Rolling Forecasts Versus Annual Budgets

Ernesto Hontoria

(Versión en castellano)

Have you ever been trapped in the preparation of an annual budget that is being changed every few weeks and you can never wrap it up? Have you ever dreamt of completely doing away with the annual budget of the company you work with? Would you embrace the idea of replacing it by easier to do rolling forecasts? That was the main idea discussed in the IBM Finance Forum 2013. Tempting? By sure it is! The idea of erasing annual budgets from the list of activities is at least “sexy” for those of us who have suffered the preparation of never ending budgets. Replacing it by rolling forecasts, which would be continually updated throughout the year, is the equivalent of replacing a mega activity that consumes a considerable amount of effort and generates a peak of work, by a series of short routines, evenly distributed through the calendar, and focused on the critical -and more volatile- variables of the business.

Sounds good so far? Well, it gets better. In an increasingly volatile and competitive environment, annual budgets begin to look like a straightjacket when you want to give a turn to your business. For example, If you are in the middle of a fiscal year, and decide to change the pricing strategy that was envisaged in the budget, or not to launch the new product that was planned to be launched, or to postpone the opening of a new store for 6 months, waiting for more favourable conditions, the possibility of achieving the goals set in the annual budget would be seriously compromised. In a rapidly changing economic environment, with a lot of pressure from new competitors (many of them global), and with technological changes every second, it is not surprising that the budget of the company could be completely obsolete in a few months, and sometimes even, after few weeks of starting the new fiscal year.

No wonder then that the idea of ​​replacing the annual budget by a process of continuing re-forecasting the business, in order to amend estimations every time that the market conditions change, looks so appealing. Moreover when business intelligence systems and technology enable and facilitate these changes. However, it is not so simple. Its implementation involves a cultural change which affects the entire company, not just those who traditionally are involved in budgeting.

The company's annual budget is a planning tool commonly used to align business goals. Rather than to forecast the future, the budget is set like a target to be achieved. It is used as a reference to determine individual goals, and employees’ annual bonuses. Very often the annual budget is the core of the employees’ incentive plans. It is also used to control the appropriate use of funds and resources, especially in governmental and public funded institutions. The annual budget could be eliminated from the task’s list, but something needs to fulfill the role that it is playing.

At the end, we are talking about changing the Planning Cycle. One option is to move away from the old annual cycle to a new one which is continually updated. Every time that something relevant in the business changes, a new forecast is produced. According to the IBM Finance Forum’s speakers some large and famous corporations –labelled by them as leading companies- have already replaced budgets by rolling forecasts and are happy with their decision. With some scepticism, I am guessing that they have changed an old headache for a new one that seems to make more sense in the current business environment.

My own experience tells me that the annual budgets are based on assumptions that are continuously changing. Those premises change several times during the budget process forcing to produce different budget versions before “the final” one is published. Once published, the assumptions start to become obsolete as the reality very often refuses to follow our budgeting path. In this sense, having a tool that allows us to update our assumptions every time they change, producing thus a fresh projection, is definitively a step forward.

The critical issue then becomes: how to set goals to measure employees’ performance, and to award them accordingly if you have replaced the budget by rolling forecasts. Today those goals are imbedded in the annual budget. But, how to set goals if everything is constantly changing? One possible solution is to set shorter cycles and to measure employees’ performance more often, but this would require a greater administrative effort. Perhaps there is also a technological solution for this problem. Another possibility is to look for new Key Performance Indicators (KPI) to measure employees’ performance. Instead of financial indicators try to find a new ones that measure the real drivers of the business, like number of clients served, or items sold per square meter instead of annual sales, for example; or try to find indicators that will remain relevant despite changes in pricing strategy or the opening or closing of stores.

I should recognize that, at the moment of writing these lines, I am full of doubts and concerns about how the replacement of the annual budget by rolling forecasts will affect the entire annual planning cycle in its broadest sense. Especially, how it will affect the thorny issue of employee’s incentives. However, I do not hesitate to welcome new tools to break the long process of annual budgeting in favour of smaller processes continuously updated. That imposes rethinking the way we do annual budget, looking for how we can continuously update the premises on which our financial projections are based, in order to facilitate a better decision-taking process. It would mean to break the budget mega activity into a number of ongoing routines of scanning the business environment. Perhaps the annual budget could be, after all, a snap shot, a photograph taken sometime in the year of the annual projection we have at that moment, plus some kind of challenging adjustment to be achieved.

Probably is time to reconsider the entire Planning Cycle Process and to see how the opportunity to replace the budget by rolling forecast can help us to break some of the perversions created by linking employees’ incentives to the execution of an annual budget. One of these perversions is the tendency to try to achieve budget despite changes in the business environment. Following blindly the budget could be sometimes detrimental to the organization in the long run, if the assumptions on which the budget was based have significantly changed. Another perversion is the tendency to spend what is left in the budget before the fiscal year end. Not because the organization needs it, but because it will be the base for next year budget allocation. For the sake of achieving budget goals or to ensure a similar allocation of resources in coming fiscal years, managers sometimes act in detriment of their own organizations. When budget time comes it is common to see how certain numbers are inflated or deflated to facilitate achieving the goals at the year end. The annual budget becomes a push and pull game between the managers and directors of the company, each one struggling to place the bar at a height that allows them to achieve their own annual bonuses. How do the rolling forecasts break these perversions? I confess that I am still studying the issue...