Why is budget forecasting important?

By Indeed Editorial TeamUpdated January 31, 2022 | Published March 22, 2021Updated January 31, 2022Published March 22, 2021In the business world, it's common to hear words like bud

Why is budget forecasting important?

By Indeed Editorial Team

Updated January 31, 2022 | Published March 22, 2021

Updated January 31, 2022

Published March 22, 2021

In the business world, it's common to hear words like budget, forecast and projection. These financial terms are types of predictions about a company's future financial conditions and goals. Budget projection is a valuable business tool that helps with informed decision making at any level of a business. In this article, we discuss what a budget projection is, why it's important and how to prepare a budget projection.

What is a budget projection?

A budget projection analyzes qualitativeand quantitative data to develop a long-term prediction of estimated future financial results. A company's financial planning and analysis team typically creates the financial budget projection. They perform rigorous analysis on all the available financial data and combine those results with insight from executives and analysts, market trends, and other sources and experts. Companies use budget projections at almost every level of the organization, from sales projections to granular forecasting of a specific product to the overall finances of the entire company.

Some financial terms that can help you understand budget forecasting include:

  • Budget: A budget is an estimate over a specific current time period of revenues, costs and resources reflecting future financial goals and conditions.
  • Budget forecast: This is a short-term estimate (one to four quarters out) of financial goals and conditions using quantitative data.
  • Budget projection: A budget projection is a long-term estimate (one or more years) of financial goals and conditions using qualitative and quantitative data.

While these definitions have subtle differences, it's common in normal dialogue to use these terms interchangeably. There are also variations in their namesfor example, "financial budget" and "financial projection" are the same as "budget forecast" and "budget projection." The word "budget" has an association with existing companies who have stable year-to-year finances, while the word "projection" has an association with startup or quickly growing companies who have rapidly changing finances.

It's helpful to know the language and definitions that your company prefers, as this brings clarity and consistency to any communications and records about financial planning.

Related: Forecast vs. Budget: Differences and Steps To Forecast Budget

Why is a budget projection important?

The budget projection is a tool that supports financial decision making, business strategy and tactical changes. The ability to estimate and predict future financial results, like goals and conditions, can inform executives and stakeholders about where to invest, what to prepare for and what choices to make. The process of creating a budget projection is also important, as it allows a company to assess its current, past and future financial situation.

Some more reasons why a budget projection is important include:

  • Turns goals into targets: A budget projection isn't just a predictionit is also a commitment to hit specific targets, gauge progress and have a successful outcome.
  • Feedback and control tool: When there are variances in the budget projection, it provides companies with a warning, a framework for determining the effects of actions and the opportunity to correct those actions.
  • Anticipates problems: A budget projection allows companies to anticipate potential problems, like when rapid growth causes a cash flow shortage or changes in projection if they do not meet a milestone.
  • Benchmark: Companies can use a budget projection as a benchmark tool that helps them measure their progress from one time period to the next and against past and current goals, helping them to manage their money better.

Related: Budgeting Report: Definition, Template and Examples

How to prepare a budget projection

Each budget projection is specific to the company it's created for and that company's specific goals. Companies use distinct sets of data and different forecasting methods depending whether they're preparing a budget projection for sales revenue in a specific region, for reoccurring costs of a specific department or for the overall net income for the entire company.

Although budget projection on a practical level is unique, here are the steps to prepare a budget projection on a conceptual level:

1. Define assumptions

Every forecasting and projection method makes assumptions, and those assumptions affect the method and results. Common projection assumptions include using historical data and assuming that data will be similar in the future or assuming there will be no external factors that will change the data. When a company defines its assumptions, it can create a common understanding of the projection goals and process.

Here are some key questions to ask when defining assumptions:

  • What is the timeline for the projection?
  • What goal is the projection meeting?
  • What are the legal issues connected to the projection?
  • What are the expenditure and revenue categories?

2. Gather information

Professionals use a combination of qualitative data, like insight from expert individuals, and quantitative data, like historical and statistical data, to support the projection process. Unlike forecasting methods that strictly use quantitative data, projections include qualitative data to increase knowledge about forces that affect the projection results.

For example, department leaders may have insight about activities that could disrupt their operating environment, or senior administrators may have insight into how long-term planning efforts could change the fiscal environment. Both quantitative and qualitative data are important because they allow for more nuanced and accurate projections.

Related: What Are Quantitative Forecasts?

3. Perform analysis

A quality projection includes both relevant economic conditions and an examination of historical data. This provides a better understanding of which quantitative techniques to use and when to use them, and it also helps determine patterns and trends. Evidence that helps with the analysis process includes:

  • Relationships: Look for important relationships between variables that can aid in forecasting and projection.
  • Outliers: Look for outliers or anomalies that need an explanation since they don't help with the predictive power of the data.
  • Trends: Look for demographic trends to see if population changes are influencing revenue or service demands.
  • Cycles: Look for business cycles that vary revenue and determine if they are independent or due to levels of economic activity.

4. Select methods

There are many types of forecasting and projection methods that a company can use. Each method has a unique purpose, and a company may use multiple methods for multiple purposes. Some of the more complex methods may result in slightly more accurate data, but simpler techniques require less data, take less effort and require less expertise. The three most common methods are:

Extrapolation

Extrapolation predicts future behavior by using historical data and projecting the trend forward. The trending method is simple to use, and the moving averages method and single exponential method are more complex but still easy to use for someone with forecasting and projection experience.

Regression

Regression is a statistical procedure that defines the relationship between dependent and independent variables. You can change one or more independent variables to predict future expenditures or revenues, assuming a linear relationship between the dependent and independent variable.

Hybrid

Hybrid uses both qualitative and quantitative data. It uses the knowledge and intuition of the professional doing the projection in addition to data and statistics. It is a very common method and can produce exceptional results.

5. Implement methods

Once you choose a method, it's time to make the projection. A common practice is to develop a range of outcomes by using multiple scenarios. Multiple projections help to inform and assist decision makers with thorough and compelling data. A good projection should have a credible presenter so the audience trusts the information, a clear message with a data-supported statement.

Video liên quan