Today’s topic of our FP&A journal is about the importance of forecasting and its relation to an annual budget. We will also cover the typical forecasting cadence, horizon and when it may substitute the budget.
Forecast vs. Annual Budget
Let’s start where our previous article Everyday FP&A left off. The annual budget is a plan that gives each leader in the company a target for spending or volume of sales to achieve. In other words, a budget gives leaders a direction on their financial objectives in each fiscal year. How would you know that the company is performing in line with the budget once the next fiscal year begins? That’s where recurring forecasts take over.
Recurring forecasts are an update to your budget that allows you to act before it’s too late. They are done by analyzing the quarters that have passed (often referred to as “actuals”), verifying the historical performance with the expectations set by the annual budget, and adjusting budgetary expectations by reflecting newly identified trends. The ultimate variances against the budget (often referred to as “bridge”) are presented to the company’s stakeholders who then decide if any actions are warranted. For example, let’s assume sales in the most recent quarter outperformed the budget. If the recent sales trend continues, how many new people should the company hire in the rest of the year in order to meet the initially budgeted profitability and complete orders on time? These are the real-life situations that would not be captured & analyzed without recurring forecasts.
Forecasting Cadence and Horizon
Now that we have forecasts well defined, let’s move on to the topic of forecast cadence and horizon.
How often should you do forecasts? Typically, large companies align their forecast cadence with their accounting close cycle. If their books are fully closed each month, they may opt for monthly forecasts. Otherwise, they typically do forecasts each quarter.
Smaller companies typically opt for quarterly or even semi-annual forecasting cycles, and thus balance the benefits of frequent forecasting with the efforts each forecast takes.
Another parameter that companies need to decide on is the forecast horizon. In other words, should you just look at your past quarters vs. budget, or should you also adjust your budget by the newly observed trends moving forward? If so, how far out should you go? Typically, large companies analyze their past quarters and project newly observed trends for the rest of the fiscal year. Some even do a 12-month rolling forecast, meaning they always forecast 12 months ahead.
For smaller companies, we recommend a quarterly forecast that analyzes past quarters and projects newly observed trends for the rest of the fiscal year. This approach balances the need for insights with data and resource availability, while ensuring new trends are captured on time. As the second half of a fiscal year begins, forecasts often substitute annual budgets altogether due to budgets being seen as obsolete by that time.
Conclusion
Forecasts are a very important element of business financial planning. Budgeting cannot work without forecasting, as it alone cannot ensure accountability, adherence and actionability. Additionally, quarterly forecasts that project new trends to the rest of the fiscal year are the preferred planning cadence & horizon for small & medium enterprises. This cadence and horizon ensures new trends are analyzed and captured on time, allowing stakeholders to act accordingly.
(This article was also published on LinkedIn)
