How do forecasts differ from budgets?
Thank you, Steve Morlidge for sharing your knowledge with the CFO.University community.
People who are highly sensitive to the lack of flexibility of traditional budgeting often see rolling forecasts as the answer. If we update our view of the future more frequently and don’t confine it to the financial year it is obvious that this will be more useful than traditional annual budgets based on the financial year.
So, you might think, forecasts are like budgets but done more frequently – right?
Forecasts and budgets are fundamentally different animals, and a failure to recognise this is the cause of many of the problems people have in implementing forecasting processes that deliver value.
The best way to think about forecasts is that they are future actuals. Whereas actuals inform you about what has happened given what you did in the past, forecasts are an attempt to work out what will happen in the future given what you have done and what you plan to do.
You can’t change what you did in the past but you can change your plans…and this is the reason why you produce forecasts. They enable you to determine if and how you need to change your plans to achieve the outcome you want.
To achieve this a forecast needs to be an honest reflection of your expectations. What it can’t be is a way of setting goals or budgets, because these reflect your aspirations. If you try to use forecasts in this way there are only three possible outcomes:
1. You will get bad forecasts
2. You will get bad targets or budgets
3. You will get bad targets and bad forecasts
Indeed, forecasts only have value if you can change your plans in order to achieve the outcome that you want. And since this might mean reallocating resources, forecasts are in opposition to traditional fixed budgeting rather than a handy uncontroversial add on to the process.
And that’s not the only reason why forecasting and budgeting make uncomfortable bed fellows.
Traditionally variance analysis is used to manage performance back to budget and in this world a negative deviation from budget is bad. In a world of forecasting, however, gaps are good, because it is the existence of gaps that tell you that you need to do something different.
Let me illustrate this with a simple example.
Imagine that you are in a sail boat. You know where you want to go and before you set out you made a plan of how you are going to get there based upon certain assumptions about the wind, tides and so on.
But very often when you are sailing – just like in the world of business – the assumptions that you originally made were wrong because you had no experience of the waters that you were sailing into. Or perhaps conditions changed after you set out. In these circumstances, in order to get where you want to go you have to plot a new course, the first step of which will involve working out where you will end up if you carry on doing what you planned to do.
This forecast may well tell you that you are going to end up hitting some rocks or in some other bad place. This is useful knowledge. This is why you forecast. Your forecast is telling you that you need to do something different.
At this point the appropriate response of the captain to the navigator should be ‘thank you for telling me. What do I need to do differently?’
In business however, because people have been trained to think that differences are bad, forecasts that show adverse outcomes are often greeted with words like ‘this is unacceptable’ or ‘you must try harder’. And worse, when forecasts change to reflect changing circumstances, we often hear ‘last month you said x but know you say y. Do you know what you are doing?’
If this is what happens people pretty soon learn that although you say you want a forecast what you really are asking for is reconfirmation of the budgeted numbers. And if this happens, whatever it says at the top of the piece of paper on which it is written, it is NOT a forecast at all, and everyone has wasted their time. Worse it might have engendered a false sense of security and you may be about to stray into dangerous waters without knowing it.
So forecasting – done well – is much more than a minor modification to traditional processes performed to provide flexibility that the annual process doesn’t possess. It is truly subversive because it demands a change in many other processes and more importantly the mindset that underpins the traditional model of performance management.
Getting the mindset right is probably the most important and difficult challenge that has to be addresses when introducing forecasting into an organisation, but it is not the only one.
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Business Forecasting thought leader, author of “Future Ready: How to Master Business Forecasting” and “The Little Book of Beyond Budgeting”
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