Effective forecasting processes quickly identify and respond to changes in the external or internal environment and assist organisations manage gaps between targets and actual results.
The purpose of a forecast is to provide an objective and realistic assessment of likely budget results on the basis of actual trends, current assumptions, and plans. It is a periodic estimate that reflects changes and impacts actually being experienced within an organisation and within the wider community.
Forecasting is more than just an extrapolation of variances. It provides managers with the tools and information to identify underlying drivers and, as a result, likely impacts on the current year and beyond.
A budget forecast is typically prepared in circumstances where a budget-to-actual variation has been identified. Forecasts provide an updated view of the likely outcome without amending the underlying budget. However, a monthly review of forecasts is also a useful means of identifying potential budget variations that are anticipated but have not yet arisen.
With a focus on responsiveness, the planning horizon for forecasting is typically less than that of the internal budget. Some organisations focus on the current year—they finalise the annual budget, review it on a monthly basis and re-project the balance of the annual results.
Better practice organisations use a rolling planning forecast that extends beyond the current financial year, for example, a rolling horizon of six to eight quarters, adding new periods as the current period ends. Monthly or quarterly forecasts are prepared for the current year and quarterly forecasts for the next financial year. The interpretation of forecasts is more effective when the organisation has considered the phasing of the original budget for the current and next financial year.
Similar to the internal budget process, an effective forecasting process is based on:
using the same chart of accounts as budget and actuals reporting to help ensure consistency,
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although typically a simplified forecasting model would be employed by summarising and reducing the number of items comprising the forecast;
the direct capture of forecasting inputs from operational managers who are closer to operational
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activities. In this way, operational managers own and are accountable for their forecasts;
an integrated calendar which sequences budgeting, reporting and forecasting activities in a
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logical fashion; and
rigorous governance processes and control over data to ensure reliability.
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20 Under a journal-based approach, each budget change is prepared using a separate journal document. This provides an audit trail showing the full impact of each adjustment on the budgeted income statement, balance sheet and cash flow statement.
forecasts provide an updated view of the likely outcome without amending the underlying budget.
the interpretation of forecasts is more effective when the organisation has considered the phasing of the original budget for the current and next financial year.
Monitoring and evaluating budgeting performance While the analysis of comparative results for the same period in previous years assists in the
identification of trends that may affect current and forecast budget performance, a driver-based approach to forecasting is more likely to result in a forecast that reflects the current underlying nature of the organisation and the external environment.
For a forecast to be meaningful, its cycle time must be short enough that the results will be useful to management for developing contingency plans, taking corrective action and advising stakeholders.
For example, if an organisation develops forecasts on a monthly cycle, but requires two weeks to develop each forecast, the results are unlikely to be useful.
Unlike the budget, which is usually developed well in advance of the period to which it relates and requires rigorous layers of preparation, review and approval, the forecast is primarily a communication tool to support rapid and flexible decision making. However, while fast reaction underpins useful forecasting, it remains important to also focus on making reasonably accurate predictions.
It is possible to complete a forecasting process within three to five days of actuals data being available. To achieve this, it is vital that organisations:
understand that forecasting is a means of enabling them to manage the gap between budget
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estimates and actual results, rather than treating forecasting as another target-setting process;
keep modelling calculations and relationships relatively simple—so that managers understand
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the model and do not get a false sense of precision;
restrict their focus to those activities or budget elements that are material and most open to
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change (for example, discretionary costs or headcounts);
forecast account aggregates or summaries. The forecast should be consistent with, but to a
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lesser level of detail to, the original budget or the general ledger. For example, the number of forecast line items is restricted to key line items so that more time can be spent on analysis;
update the forecast on a periodic or ongoing basis, by exception, rather than through a complete
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‘bottom-up’ update; and
provide concise commentary focused on insights and trends.
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Forecasting inherently contains a degree of uncertainty. As such, the use of range forecasts (expected forecast as well as upper and lower limits), scenario planning and sensitivity analysis can assist the organisation to understand the range of potential outcomes.21
Arguably the most important element of the forecasting process is that senior management promote a culture of honest forecasting; where forecasting reflects a ‘best estimate’ of the future. Do not dwell on the quality of the original estimates when analysing forecasts, rather focus instead on what action needs to be taken.
Table 8 illustrates some of the key differences between budgeting and forecasting practices.
a driver‑based approach to forecasting is more likely to result in a forecast that reflects the current underlying nature of the organisation and the external environment.
while fast reaction underpins useful forecasting, it remains important to also focus on making reasonably accurate predictions.
Table 8: Differences between budgeting and forecasting Practice Comparison of budgeting and forecasting
Objective The objective of internal budget processes is to establish limits, set budget performance targets and allocate resources.
Whereas
The objective of forecasting is to manage gaps between budget estimates and actual results, reallocate resources and revise expected outcomes.
Considerations Key questions addressed in internal budget processes include: what are our priorities? What are our targets? What are our sources of income?
How best do we allocate resources?
Whereas
Key questions addressed in forecasting include: where are we now and why? What does this mean? What are we going to do about it? What will this achieve?
Horizon The internal budget is prepared on an annualised basis (with monthly phasing) with forward year projection.
Whereas
The forecast is prepared on a rolling basis.
Level of detail The internal budget is financial statement based (summarised for each level of management).
Whereas
The forecasting process focuses on key (summary) measures that drive the organisation.
Frequency and nature of update
Revisions of the internal budget are limited to formal updates and approved changes and are undertaken through a formal process.
Whereas
The forecast is reviewed on a regular basis and is updated as necessary.
Construction timeframe
Preparation of internal budgets spans one or more months and is generally completed in advance of the performance year.
Whereas
Preparation of forecasts should be updated within three to five days of month-end results being available. The forecast is updated throughout the performance year.
revIew and ImProve Internal budget ProCesses 4.4.
A continuous improvement culture will help ensure that the internal budget process is efficient and effective and remains relevant to the organisation’s needs and priorities. Measuring budget accuracy and timeliness on an ongoing basis and periodically conducting more formal reviews are two ways to identify areas for improvement.
Monitoring and evaluating budgeting performance