In essence, a budget is a quantified expectation for what a business wants to achieve. Its characteristics are:
- The budget is a detailed representation of the future results, financial position, and cash flows that management wants the business to achieve during a certain period of time.
- The budget may only be updated once a year, depending on how frequently senior management wants to revise information.
- The budget is compared to actual results to determine variances from expected performance.
- Management takes remedial steps to bring actual results back into line with the budget.
- The budget to actual comparison can trigger changes in performance-based compensation paid to employees.
Conversely, a forecast is an estimate of what will actually be achieved. Its characteristics are:
- The forecast is typically limited to major revenue and expense line items. There is usually no forecast for financial position, though cash flows may be forecasted.
- The forecast is updated at regular intervals, perhaps monthly or quarterly.
- The forecast may be used for short-term operational considerations, such as adjustments to staffing, inventory levels, and the production plan.
- There is no variance analysis that compares the forecast to actual results.
- Changes in the forecast do not impact performance-based compensation paid to employees.
Thus, the key difference between a budget and a forecast is that the budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually going.
Realistically, the more useful of these tools is the forecast, for it gives a short-term representation of the actual circumstances in which a business finds itself. The information in a forecast can be used to take immediate action. A budget, on the other hand, may contain targets that are simply not achievable, or for which market circumstances have changed so much that it is not wise to attempt to achieve. If a budget is to be used, it should at least be updated more frequently than once a year, so that it bears some relationship to current market realities. The last point is of particular importance in a rapidly-changing market, where the assumptions used to create a budget may be rendered obsolete within a few months.
In short, a business always needs a forecast to reveal its current direction, while the use of a budget is not always necessary.
Simplify the Budget Model
The typical budget model starts as a relatively uncomplicated spreadsheet, and then gains complexity over time to reflect the increasing complexity of a business, or because management wants to include more information in the model. Over time, these additions can result in an overly cumbersome budget model that is difficult to use and laced with formula errors.
For example, a budgeted balance sheet may not be used in the original model and is added at a later date, along with manual adjustments to make the balance sheet balance correctly. If not properly monitored, it is entirely likely that the balance sheet will not balance or will yield absurd results.
There are several ways to avoid complexity in the budget model. Consider the following actions:
- Schedule an annual review of the model, with the express intent of simplifying the formulas and reducing the level of information that it contains.
- Document the reasons why various parts of the model are being used, and which parts require updating. Having to document these items may keep the budget analyst from including them in the model. Or if a section must be retained, at least it is properly documented.
- Have a third party review the model from time to time, to suggest alternative ways to simplify the model.
- Periodically review the need to swap out the in-house model for a commercially-available budget model, for which the risk of modeling errors is much lower.