Understanding The Difference Between Financial Forecasting and Budgeting

Planning is the single most important factor in business success. A good plan not only helps organizations focus on the specific steps necessary to make their ideas succeed but also helps managers achieve both short-term and long-term objectives.  Financial forecasts and budgets are the two main planning tools in modern organizations. If used correctly, financial forecasting and budgeting ensure that an organization always has enough money for the things that are most important to their short-term and long-term success.

Unfortunately, the two terms are often confused or even used interchangeably. This fluctuation is a mistake. While forecasting and budgeting are both critical to an organization’s planning process, the two differ significantly. This article summarizes the differences between the two processes.

Definition of Financial Forecasting

Financial forecasting is the process of estimating or predicting an organization’s financial future based on historical data. The main aim of a forecast is to quantify where the organization is headed over a specified period of time.

Definition of Financial Budgeting

Financial budgeting, meanwhile, refers to predicting the income and expenditure of the organization. It is the process of calculating how much an organization expects to earn in a particular period and how such earnings will be spent, keeping in mind the organization’s objectives over the budgeted period.

How Each Financial Process Works

To better understand the meaning of each process, it’s worth looking at how financial forecasts and budgets are created. Let’s begin with;

Financial forecasting

Financial forecasting involves three key steps;

1. Records gathering: Your accountant or financial management software should help you generate the financial statements needed to create a viable forecast. If you have neither, begin by taking care of that because only after your past financial statements are ready can you plan for the future.
2. Deciding how you’ll make your forecast: There are two broad categories of forecasts you can make – historical and research-based. Historical forecasting is when you primarily use your past records to plot the future. Research-based forecasts, meanwhile, involve researching broader market trends. Most organizations blend history with research when forecasting.
3. Create pro forma statements: Pro forma statements can be created using income statements, cash flow statements, the balance sheet, or any combination of the three. Whichever option you choose, the idea is to set goals and then create a schedule that will let you reach those goals.

Budgeting

The budgeting process is a little different and can be summarized into five steps;

1. Tally your income sources: Figure out how much money you bring in monthly, from sales and other sources.
2. Determine fixed costs: Fixed costs are expenses that are charged the same amount each month.
3. Add variable expenses: These are expense whose costs change from month to month.
4. Predict one-time spends: These may include retreat expenses and the cost of replacing broken machinery
5. Put it all together: Once the first four steps are completed, put everything together in a single document.

Key Differences Between the Two Financial Processes

Now that we have a better understanding of the two processes, we can more easily summarize their differences. There are five main differences between the two:

Definition

A financial forecast is the projection of financial trends and outcomes prepared based on historical data. A financial budget, meanwhile, is a statement of expected revenues and expenses over the budgeted period.

Purpose

A financial forecast quantifies upcoming business activities that express where an organization is headed over a specified period. A financial budget, meanwhile, quantifies the tactical plans that represent what the organization’s management want to achieve during the budgeted period.

Duration

Forecasts are typically created for the long-term. Although you’ll occasionally find short-term projections spanning, perhaps, a quarter, most forecasts span several years. Budgets, in comparison, span a shorter period. A typical budget covers a single financial year.

Flexibility

Financial forecasts are extremely flexible. They are regularly adjusted to vary the assumptions as well as to reflect changes in the operating environment. Budgets, on the other hand, are more static. Once prepared, a budget is only adjusted where there are changes to initial assumptions.

Application

Forecasts are strategic tools that organizations use to plan for their growth over several years. Budgets, meanwhile, are tactical tools used to manage operations over an accounting period.
It’s also worth noting that whereas a budget can be used for variance analysis of actual vs. expected results, a forecast is only a projection; it doesn’t provide any performance metrics that can be used for comparisons.

Final Thoughts on Financial Forecasting vs. Budgeting

Organizations must start taking financial forecasting and budgeting seriously. If you’re still using the two terms interchangeably or even confusing them, there’s a risk of having one but not the other. This is a dangerous precedent. You can’t have one without the other; you can’t create an effective budget without a good forecast and vice versa. You need both.