It’s the question I get asked the most by accountants who are thinking about branching into Strategic Advising services: “I do budgeting already. What’s the difference between a budget and a financial forecast?”
The answer is both simple and complex, and has a lot to do with the real value of advisory services, which is aiding small business growth.
What is budgeting?
In practice, a budget has more to do with expenses; budgets allocate expenditures for a set period of time, usually short term (quarterly or yearly). Budgets are typically prepared by detailed chart of account line item: office supplies, training, travel, and so on, and are considered spending limits. Budgets are tactical.
The practice of budgeting has two main methods: incremental and zero-based. These methods were devised in order to attempt to cover all the needs of an organization. Incremental budgeting is the more prevalent approach, where last year’s budget is amended to increase or decrease each line item for the next budget period. Zero-based budgeting starts from a place of zero by line item, and builds up, and is typically done when an organization needs a fresh start or has a major reorganization.
These budgeting protocols take into account how much an organization must spend to cover their operational needs by setting do-not-exceed limits on expense line items. In this sense, a budget is a useful tool to manage cash, and month-to-month operations—tactical things.
What is forecasting?
Forecasting is typically concerned with where a company would like to go: its growth. If a company is netting X amount in revenues per year and wants to grow to 2x revenues, how will they get from here to there? A financial forecast is the tool for that. It allows you to model financial scenarios based on desired outcomes. It is strategic.
Forecasts are not prepared by the chart of accounts line items—they are more summary in nature. Forecasts begin with sales projections and work from there, applying growth patterns over time as necessary to reach desired goals. Expenses are then layered in, beginning with direct costs and finally adding indirect expenses to meet desired net profit.
Forecasting helps a company make long term strategic decisions like partnerships, sales plans, and staffing. For this reason, forecasts span a longer period of time than budgets—usually 18 to 36 months. Growth takes time.
Once a strategic forecast is built, a well-informed budget can be devised based on the targeted forecast projections, plus industry benchmarks, and the prior year’s actual data, if it exists. This is how the two methods come together to support strong company management.
Forecasts are strategic and help companies plan for growth. Budgets are tactical and help companies manage their month to month operations. [Click to Tweet]
Forecasts and budgets in practice
Forecasts and budgets are both useful in a business environment.
Here’s an example:
A budget can be more applicable when investment has been acquired, and a company must present a use of proceeds. The company would want to write a detailed budget to ensure responsible spending. When the company begins generating revenue, a forecast should be built to predict sales over time, the necessary expenses, and related net profit. And from that, another budget should be used to detail spending by line item and ensure the expenses are not exceeded.
As a public accountant, you are probably much more familiar with budgeting, and likely do it within your accounting software. I encourage you to practice forecasting until you become comfortable with it, and then use it as a tool to help your strategic advisory clients plan for growth.
Forecasting as business planning
A well-written financial forecast should be a roadmap for running a business. A forecast is based on business drivers, like unit sales, hours billed, or memberships sold. Those drivers, once revealed and documented, can be tracked and measured, which allows the business owner to stay on top of very practical targets month by month. These are sometimes called key performance indicators, or KPIs.
On the expense side, the financial roadmap will dictate when major expense events can occur, based on sales and net profit. Purchasing capital equipment or hiring new employees are a couple examples of expense events.
If business scenarios are only considered using budgeting techniques, the tendency is to be overly cautious. Growth requires stretching the goals and aiming high. The industry term stretch-goal is used to indicate when a business is setting a higher goal than originally sought or thought possible. When reasonable stretch goals are set and recorded, they become the plan of action.
And here’s where the discussion becomes somewhat complex, because what we’re saying is that a dream, if translated into a goal, can actually be attainable with the right plan. And that’s a big subject—but one worthy of undertaking. If your clients are asking for help with budgeting, they may not appreciate the difference between an operational budget and a strategic forecast for long term growth. Use that as an opportunity to flex your advisory muscles and teach them the difference.
As a public accountant, you can turn your savvy with numbers into a wonderful offering to your small business clients by applying this knowledge in your Strategic Advising practices.
Editor’s note: This article originally appeared on the LivePlan Strategic Advisor blog.