budgeting.

 

Advantages of bottom-up budgeting

  • operating staff may be more motivated, if they participated in preparation (24)
  • operating staff is in regular and detailed contact with the budgeted objects (24) and can therefore have better information compared to senior management, which may lack this insight. But on the other hand, operating staff often lacks a complex view.
  • management can devote the saved time on more strategic issues (24)

 

Disadvantages of bottom-up budgeting

  • lower control over budgets, mainly because operating staff often lacks a complex view and concentrate just on departmental issues  (therefore the risk of not meeting the corporate objectives) (24)
  • the risk of poor budgets increases, if operating staff do not have sufficient experience (24)
  • the process of budget preparation is quite long (24)
  • operating staff may set too easy targets (24)
  • problems with coordination between departments (and departmental budgets need to interrelated)
  • senior management often adjusts the final aggregated figures anyway. It is then very difficult to explain any variances of such budgets with actuals in the future if these adjustments are not planned into bigger operational detail.


Negotiated budgeting

Negotiated budgeting is a budgeting style which combines top-down and bottom-up budgeting approaches. Negotiated budgeting can start by setting the general figures by top management. But compared to top-down budgeting, operational managers are given an opportunity to negotiate these figures. But it can also work vice versa – i.e. senior managements challenges or possibly adjusts the figures arrived through bottom-up budgeting.


Incremental budgeting

Incremental budgeting is the traditional approach that comes out either from the actual results or previous budget and adjusts it for the expected changes.

It is the opposite approach to zero-based budgeting.

 

In general, incremental budgeting does not take into account the changes in assumptions or circumstances, but it may be appropriate for example for costs that are quite easy to quantify, e.g. wages and salaries.  

 

Advantages of incremental budgeting

  • easy and quick to prepare
  • better coordination between departments
  • works well if there are no overspendings or inefficiencies in the actual figures

 

Disadvantages of incremental budgeting

  • usually does not consider any changes of methods and activities
  • budget is based on the assumptions prepared a long time ago, which are currently often even no longer known
  • dysfunctional behavior as managers tend to spend the remaining budget at the end of the year in order to keep the budget for the forthcoming period as well


Zero-based budgeting

Zero-based budgeting is the opposite approach to incremental budgeting as it begins the budgeting process from zero. Therefore, no past results are considered and budgets “are built” from item to item from the very beginning. It is very lengthy process and therefore, zero-based budgets are not often prepared for the entire entity in just one budgeting period, but only a certain area/s are reviewed during a time and the next areas are left for the future periods. Zero-based budgeting is appropriate for costs that are not so easy to quantify – usually costs of support departments or costs (or revenues) for specific jobs and contracts.

The advantages and disadvantages of zero-based budgeting can be derived from those described in the article about incremental budgeting


Steps during budget preparation

 

1. CEO appoints budget committee and budget coordinator.

Budget committee is a group of people that are responsible for budget preparation, review and approval. It is usually formed by senior managers including finance director. (26)  

2. Review the system of responsibility (budget) centers – mainly whether they include all parts of the entity. Responsibility centers are important not only for budget data collection, but mainly for control purposes. 

3. Set the basic budget assumptions such as expected inflation, exchange rate, interest rate, income tax rate etc.

4. Summarize the basic strategic points (new investments, diversification, etc.).

5. In cooperation with budget committee prepare/update budget manual and distribute it to all people involved.

Budget manual is a document that contains instructions for budget preparation. It is often used in large companies and facilitates the budget coordination process. It is usually prepared by budget coordinators (e.g. financial analysts or controllers) and approved by budget committee.

It defines mainly:

  • the purpose of budgeting and its consequences (e.g. relationship with personal targets and their evaluation)
  • budget preparation details:
    • the components of budget (e.g. sales, production, cash-flow budgets)
    • periods included and the level of split within the period (e.g. monthly/quarterly)
    • budgeting approaches used:
    • structure of data required  such as the level of detail, scenarios, additional data for sensitivity analysis or probability budgeting
    • responsibilities – defines people responsible for individual budgets – i.e. budget holders who are made responsible for budget centers (usually the same as responsibility centers)
    • budgeting timetable
    • basic planning assumptions and summary of general strategic points (steps 1 & 2)
  • budget coordination details – responsibilities, steps taken, timing, the format of master budget etc.  This part may not be available in smaller companies as the budget is often prepared by just one person and no coordination is thus necessary.
  • responsibilities of budget committee and timing of budget approvals
  • future budget updates – e.g. whether rolling or flexible budgets will be prepared
  • details about budget evaluation with actuals and possible corrective actions – for example:
    • evaluation methods, timing and responsibilities
    • possible future budget/target adjustments allowed

 

6. Define the principal budget factor – it is the key and limiting factor within the entity. Because it limits other operations, budgets containing principal factor shall be prepared first. It is usually sales, but others may be possible (e.g. raw materials if they are rare). Let’s suppose that principal budget factor is sales in the following text

7. Prepare sales budget (or collect it from sales manager or sales representatives). The following items should be determined for each product/service:

  • sales volume
  • prices – consider all the factors included in setting the selling price

→ split by sales person, responsible manager or departments, products, geographic area, etc. – what is appropriate

 

8. Prepare production budget (or collect it from production manager):

→ split by responsible manager or departments, products, geographic area, etc. – what is appropriate

 

I. First determine whether there is sufficient production capacity available to be able to manufacture budgeted sales volume. If not, consider whether and how it can be resolved. If it cannot be resolved, production budget is in fact the principal budget factor and shall be prepared first instead of sales budget. If the capacity is higher than sales volume, the entity can for example consider reduction of prices (in order to sell more), strategy of diversification or other solutions mentioned below.

 

The limiting capacity factors are:

  • machine capacity =  machine hours available less inefficiencies such as idle time

→ if actual machine capacity ≠ machine capacity required, make a decision to resolve it and adjust the relevant operational budget (e.g. capital expenditure budget or inventory budget). Possible decisions can be:

  • actual < required capacity: buy or hire an additional machine or outsource production activities etc.
  • actual > required capacity: produce more units to stock, sell the redundant machine etc.
  • direct labor (workers) = labor hours available less inefficiencies such as idle time plus the effects of learning curve or  automation:

→ if actual labor hours ≠ labor hours required, make a decision to resolve it and adjust relevant operational budget (usually payroll budget). Possible decisions can be:

  • actual < required: hire additional staff, temporary help, overtimes, night shifts etc.
  • actual > required: release existing staff etc.
  • raw materials = quantity available less inefficiencies such as normal losses

→ if available raw materials are not sufficient, consider for example possibility to purchase it elsewhere or using alternative materials (possible adjustment to purchasing budget).

 

II. Set the final production volume for each product and inventory budgets:

  • production volume + finished inventory on stock > sales volume → finished goods remains at stock (i.e. inventory budget)

 

III. Set production prices (costs) – standard costing approach or pricing available from actuals is often used.

direct materials – consider:

  • purchasing terms – i.e. not only currently agreed prices, but also  results of ongoing/expected negotiations with existing or new suppliers
  • expected market changes in prices of raw materials
  • required changes in quality – higher quality materials are more expensive
  • expected changes in transport conditions (e.g. by the entity or by suppliers)
  • age of property and equipment – old assets can produce higher losses (which increase unit price)
  • expected inflation

direct labor – consider:

  • existing wages and salaries and their expected rises 
  • expected changes in the labor market
  • expected changes of the social and health insurance rate paid by the employer
  • expected inflation

other direct expenses - production overheads –consider:

  • purchasing terms and expected market changes
  • expected inflation

 

IV. Consolidate production budget

 

9. Prepare other relevant budgets (or collect them from relevant staff). The below stated budgets are not complete and the procedures are simplified.

  1. Capital expenditure (CAPEX) budget
  2. Long-term assets budget – shall include existing assets and assets acquired during budgeting period (CAPEX) less asset removals, their expected depreciation and amortization and impairment losses
  3. Payroll budget (number of staff, wages – usually for each grade of employees)
  4. Non-production costs budget - is often split into individual departments budgets such as marketing, PR, accounting, treasury budgets
  5. VAT budget
  6. Budget for receivables and payables – can be set in detail or very simplified assumption can be used in certain cases:
    •  if the entity pays and collects its invoices in 30 days (monthly) → receivables and payables shall approximately be 1/12 of the amount of revenues/ expenses
    •  if the entity pays and collects its invoices quarterly → receivables and payables shall approximately be 1/4 of the amount of revenues/ expenses

 

  • from the budgets prepared above calculate the cash-flow and prepare cash budget:
  • if cash-flow is positive = cash inflow resulting for example in additional amounts on bank account or investments bringing additional interest or other income
  • if cash-flow is negative = cash outflow: plan a loan or other means of financing causing additional interest or other expense

 

→ prepare income tax budget – make the necessary adjustments to the tax base (not all expenses are tax-deductible, not all incomes are taxable etc.) and calculate current and deferred income tax. This step is interrelated with:

  • cash-flow / financial assets / interest calculation:  interest expense/income affect income taxes and vice-versa, income tax payments affect cash-flow and resulting interest.
  • budget for receivables and payables – income tax is usually paid the following year, thus the amount remains on payables account

 

Therefore, these calculations should be made in several iterations.

 

10. Check all received budgets centrally – mainly for typical errors such as miscalculations, wrong totals, duplicities, incompleteness, missing interrelationships with other budget components, discontinuity or the variances from last actuals/past budget.

 

11. If there are any adjustments, they shall be communicated and at least send back for information to the original contributors.

 

12. Prepare preliminary master budget.

Master budget is the overall budget that summarizes lower-level operational budgets. It usually includes:

  • summary of the most important points from strategy
  • summary of planning assumptions used
  • a set of financial statements – i.e. profit and loss statement, balance sheet and cash-flow statement; often in very similar formats as in actual reporting
  • non-financial KPIs such as number of employees, number of customers, orders, calls etc.

13. Review the master budget:

  • again check for the typical errors
  • compare the budget with previous period results
  • possibly also calculate financial ratios or other financial analysis indicators and consider, whether they either make sense and whether you can explain them (mainly in the context of past figures)

14. Ask budget committee to review the master budget.

15. Obtain senior management approvals and distribute the master budget.



Budgeting and forecasting under risk or uncertainty

There are several approaches to planning (budgeting) that can be undertaken if uncertainty is a significant factor:


Scenario analysis

Scenario analysis is a prediction method under which several possible outcomes (variants) are worked out. It is often used during budgeting process and decision-making, mainly as a method of reducing uncertainty.

The most common scenarios are:

  • optimistic (best-case scenario)
  • realistic – i.e. the most likely outcome; in budgeting, this scenario is often used as the main budget (target)
  • pessimistic (worst-case scenario)


Sensitivity analysis / What-if analysis

Sensitivity analysis (also called what-if analysis) is a technique which is used to calculate the output variable (e.g. profit, revenues or costs, NPV) under different assumptions (often different sales quantity, selling price, unit variable costs, etc.).  It is used during budgeting process and in decision-making, mainly as a method of reducing uncertainty.

A kind of sensitivity analysis is preparation of flexible budgets.

Sensitivity analysis is a technique that can be used during scenario analysis.


Budgetary control

Budgetary control is the process during which actual results are ascertained and compared with budgeted figures (variance analysis). The found differences are called variances (or deviations) and are usually further analyzed.  A remedial action can be taken based on this analysis. The corrective action may be operational (e.g. if poor-quality materials are currently causing high-level wastage, it can be decided to purchase better-quality materials from different supplier) or can also result in adjustments of strategy.

Budgetary control in its essence includes also the previous stages such as developing budgets and responsibility (budget) centers.



Variance analysis

The purpose of variance analysis is to ascertain the quantitative deviation between budgeted, forecasted or otherwise estimated figures and accounting actuals and analyze this deviation into bigger detail. It is a valuable control mechanism.

 

Factors to consider when deciding whether it is worth to investigate the variance:

  • materiality – small variances are usually either not analyzed or analyzed only to lower extent. Materiality levels can be defined:
    • in absolute figures – e.g. variances over € 100 are investigated
    • in % - e.g. variances over x% from budgeted figure are investigated  
    • are not defined and analysts evaluate their significance subjectively
  • controllability –uncontrollable variances shall be given lower care than to controllable
  • whether the variance is favorable or unfavorable – investigation is more about unfavorable variances
  • trend – if the monthly (or other period) variances keep showing a trend, it is certainly worth further analyses
  • standards used in budget preparation – if for example ideal standard is used, the variances are expected to be unfavorable
  • the cost of variance investigation should not exceed the benefits resulting from the possible remedial action (28)
  • interrelationship of variances – one variance can be related with another and it therefore depends on their cumulative effect. For example:
    • using poor-quality material can cause:
      • favorable direct material price variance
      • unfavorable direct material quantity variance (more wastage)
      • unfavorable direct labor quantity variance (worse handling)
    • more qualified staff can result in:
      • unfavorable direct labor rate variance (higher wages)
      • favorable direct material quantity variance (less wastage)
      • favorable direct labor quantity variance (less hours necessary to produce the same output)

 

In general, direct costs, revenues and margin variances can be split into:

  • price variance

Calculation:  (actual unit price – budgeted unit price) x actual quantity

Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed price (unit margin).

 

  • quantity (or volume or usage) variance

Calculation:  (actual quantity – budgeted quantity) x budgeted unit price

Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed quantity sold/produced. 

 

More detailed variance calculations can be found here:

Direct material cost variance

Direct labor cost variance

Variable production overheads variance

Fixed production overheads variance


Budgeting and forecasting techniques

Techniques used for forecasting/budgeting can be differentiated into:

  • subjective / qualitative – e.g. consensus of a working group, brainstorming meetings, customer surveys etc.
  • objective / quantitative - mathematical or statistical approach applied to past results from which future trend is extrapolated, e.g. time series


Time series

Time series represent a sequence of data for several time periods (hour, days, weeks, months, year). Independent variable is always time (axis x).  Time series is used to predict future and it has several components:

  • trend – represent long-term movement;  can be developed by regression analysis or moving averages; can be downward or upward
  • season – seasons repeat at defined short intervals (hours, days, weeks, months etc.) usually within a year, e.g. consumption of water in households is higher in the evening, consumption of gas is significantly higher during heating season (winter)
  • cycle – cycles usually last a few years and repeat in medium-term period, e.g. economic cycles
  • irregular (random) element – cannot be predicted, e.g. war

Simple moving average

Moving average is very simple method used to predict future based on the past results.  It works well if there are no seasonal or cyclical elements included in the past data. It is calculated as an average of defined number ongoing periods.

 

Příklad

 

Calculation of 3-month moving average for April: (255+260+279)/3 = 265

Calculation of 6-month moving average for July: (255+260+279+285+270+300)/6 = 275



Responsibility center

Responsibility center is an object for which costs/revenues/capital expenditures are specifically collected and analyzed. Each responsibility center is usually managed and controlled by a separate manager.

The entity is often internally split into various types of responsibility centers for the purposes of smooth management, controlling and planning (budgeting).

 

Examples of responsibility centers:

  • department (group of departments) – usually each department has its own responsibility  center
  • production hall
  • factory
  • machine
  • project

Responsibility centers can be classified as:


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