It’s early in the year and most small businesses have gone through at least one monthly financial close. For the first time during the current year, management is comparing the results to the company’s new annual budget, and the results are likely skewed in some areas. Managers are asking themselves how these variances have occurred, and what must be done to manage against this financial data.
Most companies prepare just a single budget scenario, which is their best guess of how the next year will turn out. This budget is based upon all sorts of educated assumptions and expectations. Of course, relying on any forward thinking assumptions can lead to variances and unexpected outcomes, and there usually are a number of unanticipated differences. So, though the company may spend a considerable amount of time on that “mainstream” budget scenario, just that one version will not be enough to prepare for what will probably happen. They may be better off using a rolling forecast for budget predictions.
It makes sense to add two more scenarios, one for the absolute worst case (the “doomsday” scenario), and one for the most phenomenal sales success. Often, business managers will think that it is unlikely that either case will ever happen. However, if you don’t plan for success, it never will happen, and in this economy, bankruptcy scenarios are far more frequent than we care to think of. Consequently, it is useful to know what resources a business will need for a phenomenally successful year, and how deep they will have to dig to avoid bankruptcy.
There are gaping holes between the two opposite-extreme scenarios and the mainstream version. Realistically, actual results will fall into either of those two holes, so management should spend some time figuring out what needs to be done for situations that are somewhat above and below the mainstream scenario.
Considering multiple models does not mean that a company should spend an equal amount of time on each one. The mainstream scenario requires the most work, because it is (presumably) the most likely, with less work needed for the less likely ones. The company’s management should at least spend time determining financial results at a high level for each scenario, and conceptualize what those situations will do to the company’s operations.
Should a Business Use a Rolling Forecast?
Variances between actual results and a company’s budget can occur very quickly, especially if the company’s sales backlog is only large enough to support operations for the next few months. If so, sales could change so fast that the budget will be irrelevant by the second quarter of the year, and not even bear a slight resemblance to actual results by the end of the year.
The solution is to adopt a rolling forecast are revised as soon as the financial statements are released for the preceding month. Generally, the company should drop the actual year-to-date numbers into the budget, add the revised sales forecast, and see what happens to profits. Also, the larger expense items should be adjusted to make them more representative of the actual expense experience. This will give management a budget that should be more representative of a reasonable forecast for at least the next couple of months.
Depending on the nature and size of the business, the work needed to maintain a rolling forecast may seem like an insurmountable task. However, if the company develops a simpler model that works on a higher level, a recasting of the budget should not be an excessively large chore.
The result is a budget that better reflects reality. Also, the budget can be updated without too much effort on an ongoing basis. By keeping the model simple, management can focus on the key drivers of success, rather than being bogged down too far in the details. TGG helps many of our clients develop and maintain their budgets. Call us today to get started.Written by: Steve Arman TGG Accounting