I’ve been asked a few times about the differences between forecasting and budgeting, as many people understandably think they are the same thing. In some cases, they may be close to the same thing, but there are really some nuances between the two that make them distinctly difference. Here, I’ll try to go over a simple definition of each and then point out the differences between forecasting and budgeting.
What is Budgeting
Budgeting is a method of categorizing, organizing and analyzing historical income and expenses in order to maximize potential profit. In a business, a budget is created by analyzing historical expenses and matching them to revenue. In a personal or household budget, one matches their salary or wages to their living expenses to arrive at a net surplus or deficit. In both cases, historical data is used to create a budget for the future.
In a business, a budget is created for the next month, quarter or fiscal year based on the historical results but that includes any changes in future business plans. These budgets are then analyzed by the finance department and an attempt is made to keep the expenses as low as possible. The expenses are then allocated across departments to create departmental budgets. With a set budget, each department is held accountable to staying on track with their budget. Many departments only have expenses and no revenues, so revenues from the entire company are often allocated across departments to create a department profit and loss statement. While this is an example of how budgets are used in the corporate world, each company’s use of budgets varies dramatically, as well as what they refer to their budget. Some call them financial plans, operating budgets, corporate budgets, and so on. A corporate budget is typically used to control expenses in the hopes of maximizing profit.
In a personal budget, an individual or family analyzes their monthly spending and categorizes it into discretionary and non-discretionary expenditures. In a personal budget, the end goal is to reduce your spending and increase your monthly savings. Many people have trouble controlling their finances so they create a budget that accurately tells them where their money is being spent. For people that are in debt, they want to find a way to lower their expenses so that their monthly budget has a surplus that can help pay down the debt and get them in a better financial position. While personal budgets can extend forward in time, they typically are used to create a budget rate that can be monitored over time and that will lead to better control of their finances.
What is Forecasting
Forecasting is a way of using historical data and future business plans to forecast the future. In a forecast, one predicts the future profitability. While forecasting can be done on a personal basis, most forecasts are created by businesses to predict their revenue, expenses and income. Individual forecasts are typically completed for company sales. These forecasts often assume different scenarios, which leads to numerous different company forecasts. These forecasts can vary dramatically based on their assumptions. A true forecast is not a single number, but a widespread scenario analysis that then uses probability factors to create a company wide business forecast.
Forecasts are typically done on revenues first. Then, the revenue forecasts are used to determine the expense forecasts. Expenses change based on revenues (variable costs) so it is important that an expense forecast is based on the finalized revenue forecast. Forecasts are typically updated as actual revenue and expense information is updated, so that a typical forecast is almost always a work in progress, at least internally for a company. External forecasts are sometimes given by public companies that are used by stock analysts and investors to help value a company. Overall, forecasting is an iterative process that recieves input from all departments of a company and combines the outlooks to determine the company’ forecast.
The Differences Between Forecasting and Budgeting
While budgeting and forecasting are definitely related, the primary difference between budgeting and forecasting is that one is used to predict the future and the other is used to control expenses. Forecasting uses historical data and scenario analysis to predict the financial situation of a company in the future. The forecast that comes from this process is typically used to create a corporate budget. The two processes are definitely related because a good budget relies on a detailed forecast. Furthermore, a good forecast relies on a thorough analysis of historical expenses and revenue. Therefore, you could say that while being quite different, a forecast and budget are also part of the same overall process of keeping a company’s finances in order.
In conclusion, while being very similar in many ways, a forecast and budget are really created for different purposes. While a forecast is all about predicting the future, a budget is all about controlling expenses and allocating them across departments or expense categories.