You’re six months into your year. Every budget-to-actual report is a litany of variances that show your company lacks the gift of prophecy. Things are not turning out like you budgeted six months ago. There have been some big surprises in the economy and from your competitors. Internal project timelines have changed.
And yet, staff are continuing to spend their budget allocations as planned. Some sales staff are assured of hitting their budget target and are now coasting. They may even be shifting sales into next year. Many people won’t think about the business environment’s implications until the next budgeting cycle.
The scenario I just described is why some companies have switched to rolling budgets. Rolling budgets are also known as rolling forecasts and continuous budgeting. Some may say each is slightly different, but I’ll use the phrases interchangeably in this lesson.
For some people, continuous budgeting may be too traumatic a term to use, especially when trying to convince others to switch to this method. If you get through the budget season by telling yourself the pain will someday be over, what hope do you have when budgeting becomes continuous?
I’ll compare a completely static annual budget to rolling budgets for simplification. In practice, companies can choose from a spectrum. One end of the spectrum is sticking to a completely static budget with no changes. The other end of the spectrum is re-forecasting all amounts every month or quarter. Some companies at this end of the spectrum don’t create a traditional budget; they constantly plan from rolling forecasts.
A popular hybrid approach is to create a budget at the beginning of the fiscal year and then “re-budget” halfway through the year using an updated forecast. Many companies take some ideas from rolling budgets to improve a completely static budgeting process.
Rolling budgets don’t have to entail changes to everything in every forecast cycle. Senior leaders could decide to have departments change their current budgets very little or very much. The amount of change can be different for each cycle.
Sometimes, little has changed in the business environment from the prior period, so change is disruptive. Other times, the company must make drastic changes to adapt to the business environment.
Budgeting vs. Forecasting
Are a budget and a forecast the same thing? Let’s revisit the AICPA (America Institute of Certified Public Accountants) definition of a forecast. A forecast “is based on the responsible party’s assumptions reflecting the conditions it expects to exist and the course of action it expects to take.” This sounds conceptually like what we want in a budget, but budgets are heavily influenced by company politics. Budget targets are compromises, especially if they are used to set incentive compensation payouts.
Companies must decouple compensation from the forecasts to improve accuracy. This prevents much of the gamesmanship in budgeting.
Sometimes, budgets are very aspirational. This can occur with a visionary CEO or board that wants to stretch the company. Forecasts may not factor in the stretch goals.
The budgeting process includes many people and compiles large amounts of detailed information. Fewer people work together on a forecast, and the data is often at a much higher level.
Forecasts created soon after a full budgeting process may be strongly influenced by the budget. Over time, trendlines and new analyses replace the budget assumptions.
What Are Rolling Forecasts?
A “rolling” forecast is one that’s updated periodically. Popular update frequencies are monthly or quarterly. For example, a forecast developed in December would be for January through December of the following year. Then in March, a forecast would be developed for April of that year to March of the following year. Each quarter a new forecast is made for twelve months into the future.
The decision to update a forecast may be event driven rather than on a time schedule. A significant business environment change or an internal change could trigger a reforecast. Any change to a major assumption in a current forecast should trigger a reforecast.
The forecast is developed by a smaller group of people than a large annual budgeting process. Not all line items or centers may be analyzed and updated. You may decide to only update significant items or update items on a rotating basis.
The rolling forecast could just be for the remainder of the year to anticipate annual performance. This is useful for accruing expected bonuses, profit share, or incentive comp.
Often, the forecast is for a constant period into the future. Forecasts are often done for one to two years into the future, depending on how much change is anticipated in forecast assumptions. Longer forecasts can be made if little change is expected in the business environment, internal operations, or business strategy.
Types of Forecasts
New forecasts can be anything from small changes to the last forecast to a major reforecast of almost everything. Here are some options:
- Trend analysis: This is the simplest way to forecast. Past trendlines are just extrapolated into the future. The forecast does not reflect current or future items that could cause future results to deviate from past trends.
- Projections and forecasting: A full reforecast would reassess all major assumptions from the past forecast. The forecast includes all new knowledge and strategies that were unknown at the time of the last forecast. Alternate projections may be made to decide which is the most likely to occur and be used as the forecast.
- Budget adjusted for expected large variances: A company may decide to only update items from the last budget or forecast that are widely deviating from current performance. The goal isn’t to make the forecast match current performance more closely. Instead, management can assess what’s driving current performance and what they want to change to improve performance. The forecast would then start with current performance and then show improving performance over time in the forecast. The reforecast may show worstening performance if business conditions have deteriorated. The forecast should show better performance than a projection that assumes management takes no action.
- Hybrid of detailed and summary forecasts: Some companies prepare a detailed forecast for the near term and a high-level forecast for periods further into the future. A company could prepare a detailed monthly forecast for the next quarter and a summarized forecast for the next three quarters. This pairs detailed planning for operational decisions with longer-term considerations for strategic planning. I’ve also used this hybrid approach for cash flow planning. Near-term cash flows are much easier to estimate than cash flows further into the future.
What to do with variance reporting?
Should budget-to-actual reporting continue to be based on the original annual budget, or should the “budget” amounts be updated with the new forecast amounts? Different companies choose different answers to this.
Some companies do not change the budget in the accounting system throughout the year. This choice fits companies that base incentive compensation on the budgeted targets set at the beginning of the year. These companies may still prepare forecasts for their current planning. Forecasts replace the budget in management meetings and are used for decision-making.
Other companies update the budget amounts in their accounting system with the most recent forecast. To do this, the forecast should have a level of detail similar to the budget it’s replacing. A forecast may need to be developed for each expense line item for each department. However, the level of analysis done in the forecast may be less than the budget.
If a company decides to “re-budget” mid-year, the budget amounts for July to December may be from the “re-budget” and not the original budget.
A company that does quarterly forecasting may update its budgeted amounts every quarter. January to March variances are based on the original budget or a forecast done by the start of January. April to June variances are based on an April to June forecast that’s done by the start of April.
In this quarterly example, the year-to-date sum of the variances at year end is a collection of different forecasts against actual results. It’s like the annual budget was built via four forecasts over the year.
Benefits of Rolling Forecasts
There are many benefits to doing rolling forecasts in addition to traditional budgets or in place of traditional budgets.
Constantly looking further out into the future
The budget ends at a fixed point in the future. The number of months left in the budget gets shorter each month during the year. This can cause the short-term focus I described at the start of this lesson. People may be only thinking about what they need to do to hit their desired performance for this budget year. You want them focused on constantly improving performance. If this has been a good year, they may even push some sales into the next budget year to “get a head start” on their incentive compensation for next year. Rolling forecasts promote continuous improvement. However, rolling forecasts could cause a shorter-term focus, which I’ll cover later.
Forecasting forces a reassessment of the business environment. Some managers focus on internal operations and only think more strategically during budgeting. The forecast helps these managers identify opportunities and challenges as they emerge. Updated information is constantly being gathered and integrated into financial planning.
Improved resource reallocation during the year
Budgeting forces prioritization of projects to allocate scarce resources. Priorities may change during the year. Forecasting helps identify this and facilitates resource allocation to match the updated prioritization.
Better management of revenues and expenses throughout the year
Revenues and expenses are often managed independently of each other throughout the year. Revenues are very hard to accurately forecast. That budget is sent to salespeople. Expenses are much easier to forecast. Those budgets are sent to many different cost centers, teams, or departments. Behaviorally, those cost centers see their budget allocation as their right the minute the budget is approved. Taking that pot of money away later is hard. It’s perceived as a breach of contract. What happens when revenues run below budget? Some companies don’t try to tell cost centers to delay or cut expenses, causing profits to dip. Rolling forecasts allow managers to adjust expense allocations to match the updated revenue projections.
It can be used for cash flow planning
Cash flow planning is often done at a detailed level for short periods of time. Continually updated accurate forecasts can be used for cash flow planning. Constantly updated rolling projections can be used for higher-level strategic cash flow planning.
More meaningful variance reporting
Replacing budget amounts with recent forecasts eliminates variance reporting based on old inaccurate guesses. Variances based on outdated information create “noise” that’s ignored by readers of budget reports. Those report users may also be ignoring other important information that’s still in the reports. The improved relevance of the budget variance reports maintains their effectiveness. Managers stay in the habit of reading the reports throughout the year.
Can make changes when the company is ready
It takes time for businesses to perceive, acknowledge, and act upon changes in the business environment. There is a lag between when the environment changes and when businesses are culturally ready to respond. The business environment change may need to reach a certain level before a company is willing to deal with it. Frequent forecasting cycles help management through the perception phase. Each cycle is an opportunity to enact a strategy that may be long overdue.
Challenges of Rolling Forecasts
Rolling forecasts have many benefits, but they won’t solve all your problems. They may create some new challenges for you. Below are some challenges you may face.
May reduce the planning horizon
If a budget is updated every quarter, how much effort will managers put into their projections for months 4–12? Will detailed 12-month planning disappear under rolling budgets? I know one company that switched to rolling budgets and found that managers kept looking only three months into the future. They knew they could replace their projection for months 4–12 at the next quarterly reforecast. The quality of the projections for months 4–12 may decrease under rolling budgets. The projection horizon may cause managers to always focus on the short-term. Ironically, they may do long-term strategic planning less than with traditional budgets.
What to do with annual KPIs and incentive plans?
Many companies base incentive compensation and annual key performance indicators (KPIs) on the annual budget. A great deal of negotiation goes into setting the targets for both. Should these targets be renegotiated and reset every quarter with the updated forecast? Some companies will stick with their original targets for the year. Others may move to a performance management system built for more frequent cycles, like objectives and key results (OKRs). Some companies may switch from basing compensation on budget targets to profit-sharing plans or other factors.
It might be more resource-intensive
Adding rolling forecasts to the grueling budget season may push managers past their financial analysis limit. That’s one reason why a company may replace budgeting with rolling forecasts. Rolling forecasts require more flexible planning and reporting systems than budgeting. For example, will Accounting staff put the new budgets into the current accounting software for every update of the forecast? Frequent forecasts require more Finance staff time for gathering info, running numbers, reporting, and communicating forecasts. Implementing rolling forecasts also requires a large amount of training.
It might cause the forecasts to be Finance-generated
The annual budget is often performed with broad representation from throughout the company. Rapid, repeated cycles may preclude having large groups of people involved in forecasting. This can be mitigated by good information flow up and down across the company. This allows those setting forecasts to represent those not present for forecast discussions.
More accurate forecasts may come at the expense of other analysis
Limited financial analysis time is focused on repeated forecasts rather than more scenarios, sensitivity analysis, and projections. It also may also take away from strategic planning and profitability analysis.
Your company may not be culturally ready for constant budget changes
Some managers and staff aren’t culturally comfortable with constant change. Static budgets give the impression that much can be fixed for months at a time. Many have gotten used to managing a budget allocation carefully over those months. Some people will find it hard to make long-term plans for their departments when they feel their budgets are constantly in flux.
Who benefits most from rolling budgets?
Rolling forecasts are more appropriate for some types of companies and some situations, including:
- Rapidly changing companies
- Startups and early-stage companiesCompanies going through a restructuring
- Companies in dynamic business environments
- Companies facing large uncertainty about the future
- Larger companies with a small group of people from across the company tasked with forecasting
- Companies with good processes for information flow up and down across the company
- Companies using rapid-cycle goal setting, like OKRs
- Companies that don’t need annual budgets for compensation or company performance evaluation
- Companies that have clearly identified the drivers of their performance
- Companies culturally comfortable with constant change
Check out my Better Budgeting course to get step-by-step guidance on how to improve your business’s budget. Save time and stress while putting together the pieces for a profitable future.
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