Performance Management without Traditional Budgeting

Watch out - How forecasts cause your budget to collapse!

by Wolf-Gerrit Benkendorff

If the assumptions (e.g. about customer behavior, growth, project impact), that your budget initially was based on, change during the fiscal year, then the relevance of the processes to plan and steer the business changes as well. The forecast can cause your budget to collapse partially or even completely.

Basic principle of traditional budgeting

In traditional budgeting, a plan for the subsequent year is usually elaborated in fall. This master plan is based on the best assumptions available. The budget (hereinafter referred to as the master budget) is the quantitative and thus measurable representation (in EUR, piece, minutes, percent, etc.) of this master plan.

In traditional budgeting, the master budget is the basis for financial management and control during the year: in retrospective of the past as a budget-actual comparison, and with a focus on the future as a budget-forecast comparison.

Basic principle of forecasting

A forecast describes the anticipated future outcome based on current assumptions. Forecasts can best be described by means of probabilities. This shows that the future is unknown and that a wide range of future outcomes can occur.

In contrast to this, a plan is a statement of intent and describes how the future shall be shaped. That is why a plan cannot be described by means of probabilities. Either the plan provides for e.g. a new marketing campaign or not.

Interaction of forecasting and planning

The difference between a forecast and a plan becomes evident in the forecast process. Theoretically, a forecast process can be divided in three steps.

Step 1: Creating the forecast: Which future outcomes are anticipated, based on the current assumptions?

Step 2: Establishing corrective measures: Does the forecast display future outcomes which are not satisfactory? In this case, corrective measures shall prevent that the forecast in step 1 becomes reality.

Step 3: Adjustment of the current plan: current plan + corrective measures = adjusted plan.

Only step 1 is a forecast. The steps 2 and 3 are planning activities. Unfortunately, in practice only step 3 is often referred to as a forecast and is presented to the management. In that case, the management loses significant information:

  • How large is the expected target gap? (Step 1)
  • How great is the risk of us not achieving our initial targets? The larger the target gap, the greater the risk. This also applies if we assume that we can completely close the target gap by means of corrective measures.

The interaction of plan update and master budget

If the initial assumptions change during a fiscal year, then the forecast (Step 1) reveals a target gap. Corrective measures (Step 2) lead to an adjustment of the (master) plan, e.g. additional marketing measures, recruitment freeze, postponement of investments (Step 3).

While the (master) plan is adjusted, the master budget – as its quantitative representation – remains unchanged. Plan and master budget are decoupled. This will strongly limit the usability of the master budget for steering the business. To give you an example: with an additional marketing measure, the exceeded marketing costs from the marketing budget have now become positive news. This is a situation that needs to be pointed out anew each month in the report annotation.

Often, the decoupling of master plan and master budget takes place in the second half of the year. At that point the initial assumptions are at least 9 months old.

How forecasts cause your budget to collapse

So, what do I mean by a partial or complete collapse of the budget caused by forecasts?

In a partial collapse the initial target remains unchanged. With corrective measures, we try to close the target gap that was identified by the forecast. An adjusted plan is elaborated. The master budget still represents the correct (since unchanged) target – however, the path to the target is now an obsolete plan, because it does not reflect the additional corrective measures.

In a complete collapse the initial target is dropped as well. The target gap cannot even be closed by extensive corrective measures. That means, we have a new target: “What are we able to achieve in the remaining time?” and a new plan for that: “How do we achieve this?” In this case, the master budget is twice as obsolete. It represents an outdated plan that leads to an outdated target.