For more business planning, budgeting and forecasting advice read the AFP Guide to Implementing a Rolling Forecast.
The planning, budgeting and forecasting (PBF) process for organizations is a finance department function that is time consuming, often misunderstood, and generally disliked. So, why is it needed and what is it supposed to accomplish? The answer varies depending on who you are talking to, the size and type of organization they work for, and to what aspect of PBF you are referring to.
The PBF process is actually three unique sets of business activities often grouped together:
Planning provides the overall venue and process for stating the direction and financial objectives of an organization. Most companies put together an annual plan that is part of the larger strategic plan of the company, usually covering three to five years. This is where the senior executives lay out their vision for what is possible.
The overall planning picture commonly is comprised of three main components:
Strategic Plans: Set overall long-range goals and objectives. Often, both are qualitative and quantitative in nature.
Long-Range Plans: Typically set financial targets over a three to 10-year horizon—the quantified financial plan for the strategic plan above.
Annual Plans: This is the first year of the long-range plan and provides the high level targets to guide the budget.
Budgeting supplies the execution path for the plans with a detailed, operational and short-term view. Whereas planning provides “what is possible,” budgets outline “what is expected” from the business, based on the approved annual plan.
The budgeting process is broadly focused on the following major components:
- Sales/Gross Margin Budgets
- Capital Expenditure Budgets
- Headcount Budgets
- Operating Expense Budgets.
Forecasts typically use actual performance data to project the remainder of the current year’s performance (rolling forecasts are the same concept but reset expectations for some predefined future period, usually 12 to 18 months). Forecasts are focused on what is happening from a revenue and income statement perspective.
There are three general forecasting methodologies:
Top-Down Forecasting: Primarily focused on current demand and operational conditions translated into revenue predictions.
Bottoms-Up Forecasting: Rely on business managers to enter current and specific line item details per the revenue budget.
Hybrid: A combination of the above two methodologies, e.g., a tops-down focus coupled with a bottoms-up proportional allocation.
As you can see, the processes are related but they are also distinctly different. Recognizing this is part of understanding the overall purpose behind the general process and what types of improvement opportunities exist. In fact, there are significant points of view and multiple studies that outline all the various issues with the overall PBF process; however, few have tried to answer the most important question: What is the main purpose of the PBF process?
Proper financial planning demonstrates the effects of the operational plan components on cash flow and overall financial position. Key characteristics of a financial plan include:
- Ability to easily produce a complete set of fully-integrated, relationship-based financial statements that provide the comprehensive picture of financial objectives.
- Ability to test the sensitivity of various condition assumptions across the full financials.
- Ability to quickly and accurately gauge the working capital impacts of the operating activities.
Three PBF process components defined:
Strategic Planning: A component of the planning use case in the original PBF breakdown. The strategic planning process quantifies the vision of the company and helps management determines what is possible. Information is at a very high level, is driver and scenario-focused, incorporates full financial statement impacts and produces the long-range plan. Analysis is most powerful here when external drivers are included at the higher levels (i.e. Long-Range or Strategic Plan levels) and the lower levels (i.e. Budgets or Operational Plans) are integrated to shape the outputs.
Financial Planning: Has a role in building the budget and the forecast and in general terms, is the top-down version of the budget. The output from the financial plan is the input to the operational plan. Scenario analysis, stress testing, working capital analysis and re-forecasting of the full financial statements are the key use cases.
Operational Planning: The B in PBF and focuses on what is expected while highlighting the accountability in the detailed cost structure. The operational plan is also the basis for the allocation of the top-down financial plans and is at the lowest level of detail.
Why is there generally so little focus on improved financial planning and/or having a financial planning process integrated with the overall PBF process? The answer is that financial planning is difficult and requires unique insight on how the enterprise generates cash flow. Adding to the complexity, most packaged software applications help to gain efficiencies in the PBF components but are not addressing the financial planning attributes. And maintaining the required financial relationships within a spreadsheet-centric environment is incredibly cumbersome with a high risk of error.
The ideal PBF system incorporates financial planning and will:
Ensure that the Strategic and/or Long-range Plans focus on integrated scenario analysis. The ability to stress-test plans and run multiple financial and operational what-if cases will provide unique insight to what is possible as well as better forecast what is expected.
Effectively balance top-down and bottom-up points of view and forecasting methodologies. Top-down projections apply a more centralized view and can include many influencing factors including market data, economic indicators and general product and customer trends. Bottom-up projections are accumulated from many contributors and are more inward-focused.
Produce more than a great income statement. The financial impacts of the operational plans are best analyzed with integrated balance sheet and cash flow statements.
So, what is the primary point of the planning, budgeting and forecasting process?
An optimized PBF process should provide an effective system of checks and balances on possible and expected performance from top to bottom and from immediate to long-term. It should also let management know in advance how much capital they will need and when they will need it.
Jeff Radtke is managing director at Huron Consulting Group.