Integrate Business Forecasting With Cost Analysis and Avoid Common Budgeting Pitfalls
Budgeting and forecasting are painful processes in businesses and nonprofits today. They are disliked because they are time-consuming, often involve defensive responses from staff, and seem to do little real cost management in a rapidly changing business environment. Participants in these processes are often correct in their critiques, but the problems they identify are not inherent in the processes. They are the result of:
1) Competing purposes in the forecasting process, especially the annual budget;
2) Having poor tools or confusing the process with the tools;
3) Failing to base the forecast on cost drivers;
4) Involving the wrong people at the wrong times in preparing the forecast.
Is the purpose of the budget to divide up resources or manage costs?
In many organizations, budgets and even re-forecasts serve primarily as tools to establish spending authority for department managers. Often, end of year performance goals are based on these targets. For small businesses, forecasts may simply be ways to demonstrate to lenders or other audiences the validity of a business model. Note that none of these purposes are focused on either a) accuracy; or b) cost management.
Cost management is rooted in cost analysis. To do effective cost management, leadership views the forecast through a matrix of major products and cost drivers. Drivers explain changes in expense levels over time and product / service level analysis defines the building blocks of profitability. Putting them together isolates key cost hubs that can be targeted for expense reduction with the most significant impact.
When spending authority is being negotiated through a budget process, departments have little incentive to forecast accurately. Their incentives will tend towards overstating their costs (so they can maintain their resource allocation) and understating revenue (so that they will increase the probability of meeting their goals). The finance department generally has an incentive to show good projected results and will typically understate the volatility in the business environment by producing a single point forecast.
In most organizations, spending authority must be established and the budget or forecast presented to external or governing bodies. However, to maintain forecast integrity, it may be necessary to have separate processes for establishing spending authority and for cost management forecasting. Alternatively, leadership can build a cost management forecast first, save that record, and then layer onto it the process of negotiating spending authority or preparing external projections.
Do your tools work and support the process?
Many organizations still use Excel to forecast. Budgeting and forecasting software companies have done an excellent job articulating the problems with using Excel, from overly complicated and potentially inaccurate spreadsheet templates to inadequate consolidation and general ledger integration.
The software offerings have improved dramatically, especially in the space in between Excel and highly technical and expensive legacy packages. Many companies now offer packages that can be installed and implemented quickly, with limited consulting support, at prices ranging from under $1,000 to $50,000 including all support.
These packages can solve most of the problems with using Excel, reducing the associated labor cost for those compiling the spreadsheets, but without bringing in the complex technical support requirements of the legacy systems.
Tools are not a substitute for business processes, however. If the wrong people are preparing the forecast, the incentives are misaligned, or costs are not analyzed, poor data will go into the forecast. A software with outstanding data intake and streamlined output and reporting cannot make poor data effective.
How are costs forecast?
Costs may be forecast many ways, but at a minimum an effective forecast will define the main driver of a given cost, whether financial or non-financial. This does not require full activity based costing. Further, a solid forecast will attribute most costs to the relevant product, service or program. This basic cost accounting, if completed as a basis for developing the forecast, will convert the forecast process into a cost management process. It will also make the forecast more accurate and give clues as to the necessary frequency of re-forecast.
Who is preparing the elements of the forecast?
Many organizations trade insight for efficiency in forecast preparation, assigning a finance or central staff member to prepare departmental forecasts. Others burden departments for preparing forecasts for line items they do not understand or control. Department personnel are best placed to forecast any cost or revenue items closely tied to departmental operations. However, central staff can make every effort to give departments only items that a) are tied to departmental operations; and b) need to be revisited in the given forecast cycle.